I am currently short REITs by owning a large swack of the ProShares UltraShort REIT fund, ticker SRS. It is my largest exposure by far. I have been short REITs since early in the year and have been peeling off my position as the trusts have fallen in price. We may get a bounce into year end - that's how I would be playing it if I were trading - but I think eventually, the SRS will hit $135. At that point, I intend to be more aggressive covering my short position.
However, REITs could fall even further. Want to know why? Read about the mess in the CMBS market.
Let's make it clear up front: The commercial-real-estate blowup—while ugly—won't be as bad as the current housing crisis. It's a smaller market, and any single property often has a diversified group of tenants with different sources of income. The supply of buildings didn't increase dramatically over the past several years, as in residential real estate. And the losses won't be as severe, because many commercial spaces can be refashioned for new occupants.
But there will be trouble, in part because of the rise of the untested commercial-real-estate structured-finance market. Just as with residential mortgages, Wall Street banks package commercial-real-estate loans, slicing them up into tranches according to risk and parceling them out to a range of investors. In 1995, $15.7 billion worth of commercial-mortgage-backed securities were issued. Through the third quarter of 2007, $196.9 billion was issued, according to Commercial Mortgage Alert, a trade publication. ...
Amid the tall office spires of America's cities, big-money pros have simply been playing a game of greater fool, trying to bring in huge returns with borrowed money and sell out before the arrival of the crash they knew was coming. And in this case, the fools won't just be famous developers. Some of the same banks and Wall Street firms now entangled in the subprime residential crisis will also be caught in the mess. The commercial-real-estate meltdown will be a market failure, pure and simple. We will be able to look at the wreckage in the next several years with wonder and awe, untroubled this time by sympathy for those left holding the bag.
Here's what we know about what happened in commercial real estate: Lending standards fell, starkly. Or as I prefer to see it, they were thrown out of the 60th-floor window of that gleaming office tower in downtown Atlanta/Phoenix/New York/San Francisco/insert your city here. The gap between the cost of debt servicing and the cash actually being generated by the buildings narrowed. What's more, it used to be that banks made loans for no more than 80 percent of the value of a property to ensure a healthy cushion of protection, but by the early part of 2007, loans were sometimes made for 120 percent of a property's value. Who would be so crazy as to lend more than a property is worth? Anyone who believes in perpetual-motion machines—that is, that rents and underlying property values must always go up. ...
Lending standards had been loosening across the industry for years. Standard & Poor's and Moody's both voiced early concerns in late 2004 and the beginning of 2005. Sure, "supply and demand is in balance, but that's not a license to loan more money against a given cash flow," says Tad Philipp, Moody's managing director of commercial-mortgage finance. "What we were seeing was riskier and riskier loans, and the loans got riskier still. And we are just past the top of the cycle." ...
Despite their misgivings, the ratings agencies kept slapping seals of approval on commercial-real-estate structures. Just as they did when rating securities containing residential mortgages, the agencies relied heavily on recent historical data, which were misleading. ...
[I]n the early part of the decade, commercial-mortgage-backed-securities deals rarely had any one loan that was so big it dominated the pool. But in recent years, the top 15 loans in a 200-loan pool could make up 40 to 65 percent of the pool's total value. In the old days, any single default wouldn't hurt a structure disproportionately. That's no longer true. Investors and ratings agencies haven't fully appreciated how hairy these structures have become ....
In recent months, as real estate developers have scrambled for funding from lenders, a standoff has developed. The banks haven't been able to find buyers for structured financial products. At some point, the banks will have to come down in price, and then they will take losses, just as they have with leveraged loans made to corporations being taken over by private equity. Since the losses haven't happened yet and since we've reached the end of a very good year in commercial real estate, Wall Street is understandably reluctant to face reality. Why take losses that will eat into this year's bonuses if you can take the losses next year, when, as everyone knows, the market will be bad?
We've seen this throughout the financial markets in 2007. This has been the season of see no evil, hear no evil, speak no evil—until you absolutely have to. But you can't hold off losses forever, as the huge write-offs at banks have demonstrated.
And a follow-on question.
Q: Clearly demand for commercial mortgage-backed securities has plunged, and there's no almost no liquidity at all in the commercial-property sector. But I'm interested: do you think this is a liquidity problem or a solvency problem? Many of the office-building purchasers were happy with debt service payments greater than cashflows, on the grounds that tenants were paying below-market rates and that cashflows would improve substantially when leases expired. Do you think that such faith was misplaced? Do you think that rents will go down rather than up? And is there any evidence of that happening yet?
A: You are certainly right that for now, the commercial market is facing a liquidity problem now and not a solvency problem. Delinquencies have risen off the lows of earlier this year, but not much. ...
The problems with the residential market didn't start because of oversupply, but because of bad loans -- loans made to borrowers who depended on refinancing and price appreciation to afford their loan payments. The "values' in the "loan-to-value" ratios that lenders used were falsely high, in both residential and commercial. The problems in the housing market started before prices went down; all it took was for prices to flatten and the subprime borrowers who had 2/28 mortgages couldn't refinance and couldn't afford their loans. That's pretty extraordinary.
So, I foresee similar things happening in the commercial real estate market. Borrowers depended on above-normal increases -- in rents or appreciation -- to afford their loans. Values rose to nosebleed levels and lending standards dropped. Both borrowers and lenders made assumptions about future cash flows and appreciation that were unsustainable. If rents merely fail to continue to rise, many borrowers will have problems, I suspect. ...
Also, it's worth noting that around 80% of commercial loans were interest only in recent periods, about double from four years ago. In the first quarter, 90% were IO. So these borrowers are going to be highly vulnerable to liquidity issues. Of course, the Fed rate cuts would help in that instance, if the lending rates follow. But if the banks and CMBS investors are being hit elsewhere, perhaps they won't be interested in commercial real estate loans and securities.
Moreover, prices in commercial real estate are already falling. Brian Fitzgerald of Wachovia estimated that prices had already fallen around 5% to 10% in major markets by late fall. That will accelerate, I am guessing.
Great call on SRS! Got there in quickly eh? New target?
Posted by: David | January 09, 2008 at 06:12 PM