Experts Turning Pessimistic about CRE Property

Are commercial real estate prices on the way down, adding additional surveillance effort for servicers? Certainly, they are not going up as fast as they were during the peak of the cycle in the last couple of years, when, for instance, Sam Zell sold Equity Office Properties to Blackstone Real Estate Partners, who immediately turned around and sold the EOP properties piecemeal. This sort of speculation has caught up with at least one of the buyers of these properties, Harry Macklowe, who is reportedly finding it difficult to refinance short term borrowings on these properties into longer term financing as the real estate capital markets have tightened up.

Other reasons are also being cited in the industry as to why commercial real estate prices are going down, ranging from a rise in capitalization rates, as risk gets reassessed, to shorting of the CMBX index by hedge funds. At a recent industry convention, industry participants even said that the CMBX which was expected to provide transparency and benefit the industry has turned into a de facto pricing tool that is reflecting the narrow moves of these hedge funds, rather than broader market fundamentals, causing some participants to question whether the introduction of the CMBX is turning out to be a good move for the industry.

As well, there are fears about a recession, which could turn out to be a self-fulfilling prophecy at a time when economic performance has been dragged down by the housing sector.

In a recent teleconference on the outlook for commercial real estate, JPMorgan analysts said that commercial real estate prices in the United States are likely to decline 10% to 20% during the course of an ongoing downcycle. Margaret Cannella, JPMorgan's head of global credit research, noted that while there will not be a state of crisis in the commercial real estate sector similar to the one seen in the early '90s, investors may nevertheless see a little pain.

Alan Todd an analyst in the Wall Street firm's global structured finance research group, expects loss of about $120 billion, representing about 4% of the $3.2 trillion in commercial real estate debt outstanding. He expects about $40 billion of this loss to be borne by investors in collateralized debt obligation avenues, and about $60 billion by balance sheet lenders. Commercial mortgages coming due for refinancing are likely to face problems due to declining property values and less prospects for rent growth.

Marc Levinson, a JPMorgan economist, said that there has been more discipline in this cycle than usual. While a decline in prices and a contraction in activity is likely, a lack of overbuilding will also limit the downside this time around.

The area of biggest concern, in terms of different property types, for Mr. Levinson is the lodging sector. Construction activity in this area was weak for a while and then "went gangbusters." This means that supply of lodging properties is likely to outstrip demand.

For the commercial real estate sector as a whole, an "impending decline" in property values is buffered by a healthy supply situation and a lack of speculative excess during the upcycle, which will limit the downside during the downcycle.

Two major credit rating agencies also recently reported on commercial real estate prices. Commercial real estate prices were down 1.5% in December, compared to a decline of 0.2% in November, making for a second consecutive monthly decline, Moody's Investors Service reports.

And Standard & Poor's reports, based on indices it maintains with GRA, that nationally commercial real estate prices were up 4.9% in November, compared to November 2006. However, S&P believes that while nationally "annual returns flattened, it would be premature to assume that this indicates an end to the deceleration in commercial real estate prices seen in prior months, and visible in both the sector and regional indices."

In a related surveillance teleconference, Tad Philipp, a Moody's managing director, said that Moody's expects commercial real estate prices to fall 15% to 20%, cutting into the "liquidity bubble" of the last few years.

While seasoned, fixed rate deals from earlier years have a big cushion of equity built up, it is the floating rate loans supporting the later deals that are more at risk.

Commercial real estate is better positioned to weather such a decline than it was in the 1990 to 1991 downturn, considering that vacancy rates are now at or below historic lows, according to Mr. Philipp.

As for loans having refinancing problems, about which there is a lot of discussion, he said that the industry is doing fine on the whole, while some floating rate deals are not. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/