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Wednesday, November 28, 2007 5:51 PM

Commercial Real Estate Market Is Imploding

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Deadbeat Commercial developers Signaled by Property Derivatives.

"Commercial real estate is a full-blown bubble that feels very much at a bursting point," said Christian Stracke, an analyst in London at CreditSights Inc., a fixed-income research firm. "There's a fairly toxic mix of factors at work."

The seven-year rally in offices and retail properties ended in September when prices fell an average of 1.2 percent, according to Moody's Investors Service. Banks worldwide are holding $54 billion of unsold commercial mortgages, according to data compiled by New York-based Citigroup Inc. that includes fixed and floating-rate debt.

Lenders are struggling to sell loans to investors after losses on debt backed by subprime mortgages to people with poor credit caused financial markets to seize up in July and August. Bonds with AAA ratings secured by properties ranging from the Sears Tower in Chicago to trailer parks in Delaware yield about 203 basis points more than similar maturity Treasuries, up from 92 basis points on Oct. 12, according to Morgan Stanley indexes.

The benchmark CMBX-NA-AAA index of derivatives tied to the safest commercial mortgage securities rose to 102 basis points from 44 a month ago. It costs $102,000 a year to protect $10 million of bonds backed by property loans against default, up from $44,000 a month ago.

Sales of debt secured by commercial mortgages tumbled 80 percent to $3.9 billion in October from a year earlier, data compiled by Bloomberg show. New securities backed by loans on buildings will fall 50 percent in 2008 from $220 billion this year, Moody's said Nov. 2.
My Comment: This is a full blown commercial real estate credit crunch. What else would one call an 80% decline? Furthermore, a 50% projected drop for all of next year is quite a contraction.
Real estate deals are coming apart at the fastest pace since September 2001, when the U.S. economy was shrinking, because banks are tightening standards for loans, said Robert White, president of Real Capital Analytics, a New York-based research firm.

About $15 billion of commercial property transactions of $10 million or more are under contract in the U.S., compared with about $70 billion at mid-year, White said. That's unusual because the number usually rises at year-end, he said.

Market is Imploding

More than 75 [deals] have been withdrawn because banks aren't lending, and that estimate is "probably conservative, because not all deals that blew up were well-publicized," White said.

"The commercial real estate market is imploding," said James Ortega, who manages $150 million at Saenz Hofmann Fund Advisory in Sao Paulo. Ortega has set trades to profit from a decline in property companies' shares. "We're about to experience a very significant correction."
My Comment: "Banks Aren't Lending" Fancy that. Large banks like Citigroup (C) are capital impaired. Citigroup could not do major commercial real estate deals now even if it wanted to. For more on this idea as well as the desperation at Citigroup please see Abu Dhabi Deal Raises Questions About Citigroup's Health and Petrodollars Return Home.
In Manhattan, the world's largest office market, the vacancy rate rose to 7.6 percent in October, the highest in a year, property brokerage Colliers ABR said. Rents increased 1.4 percent on average to $64.08 a square foot from September, the second-smallest month-to-month increase since June 2006.
My Comment: Blackstone (BX) has already admitted it may have "net losses for a number of years". Declining rents and rising vacancies are not going to help matters. See Commercial Real Estate Black Hole for more on Blackstone.
Subprime Similarities

Record-low interest rates in the past five years encouraged banks to loosen underwriting standards and caused prices to rise as much as 35 percent a year.
My Comment: This was obvious to the whole world and should have been obvious to Moody's, Fitch, and the S&P. Amazingly enough it either wasn't or they simply looked the other way. See Fitch Discloses Its Fatally Flawed Rating Model for more on fatally flawed models.
Banks provided loans that allowed borrowers to pay only interest, not principal, and lenders offered financing that exceeded property values, according to Moody's. The average loan-to-value ratio reached a record high of 117.5 in the third quarter for mortgages that were turned into bonds, from 90 in 2003, said Moody's, which bases its calculations on its own estimates of rental value.

Those are some of the same practices hurting the $10.7 trillion residential mortgage market, according to an annual survey in October by accounting firm PricewaterhouseCoopers and the Urban Land Institute in Washington.
My Comment: It was only a matter of time before this started to hit commercial real estate. And the key point here is that it is just starting. In baseball terms this is the top half of the first inning.
Bondholders helped feed demand for loans by purchasing a record $273 billion of securities backed by commercial mortgages this year, up from $95 billion in 2004, based on data compiled by Trepp LLC, a New York-based research firm.

Demand has dried up since July, when securities linked to subprime home mortgages contaminated credit markets and caused financial institutions to report losses or writedowns of more than $66 billion.
My Comment: Willingness to borrow and willingness to lend are both impacted. There is much pain to come. The declines in residential started out slow as well. Anyone remember the mantra "It's only subprime that affected?" The new mantra is "It's all subprime".
Banks also have about $283 billion of debt they provided to help finance leveraged buyouts in the U.S. and Europe that hasn't been sold, according to research by Charlotte, North Carolina-based Bank of America Corp.
My Comment: This is crucial. Banks will be lending impaired as long as they sit on this debt. If they dump it to get rid of it, they will take huge losses. If they sit on it, they will bleed capital and/or be lending impaired. Yes this is yet another Zugzwang for banks not strong enough to pull such "assets" on to the balance sheet.

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