March 9, 2008

Credit Availability for Commercial Properties

I have two real estate related investment, well one being RioCan, a retail Reit, and Sears Holdings, which a large part of its value is driven from its commercial properties. As well as I continue to try to find valuable commercial investment operators to add to my portfolio. So the subject of commercial credit availability is of interest to me.

In an earlier post, I have wrote that the fundamentals of the commercial real estate as being good, however credit is vanishing from a key source which is the structured debt market. Commercial Mortgage Backed Securities (CMBS) is a key funding source for doing deals in the commercial real estate. This source, as you can imagine, along with other debt markets, is under a lot of stress. CMBS issuance has slowed down some in the last two quarters and it is expected to fall by 50% in 2008 according Prudential Real Estate. Prices of CMBS have fallen significantly which sent their yields higher.

Although some widening was appropriate given the incredibly thin spreads and loose underwriting at the start of 2007, the magnitude of the increases in CMBS spreads last year is surprising against, as discussed, a backdrop of generally healthy space market fundamentals and excellent credit performance. Upgrades of outstanding CMBS by the three major rating agencies outnumbered downgrades by nearly 9:1 last year, according to Morgan Stanley. Meanwhile, delinquencies among seasoned CMBS were just 0.4% as of November, well below the peak of nearly 2.5% during the space market weakness in 2002–03.
Delinquency rates will rise over the next year or two as the most aggressively underwritten loans originated at the peak of the market cycle encounter cash-flow problems due to weaker property market fundamentals and slower economic growth. However, current spreads likely have more to do with the crisis in investor confidence than increasing risk in the commercial real estate markets.

Media and investors unjustly link CMBS with residential backed securities, where fundamental are deteriorating rapidly. I think media do not understand the differences between the two products and began to speculate that CMBS will fall in the same manner residential did.

Aside from being secured by real estate property commercial and rresidential mortgages have almost nothing in common. Commercial properties generate income to their owners making them better collateral than residential properties. Analysis of the federal reserve flow of funds show that the commercial mortgage market is much smaller than home mortgages as you see in chart # 3. Residential mortgages almost depended on asset backed products but commercial mortgages have many other sources to fund deal.

I do not think the outlook is bleak for commercial properties as many paint it to be. There will be other sources in the market to fund deals and properties although they will be able to cherry pick those deals allowing for softer prices. The most likely scenario is some deterioration in commercial real estate values due to slow economy and tight credit but it will not be a collapse as media would have you believe. Off course the major risk, possible but less likely is the "de-leveraging" in the market turns into no leverage situation. If qualified and deserving entities can't secure funding then we are in a big mess not only in commercial space but in every thing else.