Special to Realty/Builder
Connection
The current commercial U.S. real-estate market these days is a case of a dog that isn’t barking.
Like a Sherlock Holmes mystery, what isn’t happening so far in this story is more interesting than what is. The market is now entering its third year of drastically deteriorated fundamentals and yet hasn’t seen the kinds of loan delinquencies, bankruptcies, foreclosures, court fights and restructurings that have invariably accompanied meltdowns of real-estate cycles past.
A big confirmation of the relative quiet comes in a recent Salomon Smith Barney report on delinquencies in the market for commercial mortgage-backed securities. Known as CMBS, the securities are a new and relatively arcane slice of the real-estate business that have emerged as an important source of long-term financing for landlords. This new industry has also become a useful early-warning tripwire for distress in the real-estate business.
For most of the post-World War II era, big commercial banks, later joined by insurance companies and money managers, held most of the loans on office buildings and other commercial property. But the collapse in values that accompanied the real-estate depression of the late 1980s and early 1990s caused financial institutions to take huge write-downs, driving the entire savings-and-loan industry and some banks into insolvency. As the 1990s dawned, the industry needed new sources of long-term debt capital.
The CMBS business got its start through the old Resolution Trust Corporation, the federal bailout agency, which used new laws to repackage still-viable thrift loans and sell them off in pieces as bonds.
CMBS really took off only in 1997 and 1998 when big financial houses like Morgan Stanley & Co. and Citigroup Inc.’s Salomon Smith Barney unit began originating big loans to landlords and selling the debt off in pieces to institutional investors.
Like the better-known mortgage-backed securities in the residential market, a CMBS is a bond, usually sold in $1 million increments, that pays buyers their principal, plus interest over a fixed period, say around 10 years. The security is backed by the mortgages paid by the owners of office buildings, strip centers, apartments and other types of commercial property. The securities can be backed by the cash flows from a single property — like the $420 million loan on Four Times Square, the Manhattan office tower owned by the Durst Organization — but 80 percent of CMBS are diversified, based on dozens of loans on various kinds of properties in various states.
Today, there are about $223.6 billion in fixed-rate securitized loans outstanding to all sorts of borrowers, ranging from major real-estate investment trusts to mom-and-pop owners of strip malls. A big feature of the business is that the health of these loans is closely — and publicly — scrutinized by a small army of Wall Street analysts, as well as the major ratings agencies, such as Standard & Poor’s and Moody’s Investors Service.
And according to Salomon Smith Barney analyst Darrell Wheeler, the percentage of delinquent loans in March of all loans outstanding was 1.65 percent, which was actually flat from February’s 1.66 percent. That all-important delinquency figure has only slowly crawled up from last summer, when it was 1.55 percent. Delinquent loans are defined as those with borrowers that are at least 30 days delinquent on payments or if the property has already gone into foreclosure. The figures don’t include another small percentage, 0.17 percent, of loans already liquidated and repaid to lenders.
If those don’t sound like high delinquency rates, they aren’t. The figures are well below industry expectations for this point in the real-estate cycle, which usually lasts around four or five years. By contrast, commercial real-estate loan delinquencies back in the early 1990s (not CMBS, which didn’t exist, but those held by banks and insurers) soared over 7 percent. Only hard-hit hotels are in that range among loans backing CMBS these days, and hotel loans represent only 7.6 percent of total loans.
Most surprising of all is the resiliency of loans to the hard-hit office sector, which, as readers of this space know, is facing vacancies near 17 percent and rents that have fallen as much as 50 percent from their peaks, according to some estimates. But by the Salomon Smith Barney survey, office-loan delinquencies were a mere 0.65 percent of the total — actually lower from February’s 0.70 percent.
Wheeler attributes the relative health of loans underlying commercial mortgage-backed securities to conservative underwriting in the first place. Borrowers were loaned only in the high 60 percent-range of property values, not 90 percent or 100 percent as they were in cycles past, meaning that even eroding cash flows in buildings only partly rented still exceed debt service and other expenses.
“He’s got the money coming in,” Wheeler says, referring to landlords. “He’s in the mode of survive until 2005.”
To be sure, there are storm clouds on this particular horizon. Some landlords are not making their payments — and it’s biting some CMBS buyers. Last month, Standard & Poor’s lowered its rating on $397 million of securities after a building in downtown San Francisco, 555 Market Street, went into technical default on a $160 million loan, or 40 percent of the entire pool. The building is currently just 17 percent occupied and rents are not enough to cover debt service, S&P said in a release. That compares to the building’s 84 percent occupancy when the securities were issued just a few years ago during the dot-com heyday. The borrower, a unit of closely held New York developer Tishman Speyer Properties, has agreed to work with CMBS workout specialists to sell the building as soon as possible to repay lenders, and some funds have been kept in reserve, S&P said. But the rating agency added, “a loss is likely even after reserves are applied given the present state of the San Francisco office market.”
A spokesman for Tishman Speyer confirms that the developer has decided to market the property to repay lenders.
Still, that’s a pretty tough outcome for a bondholder, especially considering CMBS aren’t stocks and don’t include the prospect of the potential upside rewards that stockholders expect in return for accepting the higher risk of losses.
One worry is that if the market doesn’t recover soon, more 555 Market Street outcomes can be expected. The problem is that many office leases have five- to seven-year terms and as more expire into the current dearth of demand, landlords wont be able to pay their loans. Mr. Wheeler says if the economy doesn’t start producing white-collar jobs by 2005, delinquencies could rise as much as 40 percent. That is, to around 4 percent of the total.
And Larry Kay, an S&P director, notes that while only $321 million worth of office loans are now delinquent, another $1 billion or so now require the attention of so-called special servicers, the CMBS specialists who work with borrowers experiencing problems making payments.
But to date, the overall health of most loans underlying the CMBS industry isn’t bad. The credit dog hasn’t started to bark — yet.