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Darker Clouds Over Commercial Real Estate


Is commercial real estate getting hit by a credit squeeze unrelated to the underlying cash flows?

Prof. Shedlock's bearish read of the commercial real estate market is proving increasingly correct. Yesterday in his blog he noted that deals simply are not getting done, which creates a valuation vacuum if a company needs to refinance. We have seen this first hand as a deal with a AA rated buyer cratered on us when the financing entity (a major investment bank) backed off. If you find my experience too anecdotal, the current spreads on Commercial Mortgage Backed Securities should convince you, since AA credit rates are now in the mid 7% range, and for BBB buyers... well "sorry folks, park closed!"

So the question now is whether commercial real estate, or CRE, is getting hit by a credit squeeze unrelated to the underlying cash flows, which may create some defaults but not a systemic problem. Or whether, as is the case in the residential loans area, the debtors are actually on the verge of defaulting. I won't venture a direct answer because there are too many exogenous factors that can swing the outcome either way, but I think it is worthwhile noting that despite the drying up of financing for arguably still too-generous deals, the bonds of most public REITs still trade at historically tight spreads. On the other hand, Boo would argue that for the most part public REITs avoided the buy-at-any-price feeding frenzy of the last couple of years, and the real rot sits on the financial statements of private REITs and private equity firms.

Be that as it may, and while becoming incrementally more bearish on CRE, I still think we have a very long way to go before we see in CRE the same unraveling hitting the residential area, where the much ballyhooed write-downs we have seen from public builders are not even in the same zip code as the valuations that bond investors are attributing to the companies' inventories of land and homes. Just as examples, the nearly $2 bln of current assets reported by almost bankrupt Tousa, Inc (TOUS), are being valued through the eyes of recent bond trades, at less than $200 mln. And moving up the "quality" scale, things do not get much better for Standard Pacific (SPF), where the bonds value the company's $3 bln reported inventory at less than $1 bln.

Can we get to that point in CRE? Maybe, but I still doubt it; or at least the roadmap is not nearly as clear as the residential implosion was to me as far back as 2005. Looking at the Washington DC market, even the most expensive CRE deals in recent months have strong tenants behind them, and, for the most part, very strong equity holders, owners who can easily backstop cash flow shortfalls. This for me is a critical difference between residential and CRE: all but the best homebuyers of the last couple of years paid prices which made them inherently bad credits. In CRE however, except for random deals with extremely short time frames (pure flips in other words), which were overleveraged through expensive mezzanine financings, the vast majority of transactions were financed with legitimate cash-flow cushions (as opposed to fleeting equity cushions), which give the debt the type of stability that's non-existent in the residential market.

As direct players in the CRE market we are certainly approaching the current environment with our right hand up, and raised a bit higher than before, but for now I am saving the fallout shelter and the tuna cans for mushroom clouds originating from other sectors of the economy.
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