Sub- prime cri­sis has softer im­pact on US com­mer­cial prop­erty

The Weekend Australian - Review - - Primespace - Peter Grant Com­mer­cial

EVEN op­ti­mistic US com­mer­cial- prop­erty de­vel­op­ers are stack­ing sand­bags to hold back a fi­nan­cial del­uge in the mar­ket for of­fice tow­ers, shop­ping malls and other com­mer­cial real es­tate.

In re­cent weeks, sales of com­mer­cial prop­erty have nearly hit a stand­still.

The mar­ket value of such projects — and the mort­gages on them — have de­clined as the spread­ing fall­out from the cri­sis in risky, or sub- prime, mort­gages has made credit hard to come by.

De­vel­op­ers are putting the brakes on new prop­er­ties, cut­ting deals with ten­ants to keep space oc­cu­pied and, if pos­si­ble, ex­tend­ing the terms of their ex­ist­ing debt when it comes due.

On the bright side, how­ever, the com­mer­cial- prop­erty down­turn isn’t ex­pected to be nearly as steep as the cur­rent slump in the hous­ing mar­ket, where re­cent data showed fore­clo­sures ris­ing to the high­est level on record in the fourth quar­ter of 2007. Losses by com­mer­cial- build­ing own­ers, lenders and in­vestors are likely to be tem­pered by the lack of over­build­ing in re­cent years and the abil­ity of most of­fices, shop­ping cen­tres, ho­tels and other com­mer­cial prop­er­ties to keep cur­rent on their mort­gages for the near fu­ture.

Fun­da­men­tally the mar­kets are in pretty good shape,’’ Moody’s In­vestors Ser­vice man­ag­ing di­rec­tor James Duca says.

So far, most of the pain from the down­turn has been borne by banks and other in­sti­tu­tions that hold debt or se­cu­ri­ties col­lat­er­alised by com­mer­cial­real- es­tate loans.

Th­ese loans have fallen in value as the mar­ket has strug­gled to reap­praise their risks.

The out­look could worsen if the US econ­omy falls into a deep re­ces­sion, driv­ing rents down and va­can­cies up. But even with­out a deep dive, it isn’t go­ing to be pretty.

Last week JP Morgan Se­cu­ri­ties, which says the US econ­omy has en­tered a re­ces­sion, pro­jected that com­mer­cial- prop­erty losses over the next five to eight years would be about $ US120 bil­lion ($ 129.4 bil­lion) for build­ing own­ers, banks and in­vestors, or roughly 4 per cent of the sec­tor’s $ US3.2 tril­lion in out­stand­ing debt.

That’s far short of the $ US200 bil­lion in losses that JP Morgan is pro­ject­ing from the sub- prime de­ba­cle, a 15 per cent loss rate.

Even more re­as­sur­ing for com­mer­cial prop­erty own­ers, most an­a­lysts are pre­dict­ing that the pain this time won’t come close to the real es­tate car­nage of the early 1990s, when de­vel­op­ers such as Don­ald Trump and Olympia & York col­lapsed.

William Tanona, a Gold­man Sachs Group an­a­lyst, ex­pects Bear Stearns, Cit­i­group, JP Morgan Chase, Lehman Brothers, Mer­rill Lynch and Morgan Stan­ley to take com­bined com­mer­cial­prop­erty- re­lated write- downs of $ US7.2 bil­lion in the first quar­ter, fol­low­ing $ US1.8 bil­lion of such write- downs in the fourth quar­ter.

Dur­ing the cur­rent down­turn, com­mer­cial real- es­tate val­ues are likely to fall 20 per cent from their re­cent peaks, ac­cord­ing to JP Morgan Chase.

By con­trast, Credit Suisse pro­jected late last month that home prices, which peaked in 2005 and have de­clined sub­stan­tially since, will fall an­other 25 per cent to 40 per cent in some re­gions be­fore hit­ting bot­tom.

The delin­quency rate on the $ US840 bil­lion of out­stand­ing US com­mer­cial mort­gage- backed se­cu­ri­ties is less than 0.5 per cent, near its his­toric low, ac­cord­ing to Trepp LLC, which tracks the mar­ket.

While the rate is ris­ing, Moody’s doesn’t ex­pect it to ex­ceed its av­er­age rate of closer to 2 per cent over the next year. Com­pare that with the roughly 20 per cent of com­mer­cial loans made by life- in­sur­ance com­pa­nies in 1986 that de­faulted in the fol­low­ing 10 years.

Why is the cur­rent bad- loan rate so low? For most of this decade, de­velop- ers have been show­ing un­usual dis­ci­pline in de­liv­er­ing new prod­uct, with the ex­cep­tion pri­mar­ily of ho­tels.

Of­fice de­vel­op­ers in the top 50 mar­kets this year are ex­pected to com­plete 53.9 mil­lion square feet of of­fice space, ac­cord­ing to Reis Inc, a real- es­tate data com­pany.

While that’s close to dou­ble the 2004 pace, it is less than 40 per cent of the av­er­age 144 mil­lion square feet de­liv­ered an­nu­ally in the five years lead­ing up to the col­lapse of com­mer­cial realestate prices in the early 1999s.

Reis chief econ­o­mist Sam Chan­dan says com­mer­cial de­vel­op­ers haven’t over­built be­cause the com­mer­cial realestate mar­ket didn’t start re­cov­er­ing from the last re­ces­sion un­til 2003 and 2004. Usu­ally it takes a few years af­ter a re­cov­ery un­til de­vel­op­ers start build­ing nu­mer­ous spec­u­la­tive projects that have lit­tle or no pre- leas­ing.

We weren’t far along enough in the cy­cle for the mar­ket to start chug­ging,’’ he says. And then de­mand be­gan soft­en­ing be­cause of ( the slump in the) res­i­den­tial mar­ket.’’ Now that fi­nanc­ing has evap­o­rated, new de­vel­op­ment has screeched to a halt. That’s bad for em­ploy­ment and the na­tion’s eco­nomic out­put, but also means most ex­ist­ing projects will be pro­tected from new com­pe­ti­tion.

While of­fice land­lords haven’t dropped their ask­ing rents, many have started of­fer­ing more con­ces­sions, such as in­te­rior con­struc­tion work and months of free rent, so their so- called ef­fec­tive’’ rents are lower. Ac­cord­ing to Reis, ef­fec­tive rents were flat or fall­ing in 16 mar­kets in the fourth quar­ter of 2007, com­pared with seven mar­kets in the third quar­ter.

The prob­lem is that while most prop­er­ties’ cash flows are hold­ing up, their val­ues are fall­ing, pri­mar­ily be­cause fi­nanc­ing is so much more costly.

That’s par­tic­u­larly scary for own­ers ( and their lenders) who bor­rowed ag­gres­sively dur­ing the easy- money years of 2005 to 2007 and need to re­fi­nance soon. Many won’t be able to bor­row nearly as much or get the same terms, putting them at risk of de­fault.

The re­cent high- profile tra­vails of New York de­vel­oper Harry Mack­lowe show what can hap­pen when short­term loans on highly lever­aged prop­erty come due. Mack­lowe is in dan­ger of los­ing most of his real- es­tate em­pire.

Of the $ US44 bil­lion in com­mer­cial mort­gage- backed se­cu­ri­ties that need to be re­fi­nanced this year, $ US24 bil­lion is in short- term debt se­cu­ri­ties is­sued be­tween 2005 and 2007, ac­cord­ing to Moody’s. Many bor­row­ers will be able to ex­tend ex­ist­ing loans, but some, such as Mack­lowe, may be left strug­gling.

Most com­mer­cial- prop­erty own­ers aren’t as highly de­pen­dent on short­term fi­nanc­ing as Mack­lowe and other high- fly­ing de­vel­op­ers.

And most of those who bor­rowed dur­ing the easy- money years have seven to 10- year terms on their loans, pre­sum­ably enough time for the cap­i­tal mar­kets to fig­ure out how to price real es­tate and other forms of debt.

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