The signs are mounting that commercial mortgage-backed securities will be the "subprime story" of 2008. A startling report from Goldman Sachs has raised concerns that the losses caused by non-performing commercial mortgages will rival the losses related to subprime residential mortgages. According to Goldman Sachs, the bad commercial real estate loans may generate $183 billion in losses, compared with their estimate of $211 billion in damage caused by subprime mortgages.
The unwinding of the commercial real estate bubble seems to be following the exact path of the subprime collapse. In August 2007, French bank BNP Paribas announced it could not determine the value of its positions in collateralized debt obligations that had exposure to subprime mortgages. This admission was the tipping point for the subprime mortgage market. Any borrower seeking a non-conforming mortgage found financial institutions more hesitant to approve the loan. The reason, of course, was because these firms had simply passed the mortgages on to investors through one of many forms of private label mortgage securities. When investors balked at the risk embedded in these securities, institutions had no choice but to tighten the spigot at their loan origination desks.
A buyers' strike is also underway in the CMBS market. The Wall Street Journal recently reported that no new CMBS were issued in January 2008. The last time the markets saw such a shutout was in October 1990. Again, the reason behind this was not because developers suddenly don't need funding. Instead it's because investors do not want to assume the risks associated with exposure to commercial real estate loans. Tighter credit will force the hands of many commercial real estate developers, leading to foreclosures and losses for investors in CMBS.
One might think that a calamity of the same order of magnitude as the subprime crisis would get a lot of attention in the media, but the deflating of commercial real estate bubble is unfolding with little fanfare. We have been following several interesting stories over the past two months that are prompting concerns that commercial real estate will drag down the economy in 2008 and beyond, and lead to more losses at financial institutions.
Before we cover those news items, a very brief primer on commercial real estate is in order. The indispensable economics blog, Calculated Risk, reported that patterns in commercial construction follow trends in residential real estate, but with a lag of about five quarters, or 15 months. This makes a great deal of sense when we think about how metro areas have sprawled over the past decade. The first buildings erected are the homes, followed by basic commercial structures like gas stations and grocery stores. It is only when an area has a critical mass of homes that developers start building large strip malls, movie theaters, restaurants, and other places for entertainment.
With history as a guide, non-residential real estate construction should have begun falling in 2007. In fact, 2007 appears to have been a banner year for commercial construction. This can be spun one of two ways. Either (1) commercial real estate construction continues apace because of pent-up demand resulting from the unusually deep slowdown in this sector in 2002, or (2) commercial construction is in a speculative frenzy driven by ready access to financing.
The evidence is starting to mount that the latter is true: commercial real estate is following the path blazed by residential real estate. In mid-January, Ian Bruce Eichner, developer of the Cosmopolitan Resort and Casino in Las Vegas, defaulted on a $760 million construction loan. Eichner's partners, including Hyatt hotels, will likely bail out the project, but the Wall Street Journal reported that nerves are getting frayed in Las Vegas, where $35 billion in projects are underway that will add 40,000 hotel rooms by 2012.
In late January, noted New York real estate investor Harry Macklowe's empire began crumbling. Less than a year ago, Macklowe bought seven large Manhattan office buildings for $6.8 billion. Macklowe was able to arrange $7.6 billion in financing and only put $50 million of his own money into the deal. Macklowe faced large loan payments and tighter credit markets, so he decided that his best option was to leave the keys in the proverbial mailbox.
But the most interesting turn of events may have been the Jan. 31 announcement from Comptroller of the Currency John Dugan that "the OCC is focusing increased attention on problems arising from high community bank concentrations in commercial real estate (CRE) at a time of significant market disruptions and declining house and condominium sales and values."
Dugan noted that banks needed to downgrade assets, increase loan loss reserves, and reassess the adequacy of bank capital. Dugan also remarked on the risks being concentrated at some banks: "over a third of the nation's community banks have commercial real estate concentrations exceeding 300% of their capital, and almost 30% have construction and development loans exceeding 100% of capital.
The subprime residential real estate collapse has mostly affected institutional investors and large money center banks. The banks that have taken the largest writedowns were the exact same firms that profited handsomely from the origination of the securities now held in institutional portfolios. More importantly, these banks have shown a remarkable ability to use their contacts to raise needed capital and avoid running afoul of regulators.
Institutions with too much exposure to commercial real estate may not be so fortunate. For one, they're likely to have less diversification in their assets than the large banks did. Secondly, these banks will not find the capital infusions as easy to come by. The message from the OCC should have set off alarm bells. The regulator knows that too many institutions are too dependent on commercial real estate, and as losses accelerate in 2008, these institutions will find themselves undercapitalized or insolvent.