Thursday, July 23, 2009

The CRE disaster

Posted on Reuters by Rolfe Winkler:

Earlier this week, I was surprised when I read that Moody’s put the decline in commercial real estate at 16% over the last TWO MONTHS. That’s a stunning rate of decline that has very negative consequences for banks who are still carrying commercial whole loans on their balance sheet at close to 100¢ on the dollar.cre-vs-residential-prices

For comparison, consider the chart to the right, which compares the Case-Shiller Composite 20 Index for residential real estate prices with the Moody’s/REAL National All Property CRE Index.*

(Click chart to enlarge in new window)

Peak to trough the declines are similar: Residential is down 33% from its July ‘06 peak while commercial is down 35% from its October ‘07 peak.

But note the stunning rate of decline of late for commercial. 28% since September. Residential is off half as much over that time.

To be sure, comparing these two indices isn’t totally fair. As Dan Alpert of Westwood Capital pointed out to me, there are millions of transactions that go into Robert Shiller’s residential index. It’s very granular. On the CRE side there have been very few actual sales that indicate recent pricing. So you have to read Moody’s/REAL with a grain of salt.

Directionally, however, the index is correct. Commercial is collapsing very quickly, even as residential looks to be forming a bottom.

What are the implications? Consider the $1-$1.5 trillion in commercial mortgages being held as whole loans at commercial and savings banks in the U.S. Because whole loans are typically “held to maturity,” they are carried at full value until the borrower actually defaults. Never mind that the underlying collateral is now worth far less than the mortgage.

But banks aren’t forced to take writedowns until an event of default. To avoid that they can play all sorts of games to make things easier for the borrower. According to Alpert:

Banks and other lenders with loans collateralized by income-producing properties have been offering borrowers nearly any forbearance imaginable: loan extensions, interest rate reductions, delayed principal payments, wavers of covenants and guarantees, and in some instances additonal funding—anything and everything to avoid taking a current loss, as long as there is some cash flow or reserve balance to draw on so as to maintain that the loan is performing against its (often heavily modified) terms.

The bottom line is that banks still have hundreds of billions of losses buried on their balance sheets. Commercial real estate prices aren’t coming back, which means these loans will have to be marked down eventually. The longer banks wait, the more painful the writedowns will be.

Bank shareholders should take note. There are still stupendous losses to come. Will the government agree to absorb all of them? Probably not, which means equity holders will feel the pain.

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