The Other Mortgage Market

It's funny to just be hearing about how bad commercial real estate will get because I've been writing for the past year about how bad it's been getting--and it gets worse.

California hotel foreclosures and delinquencies, for example, increased 220 percent and 389 percent, respectively, according to Atlas Hospitality Group, a consulting firm based in Irvine, Calif.

Alan Peay, the president of Atlas, said alot of those loans are 2005-2007 vintage CMBS loans--a vintage with rather lax underwriting.

Trepp LLC, a New York City research firm that monitors commercial mortgage-backed securities, said appraisal reductions increased 75 percent on $4.29 billion of CMBS loans. That means property values are falling like they've been doing in the residential market.

Many analysts I've spoken with say commercial real estate is a reflection of the residential market because capital chased product in both markets and inflated prices so that cap rates were driven to ridiculously low levels on commercial properties.

That said, Victor Calanog, director of research at Reis Inc., New York, does not expect property values to return to their peak levels for more than 10 years. That means banks are sitting with undervalued assets on their books that they are currently trying to extend--and CMBS special servicers also play the extension game for as long as they can.

Trepp said that in September, 1039 CMBS loans with a total balance of $11.81 billion had deteriorating delinquency status. Of the $11.81 billion, $739 million represented extended performing matured balloons. $3.19 billion of loans moved from current to 30 days delinquent; $3.80 billion went from 30 to 60 days delinquent; $1.87 billion went from 60 to 90 days delinquent; $892 billion were non-performing extended balloons.

$3.25 billion in loans improved their delinquency status but the net deterioration was $8.56 billion.

Retail loans had the highest balance of loans with deteriorating delinquency at $3.4 billion, followed by office loans at $2.2 billion and hotel loans at $2.3 billion.

I was just thinking, in fact, how Kevin Donhaue, a special servicer at Midland, spoke at a Mortgage Bankers Association conference nearly two years ago and said this danger awaited the CMBS industry.

I was at another conference where an investor said--off the record--that the CRE CDO market was going to implode.

Yes, there is a major spike in commercial defaults and more are coming. How bad do I think it will get? I think it's already bad. Bank CEOs are telling me that at least 500 banks are going to shut down and commercial real estate is a big reason for it (alot of construction loans out there).

In an article for tomorrow, I emailed Calanog and he replied that vacancies and effective rents for office properties will not return to their peak levels until 2017; for retail, 2015/2016; for industrial properties, 2013/2014.

Bad fundamentals, no CMBS market (although the Fed has the Troubled Asset Backed Securities Loan Facility to purchase AAA legacy securities and assist in new issuance), no banks lending on risky assets and alot of private equity waiting to scoop up assets at bargain-basement prices.

The Fed and Treasury are caught between a rock and a hard place. The accounting rules are more favorable for banks to make extensions because they do not have to declare "mark-to-market" values.

That said, if it takes 10 years or more for properties to return to 2007 values, I'm not sure how banks can keep these loans on their books without becoming "zombie" banks, a la Japan during its lost decade or two.

And, how do investors determine true value if the rules change in mid-stream? And, when will banks be able to lend again holding these risky assets?

Sticking with the Fed's present course, the only step is to create an GSE-type agency, like Fannie Mae or Freddie Mac, to refinance all these commercial properties with more printed money.

The U.S. is already ridiculously in debt. What's a couple more trillion going to hurt as long as banks don't have to admit that their loans are undervalue. That way, the Federal Deposit Insurance Corp. can save their money so that they don't have to borrow from Treasury.

Or, the Fed can print more money and give it to Treasury to loan to the FDIC to seize the banks.

There are probably only two people in the United States who have the answer to this commercial real estate dilemma we are in--rising defaults without liquidity to refinance maturities--and if Ben Bernanke and Timothy Geithner don't have it, then we are really in trouble.