Friday, May 29, 2009

Commercial Real Estate's Funding Dilemma

The prevailing conventional wisdom, for the past 6-8 months or so, has been that commercial real estate would suffer a residential-like implosion. While we did acknowledge that the key economic ingredients were in place for a decline in the sector, we remained a bit wary of the overwhelming consensus that had developed. In terms of financial markets and the economy, the stronger the consensus, the more likely that the herd is dead wrong. Our approach has been one of cautious assessor, avoiding a conclusion until more material evidence of a deterioration, or possibility thereof, arose with respect to commercial real estate. We believe now to have that evidence in hand.

We refer specifically to the not so subtle foreshadowing by Standard & Poors, that a vast swatch of CMBS now stands on the precipice of a downgrade. In fact, if we are to fully believe the extent of the sabre rattling, a full 90% of all AAA rated CMBS issued in 2007 stands to be downgraded. This is important for several reasons. First, 2007 represents the time just before the peak of CMBS issuance. It also represents, arguably, the most poorly underwritten vintage active today. Second, the US Government has just announced that its TALF program could only be utilized for the purchase of AAA CMBS securities. Meaning: the CMBS vintage most in need of removal from bank's balance sheets has just been disqualified from TALF.

The CMBS market is quite important for the functioning of a healthy commercial real estate sector, as it provides financing for approximately 25% of mortgages on commercial property. As evidenced by the attached chart, it may be difficult to conjure an adequately grim description of what has happened to CMBS issuance thus far in 2009. As long as the ratings agencies continue to apply heightened standards to the credit quality of CMBS,  we don't expect any change to the current trend. Additionally, now that rapidly deteriorating CMBS will have to remain on the balance sheets of financial institutions, the availability of financing for new commercial real estate projects will be greatly reduced.

The pending S&P ratings downgrades will stymie all major outlets for the financing of commercial real estate projects, and serve as a catalyst for the further deterioration of the sector.

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