S&P's latest equity research notes this morning acknowledged the weak and still deteriorating commercial property fundamentals that exist in today's environment. The ratings firm specifically identified two corporations - Winthrop Realty (FUR) and CapitalSource Inc. (CSE) - as having a troubling level of exposure to the imploding realm of commercial real estate.
For Winthrop Realty:
"...we think the loan asset and property operating businesses will be hurt by rising delinquency levels caused by the soft economy"
And for CapitalSource:
"CSE's commercial real estate portfolio deteriorated as impaired loans as a percentage of total lending assets increased to 12.1% from 8.2% in Q1"
In today's universe of investment outlooks, the bear camp continues to maintain that the commercial real estate fallout will cause at least a similar level of market disruption as was provoked by the now decimated residential market. The Bulls have chosen to either dismiss this argument as simply not true, or to cite analytically weak differentiating factors between the nature of the commercial and residential boom cycles; most popularly, we are told that CRE neither overbuilt nor lent to sub prime borrowers.
What Bulls seem to ignore is the fact that residential defaults/foreclosures have mostly been the result of millions of individual "business" decisions. That is, the homeowner has realized that he is underwater, and has punted the mortgage accordingly. In commercial real estate, this process will play out even more efficiently to the downside, as all pride/personal affection towards the subject property is thrown out the window. These decisions will be made strictly according to the numbers; and the numbers aren't good.
The Commerce Department today released it's construction spending figures today, which while displaying a meager 0.3% uptick from May, remained solidly depressed, -10.2% to be precise when compared to the prior year's figures. Furthermore, beneath the major headlines - and depending upon the legitimacy of the media outlet - you will find that lo and behold, Public construction spending was up 1% month to month, and 5.1% year to year.
For these reasons, the chart above has been created to include only private construction across a broad category of commercial real estate. Realistically, the chart above illustrates the trend that is supposed to be happening, as the number of profitable commercial real estate investment opportunities declines precipitously during a depression. The sheer magnitude of declines though, across broad sectors of the commercial real estate market, do nothing if not foreshadow the massive CRE losses related to the gangrenous commercial debt securities tucked deep within bank's balance sheets.
There is an odd bit of news on this report however; that being the 22.2% year over year Increase in construction spending on automotive parts and service facilities. Likely, that data represents a mini-bubble that formed early in the recession when the populace decided that fixing an old car was better than buying a new one. That bubble was just pricked by the ill-reasoned Clunker program, as everyone now owns a brand new vehicle that - assuming an American made vehicle - has at least 40,000 miles left before it breaks down.
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General Electric (GE) has spent the past 18 months operating under the stigmatic label of "financial company". During the real estate boom such a label was entirely appropriate, as operating earnings from the Consumer/Commercial Finance segment routinely represented 40-50% of GE's consolidated net income. Now however, as evidenced by the revenue and profit breakdown charts, the Company has already begun to take the form of an Infrastructure conglomerate that happens to have a finance unit. Within the context of many investor's vision of the progression of the global economy, a Company described by the terms above would be exceedingly well positioned to capitalize on the future "building of the world". GE's capacity for future growth could be hindered by larger than expected losses at GE Capital. However, based upon our interpretation of the most recent detailed disclosures pertaining to that unit, there is reason to be optimistic.
On March 19,2009, GE released an 88 page presentation that detailed GE Capital's commercial real estate, mortgage and consumer exposure. The segment's $81B commercial real estate holdings - split fairly evenly amongst debt and equity - are well diversified across all property types. In the debt arena, GE holds a first position lien in the majority of instances. When the Company assumes an equity position in a property, it does so primarily as the owner/operator without the use of any 3rd party debt. This is an extremely advantageous position to be in, as GE has the flexibility to manage it's leases and cash flows without the burden of debt service. Yes, GE Capital will face further real estate related losses. However, the manner in which GE has typically financed it's holdings should give it an edge over other traditional financial institutions.
General Electric is perfectly positioned, we believe, to profit from two major trends that are unlikely to be derailed.
First, is the United State's movement towards the adoption of cleaner energy technologies. On this note, the Company has already developed an Integrated Gasification Combined Cycle (IGCC). This process converts coal into a fuel that when burned, emits 50% less sulfur and other particulates than if not treated. Additionally, GE already offers wind,solar and nuclear power products.
Second, is what we simply refer to as the "building of the world". Power grids, clean water, and the inexpensive transport of goods through rail systems are all components necessary for the support of growing middle classes in the developing world. GE happens to offer products and services in all of these areas.
Without a doubt, problems linger on at both GE Capital and in the financial system at large. This fact may though have blinded many to GE's unique positioning as a Company which provides essential services to a growing world. As the problems at GEC are worked away over time, the trend that has already begun will become increasingly apparent: GE is no longer a financial company.
The news looks good on the commercial real estate front, as S&P has just announced the downgrade of 384 classes of commercial real estate collateralized debt obligations and re-REMIC(you don't need to know what this stands for). This action alone will affect $17.1B worth of commercial mortgage securities. These and other ratings actions are important because, at this time at least, the Government has said it will limit those assets which can be pledged as collateral in it's balance sheet cleansing programs to AAA securities. No AAA=No program
We commend S&P for at least appearing to possess a modicum of independence in it's ratings decisions, especially as the AAA-needing Treasury Department alphabet programs are struggling to get off the ground. It's actually surprising that the Treasury/Fed has not tried to punish S&P yet for it's rebellious ways. As soon as the Administration starts bandying the term "ratings reform" about, we will at least know what prompted it.
The chart above, courtesy of MIT's Center for Real Estate, illustrates the data contained in Moody's most recent report on the state of commercial real estate. For those of you who are unaware, there is a two month delay in the actual data, i.e June's report presents data that is current only as of the end of April. We've been wanting to do an old fashioned parsing of the Moody's/REAL Commercial Property Price Index and its underlying methodology, but we haven't found the motivation to do so yet. Regardless, the chart is not pretty. CRE prices appear to be in a literal free-fall, with the index posting a Month-to-Month decline of 8.6%. That's correct, meaning that between March and April of 2009, the value of CRE properties nationwide fell at an annualized rate of 33.9%. With the April year-to-year loss reported at 25.3%, it would appear that the pace of the decline in the commercial market is accelerating. The most despair inspiring corners of the market, listed in descending order based upon the sheer level of despair caused by the annual rate of decline, was South-Industrial(-28.8%) , East-Office(-27.2%), South-Office(-25%) and South-Retail(-23.3%).
The most popular explanation for the severe price declines is that we are just beginning to see closings of deals that were negotiated towards the end of 2008 - a time when the peddling of "Depression survival kits" likely reached its peak. While we will sign onto the validity of that assumption, we will not conclude from it that stabilization of this Market is just around the corner. The financial crisis portion of this recession may have abated, but CRE will still have to deal with economic contraction that has ensued as a result of said financial crisis. The de-leveraging process is continuing, and although Fed/Government actions will reduce the acuteness of the pain at any one given point in time, the inescapable truth is that even the Fed can not grant amnesty to multi-decades long debt agglomeration binge.
With all of the talk about commercial real estate, a.k.a the next shoe to drop, we thought we'd share some actual revenue projections that are used to assess the financial viability of a deal at its infancy. The blue line above represents actual base rental revenue projections for a large, well known office building. These figures are typically projected out ten years into the future. As is evident by the slope of the blue line, the assumption is that, generally, rental revenue will always go up. The red line represents what we would call a "mild recession scenario", where rental revenue drops 5%/year for three years, at which point it stops declining and begins increasing, at the rate of 5%/year for the remainder of the 10 year projection. As you can see, the red line is unable to surpass the blue line - despite the fact that the growth of the blue line slows significantly around the 7th year. Based on these numbers, a building that follows the path of the red line will collect rental revenues that total $31.6M or ~11% less than a building following the blue line's path. While this isn't necessarily a good thing, it probably doesn't mean the project will fail outright. Don't forget however, that the red line corresponds to a recession much milder than we are experiencing, and the blue line projections (forecast circa 2000) are not nearly as optimistic as the CRE projections going on in 2007. At a certain point, a building is simply unable to service its debt and operational costs with a dwindling revenue stream. That reality is certain to transpire for many of the commercial mortgages written on buildings at or near the peak of the CRE cycle.
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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.
Let us begin by stating that there is a certain degree of truth to the layman's assertion that psychology plays a significant role in periods of economic contraction. Clearly, when consumers notice the early signs of a recession, they assess the likely threat to their job, standard of living, premium movie package, wine tasting club, Junior's college fund, etc., and adjust spending according to the perceived threat level. This collective consumer retrenchment has the potential to create a negative feedback loop whereby decreased consumer spending begets a weaker economy begets bad news begets further cuts to household spending. The most logical conclusion that can be derived from this sort of logic then, is that a dose of Happyspeak and a dollop of optimism can cure all ills. While this logic may have been valid during the infantile recession that ended in 2003, the situation at hand today is beyond the scope of what Optimism Alone is capable of repairing.
At present time we are in the midst of a balance sheet recession, characterized by the fact that the Total Liabilities of the financial system far exceed the dollar value of Total Assets. The scary thing is, we have only seen phase 1 of this grand and inevitable deleveraging process that must be completed prior to any sustainable recovery. Various other categories and breeds of poorly underwritten debt, whose combined value dwarfs the issues in subprime residential real estate, are currently lurking in the shadows of the Banking Sector's balance sheet. As evidenced by today's bankruptcy filing by the Nation's second largest mall owner/operator, commercial real estate has joined the deleveraging party. Next, consider the impending credit card debt debacle: At the exact moment that household incomes are being decimated by job losses and pay cuts, credit card issuers are aggressively slashing credit limits and ramping up interest rates. To invoke a suddenly relevant comment made several months ago by an acquaintance of ours "Are these guys suicidal?"
The primary point we would like to make is that optimism, regardless of its source, can only provoke households to spend a few extra dollars. Optimism will not, in any way shape or form, hasten the inevitable deleveraging process, nor will it reduce the Totality of Pain that comes as a result of the process.
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