Portfolio.com is writing about Wall Street’s Next Crisis.

Now that the subprime shakeout is nearly over, another real estate mess looms, this time in commercial property.

My Comment: This article is off to a rocky start. The subprime blowup is well underway but by no means over. Two more waves of Alt-A and Pay-Option-Arms are coming up and those waves are now approaching shore. The Pay-Option-Arms problem could be worse because it will saddle lenders with hugely underwater properties.

In their own way, however, commercial-real-estate loans were no less foolish than those made to home buyers with speckled credit. And as with the subprime mess, the reckoning will come.

My Comment: Much better. I agree with both statements.

The implosion is going to be a refreshingly simple and familiar story. The commercial-real-estate frenzy has none of the nagging complications found in the residential market. There aren’t any targets of predatory lending. There are no huge failures by government regulators. The aftermath won’t see people thrown out of their homes—an unadulterated societal ill regardless of whether they should have known better or were tricked into taking on loans they couldn’t afford.

My Comment: Once again I whole heartily agree. But ironically enough “refreshingly simple” adds its own complexities in that there will be no options to deal with it. Unlike residential housing where there are numerous plans to keep homeowners in their homes they will all fail. See Paulson’s Plan Is Nothing But Lip Service for more on this idea.

On the other hand, with commercial real estate there will not be lawsuits, bailout plans, lip service, or any other of complexities. When store owners can no longer afford the rents they will go bankrupt and break leases. When property owners can no longer make mortgage payments to banks they in turn will go bankrupt and banks will end up owning buildings.

In this “refreshingly simple” world, Congress will not attempt to make lease payments for bankrupt businesses.

Let’s make it clear up front: The commercial-real-estate blowup—while ugly—won’t be as bad as the current housing crisis. It’s a smaller market, and any single property often has a diversified group of tenants with different sources of income. The supply of buildings didn’t increase dramatically over the past several years, as in residential real estate. And the losses won’t be as severe, because many commercial spaces can be refashioned for new occupants.

My Comment: This is a mixed bag but I think commercial real estate is as overbuilt as housing is. However, the total amount at risk is smaller. On the other hand, the amount at risk is likely to be more concentrated because the size of the deals are far greater. Those deals are in fewer hands. As for new occupants in a slumping area: forget about it.

Right now, there is about $730 billion in commercial-mortgage-backed securities outstanding. “Not only have we been in a rising tide, but the loans are very different in underwriting standards than even five or 10 years ago,” says Alan Todd, head of commercial-mortgage-backed-securities research at J.P. Morgan. “We haven’t been through a cycle yet” with these new structures, he adds ominously.

My Comment: What’s been securitized is one thing, what banks are holding is another, and the concentration of risk is a third. Obviously there are lots of guesses here but a sure-fire prediction here is this is going to end ugly.

The perennial lesson to be drawn from the coming slump: You can’t protect greedy and myopic people from themselves. Everyone knew that the [commercial-real-estate] business is highly cyclical. Indeed, a huge downturn had occurred as recently as the early 1990s, within the memory of most of the professionals now in the market.

My comment: I certainly agree with that.

Amid the tall office spires of America’s cities, big-money pros have simply been playing a game of greater fool, trying to bring in huge returns with borrowed money and sell out before the arrival of the crash they knew was coming. And in this case, the fools won’t just be famous developers. Some of the same banks and Wall Street firms now entangled in the subprime residential crisis will also be caught in the mess. The commercial-real-estate meltdown will be a market failure, pure and simple. We will be able to look at the wreckage in the next several years with wonder and awe, untroubled this time by sympathy for those left holding the bag.

My Comment: It will be a failure alright, but it will not be a “market failure”, at least not a “free market failure”. The Greenspan Fed purposely and willingly created the housing bubble. Commercial real estate went along for the ride. Please see Missing the Boat on Monetary Easing for more on this idea.

Here’s what we know about what happened in commercial real estate: Lending standards fell, starkly. Or as I prefer to see it, they were thrown out of the 60th-floor window of that gleaming office tower in downtown Atlanta/Phoenix/New York/San Francisco/insert your city here. The gap between the cost of debt servicing and the cash actually being generated by the buildings narrowed. What’s more, it used to be that banks made loans for no more than 80 percent of the value of a property to ensure a healthy cushion of protection, but by the early part of 2007, loans were sometimes made for 120 percent of a property’s value. Who would be so crazy as to lend more than a property is worth? Anyone who believes in perpetual-motion machines—that is, that rents and underlying property values must always go up.

My Comment: “Who would be so crazy as to lend more than a property is worth?” That’s a good question but that is not the worst of it. Consider this simple fact: A 90% loan and a mere 10% decline wipes out all equity. My opinion is commercial real estate is going to plunge 20% or more easily.

A prime example is Tishman Speyer Properties, which paid a record price for two giant New York apartment complexes. To make the purchase work, the company must now figure out a way to kick out current tenants—many of whom have their rents stabilized by law—at a faster rate than has been managed in years past, in order to replace them with ones who will pay more. Historically, that turnover has been about 6 percent, says Todd, but Tishman Speyer is assuming a rate of more than double that for the first couple of years, and 10 percent for the next few after that.

My Comment: That is a “prime example” of how insane things got. And it is by no means an isolated event. Tishman Speyer Properties is in deep cereal trouble as is anyone who lent them money.

Harry Macklowe, a famed New York real estate buccaneer, leveraged himself to the gills to buy seven New York office buildings from E.O.P., a side agreement to the Blackstone purchase. He borrowed $7.6 billion, based on stratospheric valuations, while putting a minuscule $50 million of his own equity into the deal, financing much of the purchase with short-term debt. Since the summer, Macklowe has struggled to refinance the debt in increasingly choppy markets. And he has had to put up as collateral his trophy property, the General Motors Building in midtown Manhattan.

My Comment: Harry Macklowe made one greedy bet too many. He can look forward to losing his trophy property for that greed unless he takes appropriate measures immediately to prevent it.

Lending standards had been loosening across the industry for years. Standard & Poor’s and Moody’s both voiced early concerns in late 2004 and the beginning of 2005. Sure, “supply and demand is in balance, but that’s not a license to loan more money against a given cash flow,” says Tad Philipp, Moody’s managing director of commercial-mortgage finance. “What we were seeing was riskier and riskier loans, and the loans got riskier still. And we are just past the top of the cycle.”

My Comment: Spare me the sap. Exactly when did any of the rating agencies act on this?

Despite their misgivings, the ratings agencies kept slapping seals of approval on commercial-real-estate structures. Just as they did when rating securities containing residential mortgages, the agencies relied heavily on recent historical data, which were misleading.

My Comment: Bingo

To its credit, Moody’s started requiring higher levels of protection in the spring of 2007. S&P; and Fitch, according to a J.P. Morgan analysis, lagged significantly—and won market share as a result. Those two will come to regret that they didn’t respond faster to the Moody’s move.

My Comment: Giving Moody’s any credit for this is ludicrous. The analogy is like praising a student for a D— because someone else got an F. There is no credit to be given here, only greed and shame.

There is no question Fitch is the worst of the lot. As proof I offer Fitch Discloses Its Fatally Flawed Rating Model. Having said that, and with apologies offered to regular readers for repeating myself so often It’s Time To Break Up The Credit Rating Cartel.

Ask And Ye Shall Receive

Those bullish on commercial real estate may wish to consider this anecdotal evidence on the Downtown Sacramento Commercial Real Estate Photolog.

Mish and others requested more CRE photos, so who am I to deny them? The following is a random sampling of the glut in commercial real estate in downtown Sacramento. It is by no means comprehensive, but I think it does represent the glut fairly well.

Click on the above link to see some of the overbuilding in commercial real estate in Sacramento. For more on Southern California Real Estate you may also wish to consider An Elk Grove Commercial Real Estate Photolog.

Max keep those photologs coming. If California is any guide (and I think it is) your images show how refreshingly simple the commercial real estate implosion is going to be.

Mike “Mish” Shedlock
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