Wednesday, 14 November 2007

More on Commercial Real Estate

Back in September I started talking about the coming demise of Commercial Real Estate (CRE). I have been drawing mainly on the work of Mish at MGETA and at Calculated Risk as well my knowledge of economics 101 which reminds me that changes in Commercial Real Estate Investment lag changes in Residential Investment.

Nouriel Roubini came out with a rather strong post on his blog today with some fairly strong evidence for why CRE is headed into the abyss. Below is an excerpt:

The Next Shoe to Drop in the Credit Meltdown: Commercial Real Estate and Its Massive Forthcoming Losses

The reasons for this coming bust are clear. Commercial real estate – or more generally non-residential investment in structures - includes two main elements: office buildings, shopping centers/malls; and construction of structures for the manufacturing sectors (i.e. new factories). Both components are now under stress. The reason why we will observe a sharp slowdown in construction of new offices and shopping centers is that, with a lag, commercial real estate follows residential real estate.

Indeed, as the SF president Janet Yellen put it last year there are plenty of new residential ghost towns in the West in places like Nevada, California, Arizona, etc. So why would anyone want to build new shopping strips/malls, hotels and offices in such ghost towns. If the towns are empty the stores and malls and offices will be empty too? Thus, as suggested by formal research – such as that by McGraw Hill Construction – with a leg of a few quarters non-residential construction follows residential construction. Thus, you can expect in the next two quarters commercial real estate to follow the slump of housing and its rate of growth to fall from double digits close to zero.

The other main component of non-residential investment in structures is manufacturing structures (i.e. new factories). But with manufacturing slumping and real investment in equipment and software slumping too (capex spending by the corporate sector) the demand for new manufacturing structures is slumping too. If you don’t invest in new machinery you do not need new structures where such machinery produces goods. And capex spending is under severe pressure given the credit crunch, the uncertainty about the economy, the widening of credit spreads for corporate firms (junk bond yield are now up 300bps higher than before the summer crunch and heading above 500bps over US Treasuries) and the slowdown in the economy....

The coming meltdown of commercial real estate is also evident by the sharp widening in credit spreads for CRE mortgages and commercial mortgage backed securities (CMBS). One of the most clear signals of this extreme stressed in the non residential MBS (CMBS) market is given by the CMBX index that is reported by markit.

The data are scary: for BB tranches the spread is now over 1500bps; for BBB- the spread is 1,100; for BBB is 965; even for A is 540; and 326 for AA tranches. All these spreads have sharply widened compared to their spring 2007 levels. At these spreads the ability to finance any new CRE investment – apart from those already committed and financed – is practically null. After the pipeline of already financed projects is finished the market for financing and securitizing CRE – apart from the highest rates projects – is practically frozen. Indeed, the issuance of CMBS fell to $6.3 billion in October, down 84% from a record $38.5 billion in March that finance about half of commercial property purchases. So the CRE market now behaves similarly to the sub-prime market; it is totally frozen.

The chart above is one of the worst performers of the CRE indices Roubini mentions, the CMBX-NA-BB 2. As you can see the spread has increased by close to 1,000 basis points, not a pretty picture. Whilst Wall Street and the media obsess over the losses attributable to the residential real estate meltdown the the CRE market has gone largely unnoticed. However one gets the feeling they won't be able to ignore it for much longer.