WSJ on Commercial Real Estate

The Wall Street Journal has picked up the scent of the impending implosion in Commercial Real Estate (CRE). From the WSJ:

Commercial Property Now Under Pressure

The value of commercial real estate, which nearly doubled in the past seven years, is now starting to decline due to the credit crunch, according to a report set to be released today by Moody's Investors Service.

The report found that the value of commercial property declined 1.2% in September from the previous month. Particularly hard hit were apartments in the West and office property in most states other than California.

The report is an early sign that the commercial-property sector is being dragged down by the growing reluctance of lenders to extend credit for anything related to real estate, which in turn could create a new drag on the economy and additional problems for investors. Declining commercial-property values could lead to an increase in default rates on commercial real-estate loans and on commercial mortgage-backed securities.

No one is predicting that defaults in the commercial sector will come close to rivaling those in the housing sector. The default rate for commercial mortgage-backed securities is about 0.4%, compared with a 20% default rate for subprime, or high-risk, home loans, the hardest hit segment of the residential mortgage market. And commercial rents in many markets continue to rise.

Tad Philipp, a Moody's managing director, says he wouldn't be surprised to see the commercial-mortgage default rate double or triple, but he notes that still won't be "alarming" because historically the default rate is about 1%.

I'm willing to bet Mr Tad Phillip is going to be in for a surprise. Whilst Commercial real estate won't be as bad as residential it has been subject to some of the same excesses.

Still, the latest trends "might represent the inflection point in commercial real estate values given the ongoing liquidity crunch," the report states. Commercial-property values are primarily being hurt by the increasing cost and declining availability of financing. Given the higher cost of debt, buyers need to pay less to get the return on equity they want.

Even a slight decline in values could make it difficult for property owners to refinance their mortgages, especially if they have been paying only interest on their existing debt and not paying down principal. Such interest-only mortgages have become increasingly popular.

...and that is one of the reasons why CRE is set for a big fall, interest only mortgages on properties that nobody wants to buy, you don't have to be Einstein to see where this is headed.