CMBS will be the next shoe to drop?

Some Fear Commercial Property Loans Will Be Next Stage in Downturn By LOUISE STORY As the value of home mortgages crumbles by the day, Wall Street has hoped that commercial real estate loans would stay clear of the storm. But bankers believe the headwinds may be shifting after a large apartment complex in Harlem warned last week that it might not be able to make good on a $225 million mortgage payment by September. A default by the complex, the rent-regulated Riverton Apartments, a 12-building residential development constructed after World War II, would be New York’s largest in the current housing crisis. For Wall Street banks, which hold about $100 billion of commercial mortgage-backed securities, the prospect has fanned new worries that a deterioration of the overall commercial property market could prompt more write-downs in the coming quarter, on top of losses already expected from their distressed mortgage securities holdings. “The fear is the next shoe to drop may be commercial real estate,” said Jeffrey Harte, a banking analyst at Sandler O’Neil. “When consumer credit goes south, commercial will follow.” At the end of the second quarter, Deutsche Bank held $25.1 billion worth of commercial mortgage backed securities. Morgan Stanley held $22.1 billion and Citigroup had $19.1 billion. Lehman Brothers, which has the largest exposure to this type of security, is shopping about $40 billion worth of commercial real estate assets, as well as its entire commercial real estate business. A large part of its portfolio is a high-risk loan known as bridge equity made with Archstone, a metropolitan apartment developer, and most of the rest are floating-rate loans, which are riskier, according to a person who reviewed the offering. Banks are scrambling to dispose of these loans, typically made to hotels, office developers and retail strips, before problems arrive. Broader real estate indexes are already showing signs of trouble. Moody’s/REAL Commercial Property Price Index has dropped nearly 12 percent since its peak last October. A more conservative index by the National Council of Real Estate Investment Fiduciaries shows growth slowing to one-half of a percent in the second quarter, from upward of 4 percent a quarter. Loans made for commercial real estate are typically among the safest, because a building can be used as collateral and big property developers generate income from the investment, raising the likelihood they will repay their loans. But cracks began to emerge late last year, when Morgan Stanley reported write-downs of $400 million in commercial mortgage losses. In the first quarter, Wachovia, which had transformed itself into a leading lender in the nation’s commercial real estate market, said it would take write-downs of more than $1 billion for commercial loans for the second half of 2007. Investors had already begun balking at buying securities backed by these bonds, so banks like Wachovia were stuck with loans of diminished value. Around the same time, the New York developer Harry Macklowe was forced to sell seven office buildings he had bought in Midtown Manhattan, as well as the General Motors Building, after he was unable to refinance the loan with his lender, Deutsche Bank. Now, the prospect of an immense default on a commercial residential property in New York — which has not suffered as much as troubled markets like Florida — has lent new momentum to concerns over the stability of commercial real estate loans. As Harlem grew into an increasingly attractive neighborhood at the height of the housing market, bankers assumed that Riverton’s owners could quickly convert many of its roughly 1,230 units from lower-priced rentals to apartments priced closer to the higher market average. That would generate a richer income stream, allowing the companies to pay off high mortgage bills. It was the kind of optimistic assumption that ran rampant in the residential housing market, but one that remained less common for commercial real estate loans. On Monday, Fitch Ratings issued a negative watch on part of the Riverton Apartments trust, saying developers had made only scant progress toward their goal. Rockpoint Group and Stellar Management — the developers that own Riverton — did not comment. Before the credit squeeze, financial companies bundled commercial mortgages into securities in much the same way they packaged home loans and private equity debt. Riverton’s mortgage was one of the last ones to be wrapped into a commercial mortgage-backed security in the spring of 2007; it was then cut up and sold as bonds. A recent report by Lehman Brothers showed that aggressive underwriting is what probably has brought Riverton to the brink of default, not a fundamental deterioration in the overall market. But that report noted that there are other commercial properties that received similar optimistic underwriting, known as a pro forma loan. Ratings agencies have only downgraded a few commercial real estate securities. At Moody’s, the list includes loans given to the Ritz-Carlton in New Orleans, a casino in Atlantic City and a land development deal in Miami. Still, many analysts say a lengthy downturn in the economy would probably lead many commercial property owners to struggle with their mortgage bills. And pricing in commercial real estate is starting to reflect a tightening in commercial lending, they said. “The risk here in commercial real estate is, What happens when those loans mature in two, three, four, five years?” said Nick Levidy, a managing director at Moody’s Investors Service. “When these loans come up for refinancing, unless the credit markets improve significantly, the terms will be quite different.” Citigroup and Deutsche Bank created the commercial mortgage trust that included Riverton’s mortgage in March 2007. Riverton’s loan is the seventh-largest in the $6.6 billion trust, according to Fitch Ratings. After the deal closed, only three other commercial mortgage trusts of comparable size were created before the market collapsed, according to Dealogic, a financial information service. Losses are rising in this sort of trust. Fitch reported last week that delinquencies rose at the end of July to 0.43 percent, from 0.41 percent at the start of the month, a pace of deterioration that has been steady since the winter. Since February, delinquencies on commercial mortgage-backed securities have increased 43 percent. At the same time, investors are also expecting further trouble in commercial real estate bonds. The top-rated part of the index that includes the Riverton Apartments, for instance, indicates that the risk of those securities has increased by 44 percent in the past month, according to Markit, a financial services company. “The housing market’s weak, so market perception is that commercial real estate fundamentals will follow,” said Steve Gordon, managing director of MKP Capital Management, a hedge fund that manages $4 billion.