Riverton problems come home to roost - FT

Commerical property issues, which tend to lag behind cyclical downtowns of residuential properties, is now coming home to roost. The most vulnerable sector will be multi-family due to the softening job growth. Retailors, Hotels will be next. Issuance dried up but FNM ad FRE will step in to pick up some slack.... By Nicole Bullock in New York Published: September 3 2008 03:00 Last updated: September 3 2008 03:00 The US commercial mortgage bond market this month faces one of its largest defaults ever, shining a light on problems that have been building up for months in the shadow of the residential real estate crisis. The owners of Riverton Apartments, a 1,230-unit complex in Harlem, Manhattan, indicated last month that they were likely to default on a $225m loan written in the go-go days of the credit markets. The news heightened concern that US commercial mortgages could cause the next wave of losses for the financial system as the consequences of another area of aggressive lending also come home to roost. The market for bonds backed by such loans was already under pressure well before events around Riverton added further fears of tangible losses. Risk premiums, or spreads, on US commercial mortgage backed securities (CMBS) are more than 10 times the levels of last summer, while new issuance has dried up. "We have seen a very slow deterioration in the performance of commercial mortgages and we think it will get worse," says Roger Lehman, a CMBS strategist at Merrill Lynch. Since the end of May, a derivative index for commercial mortgages, known as the CMBX has widened sharply. Last week, the CMBX recovered some ground, but with the triple A index at 165 basis points, it remains well above its close of 109bp at the end of May. August marked the second successive month without any new CMBS issuance, according to RBS Greenwich Capital, which expects just one new deal in September. But banks have still been making loans and Fannie Mae and Freddie Mac have stepped in to pick up some of the slack. They increased their dollar volume of commercial and multi-family loan financing by 66 per cent in the second quarter, according to the Mortgage Bankers' Association. This comes at a time when investors have expressed concern about the capital levels at Fannie and Freddie as real estate values keep sliding. Nobody is yet expecting commercial mortgage problems on the scale of those in the residential market, where default rates have topped 20 per cent and 30 per cent in some cases. "While delinquencies have been increasing, the sky isn't falling," says Frank Innaurato, head of analytic services at Realpoint, an agency that specialises in structured finance. Commercial space, which tends to lag behind cyclical downturns in residential property, is far from immune to a struggling economy and the same factors putting pressure on the residential market. Delinquencies have risen to 0.49 per cent from 0.29 per cent in August 2007, according to RealPoint, which predicts that rates will rise to 0.6 per cent by year end. One area with the highest rate of current defaults, according to Fitch Ratings, is multi-family mortgage loans, which are classified under the commercial umbrella. These are loans to owners of large apartment blocks that house multiple families. "With slower job growth and household formation expected in the near future, we expect increased stress on the multi-family sector," says Susan Merrick, the head of US CMBS at Fitch. Another area of concern is so-called pro-forma loans, according to Mr Lehman, which were a hallmark of the loose lending years of 2006 and 2007. While traditional commercial property mortgages are based on cash flows from the preceding few years, pro-forma loans, such as Riverton's, are based on expectations of future cash flows, which are falling as the economy weakens. Standard & Poor's said last week that Stellar Management, one of the two borrowers for the Riverton Apartments, had proposed modifying the loan by putting up more capital, which would enable them to meet their September debt payment and avoid default. "Although the parties are now analysing the proposed loan modification, other work-out strategies remain possible, including foreclosure," S&P analysts said. The recent bankruptcies of retailers such as Boscov's, Linens'n Things and Steve & Barry's, have also illustrated the stress on commercial mortgages to retail property, another area directly hurt by consumer weakness. Hotels and resorts, another commercial property sector vulnerable to cyclical downturns, has so far been protected by the weak dollar. "In an economic downturn, where business travel is slow and a stressed consumer curtails leisure travel, the hotel sector should be under pressure," says Ms Merrick. While commercial real estate remains healthy, Standard & Poor's also sees signs of softening in the property market and restraints on liquidity. As a result, delinquencies should climb over the next few years, which will likely prompt bond downgrades. In the second quarter, the ratio of upgrades to downgrades of ratings on commercial mortgage bonds from S&P shifted dramatically. The rating agency said it expects downgrades to exceed upgrades for the rest of the year, a scenario that has not occurred since 2002. That could mean more worries for banks, many of which maintain large exposures to the area through holdings of CMBS bonds as well as through books of mortgages themselves. Lehman Brothers is trying to offload commercial real estate assets, which were valued at $40bn at the end of the second quarter.