How Lehman Hurts Commercial Real Estate

I'm still trying to get my head around the implications that Lehman's collapse has for the commercial real estate sector. As I see it, there are a handful of ways this is negative or potentially negative for the sector. If you've got any feedback or disagreements, let me know in the comments section.

I. Values: Lehman's sitting on $32.6 billion in commercial real estate investments in the form of loans and equities. It was a big investor in commercial mortgage-backed securities. What's it going to do with that? Will it still roll those holdings into the bank it talked about last week? Or will it try to sell this stuff on the market. Right now, investors are so skittish about any kind of securitized debt, Lehman may have to sell at deep losses. That, in turn, will force other holders of CMBS bonds to "mark to market" based on Lehman's precedent. So we're looking at a real potential drop in perceived values of CMBS bonds. That could also have effects on determining the value of actual real estate. If the CMBS valuations are to be believed, it would imply deep discounts on actual property values. The industry had been hoping that the correction would be 10 to 15 percent. Now it's looking like it may be a steeper drop than that.

A perceived drop in values of real estate is also going to hurt retail REITs. The correction in REIT stock prices had settled in at a 10 percent to 20 percent drop from 52-week highs. Now it's looking like REITs are going head lower again.

II. Lending: In turn, the volatility in prices and the drop in the value of CMBS bonds keeps lending on commercial real estate dicey. The lack of a market for new CMBS bonds means CMBS lenders will have to continue to sit on the sidelines. Banks and insurance companies have made it abundantly clear that they don't want to fill the $250 billion void left by the CMBS lenders. So as long as the CMBS market is haywire, the lending market is going to remain incredibly tight.

Moreover, if there is concern about the health of commercial real estate, lenders of all stripes are going to be rather cautious about expanding their allocations. The upshot of this is that it will be difficult to refinance. It will be difficult to get new financing. Developers, investors, etc., will have to use more of their own equity to complete any deals. That's going to limit the amount of investment and development that takes place.

The big counterargument is that defaults and delinquencies on commercial real estate are much, much lower than on residential. That is true. But I think a lot of people are very worried about 2006 and 2007 vintage loans. They fear these are going to start going bad soon, especially as borrowers reach the end of interest only payment periods. Aggressive underwriting, as well, assumed high property values and NOI increases that aren't going to materialize. I don't think defaults and delinquencies and foreclosures will reach residential levels, but they will start rising sooner or later.

Ultimately, part of what we're dealing with is that the financial infrastructure of the commercial real estate sector has been damaged severely. That needs to be reckoned with.

III. Office rents: The vacancy rate in New York is about to take a hit it doesn't need. Lehman's got a massive building in midtown and occupies a variety of other spaces. A rise in vacancy, of course, means that rents will stay flat or drop in the city.

IV. Where's private equity?: Everybody knows that private equity firms have a ton of cash. They have chosen not to come in and buy banks. There are a lot of reasons for that. Getting into the banking business opens private equity to greater scrutiny and regulation. That's anathema to the whole point of private equity. But private equity did show a previous affinity for commercial real estate. Will we see those players come back? Of course private equity is pretty reliant on financing. And, as noted, that's harder to get these days. I still think at the end of the day private equity will be a force to be reckoned with in this cycle.

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