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Credit Bears Romp

It sure is tough to be a bull these days. One ominous signal: On Oct. 19, exactly 20 years after the Black Monday stock market crash, the Dow Jones Industrial Average (DJIA) plunged by 366 points in a 2.5% decline. A slew of uninspiring third-quarter earnings from big banks such as Bank of America and Wachovia were blamed for the sell-off.

Only days earlier, some commercial real estate observers declared that the 2007 credit crunch was over. One Manhattan-based real estate brokerage even issued a report in late September titled “What Credit Crunch?” That optimism now reeks of escapism: The bulls drew encouragement from Tishman Speyer and Lehman Brothers, who earlier in October closed on their $15.2 billion acquisition of Archstone-Smith Trust after a three-month delay.

Don't break out the party hats just yet. An overhang of hard-to-value securities such as commercial real estate collateralized debt obligations (CRE CDOs in Wall Street jargon) still need to be cleared before the market can bounce back. More weak earnings reports could spark new stock market declines in coming weeks.

Not only did outstanding securitized commercial mortgage debt rise from roughly $573 billion in September 2006 to more than $835 billion at the end of September 2007, but financing large-scale asset and portfolio sales still posed a challenge. A flurry of downbeat third-quarter earnings from big investment banks like Citigroup and Bank of America also suggests that the credit mess is far from resolved.

Bearish signs

Experts who said the credit crunch would only last three or four months wanted to believe that, says Jay Epstien, chairman of the real estate group at Washington, D.C.-based law firm DLA Piper. “Until the banks can sell this massive volume of commercial paper, it will continue to be very difficult to finance large deals.”

Recent data support his bearish view. In mid-October, for example, DLA Piper unveiled its 2007 real estate survey after polling 300 leading commercial real estate executives nationally. As many as 63% of respondents were involved in transactions that were either delayed or canceled earlier this year due to the credit crunch.

Few of them predict a fourth-quarter miracle: 61% believe it will take another nine to 12 months before the real estate finance markets bounce back from this credit downturn.

Then there's the subprime lending debacle. On Oct. 11, RealtyTrac reported that $600 billion in adjustable-rate mortgages won't see their interest rates reset at higher rates until the end of next year. That will effectively raise subprime borrowers' monthly mortgage payments, so a spike in resets could exacerbate distress among subprime borrowers.

Prolonged distress?

If DLA Piper survey respondents are correct, the credit crunch of 2007 will go down in the books as longer than the last major credit downturn of 1998. Judging by CMBS spreads and other bond market signals, that credit crunch lasted roughly six months.

Assuming this current credit crunch doesn't snowball into a full-blown recession, it will have served an important purpose, says Peter Linneman, an economist with the Wharton School of Business. “People are clearly more focused on fundamentals now than they were earlier this year,” says Linneman.

“There were plenty of idiots who took huge risks, but they're not getting away with the same deals anymore,” adds Linneman.

But greed was quickly replaced by fear as lax underwriting standards tightened almost overnight. Deal size and volume have been affected by the shift. Investment sales activity has even declined in bellwether markets such as New York City. Real Capital Analytics reports that all New York City commercial property sales peaked at roughly $20 billion in the first quarter, but volume during the next two quarters registered just $11 billion and $8 billion.

In early October, Linneman agreed that it was simply too soon to start waxing nostalgic about the credit crunch of 2007. For one thing, much of the risqué commercial real estate debt packaged in late 2006 and early 2007 will mature in coming years. Fitch Ratings and Moody's have publicly alerted investors that CMBS of the late 2006 and early 2007 vintage will be closely monitored because of concerns about lax underwriting standards.

“There's still so much uncertainty out there that people are sitting on the sidelines and waiting for the first real signs that the market has stabilized,” says Epstien of DLA Piper. “I don't think you'll see the capital start flowing into commercial real estate deals until there's a consensus that we've reached that point.”

Don't hold your breath waiting for that consensus on market stability.

Parke M. Chapman is a senior associate editor with NREI. Based in Manhattan, he is a veteran reporter on the U.S. commercial real estate beat. He can be reached at [email protected].

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