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Lehman Dilemma Spotlights Investor Aversion to Real Estate

Lehman Brothers’ plan to spin off most of its commercial real estate portfolio illustrates just how averse to property market exposure many investors have become. This week the investment bank attributed its $3.9 billion third-quarter loss — its largest ever — almost entirely to write-downs on real estate holdings and laid out a plan to remove most commercial real estate investments from its balance sheet.

Lehman (NYSE: LEH) cited mark-to-market gross losses of $5.3 billion on residential mortgage holdings and $1.7 billion in gross losses on its commercial real estate debt, equity and securities during the third quarter. Those losses were mitigated in part by hedging and debt valuation gains, the company reported.

Mark-to-market adjustments set asset values according to current market prices as determined by a benchmark, such as a price index. Many market observers contend today’s prices for commercial real estate and real estate securities are unrealistically low because the fallout from subprime residential mortgage failures has tainted all real estate in the eyes of investors. That lack of investor demand has contributed to sale prices that undervalue cash flows from some properties, observers say.

That explains why Lehman has mapped out a plan for enabling shareholders to retain the company’s $25 billion to $30 billion in commercial real estate holdings under a new, publicly traded company that isn’t subject to mark-to-market reporting. As a securities broker/dealer, Lehman Brothers must mark-to-market, but spinoff company Real Estate Investments Global (REI Global) will be free to hold its assets until the market supports better pricing, rather than be forced to sell while those assets are unlikely to garner attractive sale prices.

“Lehman is saying the mark-to-market on these [holdings] and the current valuation of these is off, and that it’s much better for investors if they hold onto them and let them continue to perform rather than sell them at these dislocated prices,” observes Jamie Woodwell, vice president of commercial/multifamily research at the Mortgage Bankers Association (MBA).

Lehman executives haven’t specified which assets will be transferred to REI Global, but the portfolio is mixed and includes the company’s position in the Archstone-Smith Trust apartment portfolio, which it purchased in partnership with Tishman Speyer Properties last year. “The portfolio we expect to contribute to REI Global is highly diversified across regions and asset types,” Ian Lowitt, Lehman’s chief financial officer, said in an earnings call Wednesday.

By value, approximately 57% of the holdings are in the Americas, 26% in Europe, and 17% in Asia, Lowitt says. Approximately 58% are debt positions, 26% are equity positions, and 16% are securities. No property type represents more than 22% of the portfolio, with multifamily at 22%, and office at 18%.

While Lehman executives on Wednesday avowed that their measures would shore up the company’s balance sheet, investors appeared unconvinced. Lehman share prices on Thursday continued a week-long downward spiral and fell to $4.12 per share in afternoon trading, down nearly 75% from the previous week’s close of $16.20.

“There’s no question that investor psychology is heavily influencing Lehman’s stock price, and maybe unfairly, because some of their real estate assets do have value,” says Dan Fasulo, managing director at New York-based research firm Real Capital Analytics. “It doesn’t appear at this point that Wall Street will accept those assets.”

Woodwell of the MBA believes Lehman’s move to spin off its real estate is, in part, a response to investor sentiment that fails to differentiate between troubled residential real estate securities and relatively healthy commercial real estate assets and instruments. “People are projecting what’s happening in the single-family market onto the commercial market,” Woodwell says.

Despite some investors’ alarmed reactions to declining values on real estate assets and debt instruments like those in Lehmans’ portfolio, most commercial mortgage-backed securities (CMBS) are performing well. Loan delinquency rates edged upward slightly in the second quarter but remained lower than historic ranges, according to a report published on Sept. 10 by the MBA.

The delinquency rate for CMBS loans more than 30 days in arrears was 0.53% in the second quarter, up five basis points from the first quarter. Only 0.03% of CMBS loans were more than 60 days delinquent, although that rate was up 2 basis points from the previous quarter.

“Commercial/multifamily mortgages are not seeing the same kinds of deterioration in performance that single-family mortgages, construction and some other types of loans have seen,” Woodwell says. “While delinquency rates for most commercial/multifamily investor groups are slightly higher over the last two quarters, it is important to remember that we are coming off record lows for the past year. The takeaway is that commercial/multifamily mortgage performance generally remains strong and well within expectations.”

While it may be too late to ease Lehman’s plight, financial tools in the form of derivatives trading platforms are available to protect against mark-to-market losses, experts say. Using one of several indexes that track commercial real estate, an investor can take short positions against the index that will pay off in the event that market-wide property performance deteriorates.

“There’s no reason why these Wall Street firms couldn’t have hedged their real estate portfolios just they way they hedge their equities or stock,” Fasulo says. “I’m hoping that as we come out of this environment, more investors will see the value of commercial real estate derivatives as an effective hedging tool.”

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