Commercial real estate plunge may be overdone

Some people on Wall Street are betting that commercial real estate will turn out to be the "next subprime" mortgage mess. Not necessarily.

Sure, tightening credit and a slowing economy are leading retailers to close stores. Yes, architects are seeing a noticeable decrease in demand, and prices are expected to come down for office towers, malls and warehouses. But no, it's not as ominous as some investors are making it out to be.

Delinquency rates on commercial mortgages remain very low and the risks aren't the same as with residential loans.

The pessimism building on Wall Street is showing up in an index called the CMBX, which tracks the value of bonds backed by commercial mortgages on such things as malls, hotels and office towers. Investors can choose between four series of indexes, each broken down by credit risk ranging from triple-A to triple-B-minus.

The way trading has gone in recent weeks says that commercial real estate is doomed, which is raising fears about more big writedowns hitting the nation's already-battered banks and about continued volatility in financial markets.

The index has been soaring, indicating that investors see increased risk in commercial mortage-backed securities. Some of that move is being driven by short sellers who are using the index to bet against the commercial market, according to analysts at independent research firm CreditSights.

Goldman Sachs is forecasting future losses on commercial mortgages of as much as $183 billion, but the brokerage house says the CMBX index is pricing a loss of $199 billion, 8 percent higher.

Consider that last October, it would have cost $35,000 to insure a $10 million basket of triple-A rated 2007 commercial mortgages — which should be the least vulnerable to potential losses — against default. That shot up to $65,000 at the end of last year and jumped to more than $200,000 last week. It is now trading around $185,000.

Why is the market pricing in so much fear? The alarming rate that subprime borrowers have defaulted on their mortgages over the last year has caused a widespread tightening of credit, with lenders everywhere raising their borrowing standards and investors shying away from anything they see as risky.

Those seeking commercial loans are seeing the results firsthand. The Federal Reserve's latest survey of senior loan officers showed 80 percent of domestic banks tightened their lending on commercial loans from October through January, the highest level since that question was first asked in 1990. That means borrowers are having a tough time refinancing loans.

Beyond that, Goldman Sachs estimates commercial real estate prices could drop 21-26 percent from current levels. The American Institute of Architects' Architecture Billings Index fell in January for the first time in three months, a leading indicator for weak construction growth in the months ahead. The International Council of Shopping Centers projects 5,770 stores could be closed this year, the largest number in four years.

All that negative data still doesn't support the distress signal being sent by the CMBX index, however. It's flashing doom, but there are good reasons to think the situation is not that dire.

To start with, actual delinquencies on commercial mortgage bonds were a tiny 0.28 percent at the end of 2007, according to Fitch Ratings' Commercial Mortgage-Backed Securities Index covering 48,000 loans. Even if that rate goes up, as expected, it still isn't anywhere near the double-digit default rates being seen on subprime loans.

Also, the loans backing commercial properties are considered less risky than subprime mortgages.

Derrick Wulf, a portfolio manager at Dwight Asset Management in Burlington, Vt., noted that commercial loans are underwritten based on financial statements, rent rolls and site visits, and there is a lot more "due diligence done on a $100 million office building than a $150,000 subprime loan."

"Commercial properties are income producing assets, often with long-term, in-place revenues and a diversified corporate base," Wulf said. "They can continue to produce positive net incomes even when their prices decline."

Lastly, only 28 percent of commercial mortgages since 1995 versus 80 percent of subprime loans are securitized, meaning they are sliced up and sold to investors as securities. That means the losses on those loans can be recognized more slowly by banks and other financial institutions, and they won't create the same capital pressure as subprime losses have. Instead, they will create an "earnings drag," Goldman Sachs said.

The outlook for commercial real estate isn't pretty, but it also may not be as ugly as some expect it to be.

Reach Rachel Beck at rbeck@ap.org.