Looking for Upside? Try Commercial Property Bonds

The cautionary messages from analysts seem warranted because of the overall gloomy commercial property market, which many analysts see as headed for a 20 percent drop from its 2007 peak.

The hardest hit are multi-family properties which already account for more than 40 percent of delinquencies on loans totaling $1.1 trillion, followed by retail and office properties, which together make up about 35 percent.

Next comes hotels, industrial and healthcare facilities, including hospitals, in the commercial property market that is estimated to be worth $3.4 trillion.

Roughly 42 percent of commercial mortgages are held by banks, while 22 percent of the loan market has been securitized and sold off, mostly to institutional investors, including banks and thrifts, insurance companies, hedge funds and government-sponsored agencies such as Fannie Mae and Freddie Mac.

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“Banks are very susceptible to the economy—that’s not rocket science—and now as the economy is starting to turn—there is a high correlation with the strength of the economy and underlying commercial loan quality,” says Terry McEvoy, a banking equities analyst with Oppenheimer & Co.

Most vulnerable to the downturn are regional banks, said McEvoy.

They are not big holders of CMBS but they originate a lot of whole loans for their own books.

Among banks that have more than 45 percent of their loan book devoted to commercial real estate are: Hanmi Financial , PacWest Bancorp , Umpqua Holdings , CVB Financial , and Cathy General .

Currently, CMBS delinquencies are running at 0.64 percent, but Fitch Ratings expects these will at least double next year. It's worst-case scenario, pushes this figure over 4 percent.

But this compares with delinquencies of roughly 25 percent in subprime residential mortgage market and about 20 percent in the Alt-A market.

But everyone expects the overall market conditions to worsen as the credit crisis buzz-saws through the real economy, with new lending all but completely vanished, even after actually rising slightly in the second quarter of this year.

The speed and sheer force of the economic downturn has spooked investors, sending REIT equities plunging down roughly 47 percent from their February 2007 peak.

See accompanying video for discussion on benefiting from low mortgage rates, with executives from  Boulder West Financial Services and Cumberland Advisors.

The spreads on CMBS widened dramatically after Treasury Department backed off its plan to buy toxic mortgages, but its latest moves to buy consumer-related asset-backed securities might offer indirect relief. 

“Now what about the commercial piece that is now just starting to show stress, you have all these big retail companies that have filed for bankruptcy, there will be a lot more of those in January I assume, but without the conduit market, without Wall Street getting involved, with commercial-backed securities, where is the liquidity going to come from?,” worries McEvoy.

The current illiquidity of credit markets—not to mention massive equities selling into a cratering market—has exacerbated the downturn and some say markets have significantly overshot.

Jamie Woodwell, commercial property research director at the Mortgage Bankers Association, said recent “wild fluctuations” in CMBS prices reflected a pronounced “disconnect between the pricing of securities and the performance of underlying loans,” a fact he attributed in large part to the fear that has gripped credit markets.

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“CMBS markets has become part of global capital market, so what effects those markets effects CMBS,” he said.

Commercial mortgage spreads recently widened to unprecedented levels when two large loans—a $209 million loan for a Westin hotel in Tucson, Arizona and a Hilton property in South Carolina—were transferred to special servicer due to an imminent default less than a year after the mortgage was originated.

It usually takes two or three years before signs of credit deterioration appear, and these loans were 20 percent of the bond.

Still, when Citi ran the loans through a “severe liquidation scenario” analysts there concluded there was only a “small chance” of default.

“This hardly impressed the CMBX market,” conceded Citi’s CMBS Weekly note from November 21, “where spread have been pushed to levels that are completely disconnected from fundamentals, realistic default expectations, or even the actual cash flows that would need to be exchanged in severe liquidation scenario.”.

© 2012 CNBC.com

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