Is CMBS The Next "Shoe To Drop"? GGP Sales Suggest Commercial Real Estate Crashing

Apparently people are growing less and less "eager" to shop in America's dilapidated malls of the 80's. Stunning Soviet-era architecture just doesn't draw the crowds it used to. The mall, once a hot spot for American youth, has aged (and not so gracefully we might add) due to the consequences of a decade of extreme under-investment as REIT investors sacrificed long-term success for current yields. Add to that the fact that Amazon (AMZN) is eager to sell almost everything you could possibly want at a loss and ship it to your door within 27 minutes, it's not surprising that mall traffic is suffering. 

The problem, of course, is that none of this curbed investor appetite for CMBS securities or commercial real estate REITs as investors have spent the past 7 years reaching for yield in a low-interest rate environment. What better place to park capital than a "safe," commercial real estate REIT with high income visibility from long-term lease agreements? Sounds like a great idea as long as you can ignore the pesky little fact that REIT dividends have predominantly been funded with cash saved from under-investment in repairs and remodels making those distributions effectively a return "of" capital rather than a return "on" capital...details...as long as you can sell to someone else before then music ends then you'll be just fine.

Unfortunately for those investors, recent signs seem to indicate that the music is, in fact, ending. This is a topic we've discussed in the past (see recent post entitled "Time To Take The Fed's Warning Seriously: CMBS Has "Greatest Ever Monthly Delinquency Increase") as signs are starting to emerge that delinquency rates for CMBS structures are on the rise while valuations of underlying properties are on the decline.  

Our most recent example of deterioration comes from data disclosed by GGP in its 2Q earnings call. According to a research note published by Richard Hill at Morgan Stanley, GGP announced the sale of the Newgate Mall in Ogden, UT and the Rogue Valley Mall in in Medford, OR for 16% and 25% less than their appraised value in 2012. They look like beautiful establishments, no Soviet-era architecture here folks.

 

According to Mr. Hill the assumption of debt attached to the properties is the only thing that made the sales possible even at discounted valuations. The Newgate Mall will have a pro forma LTV of 83% while the Rogue Valley Mall is 91%. As Mr. Hill points out, debt investors in these two projects should beware of the "put option" as the high leverage of the structure pretty much insures that the new equity owners will make money even if the projects default at maturity:

Assumable debt made the sales viable, but beware of the put option.We utilize a discounted cash flow model to estimate the levered returns to the buyers on the sale of these properties based on the terms of the assumable debt (and assuming current NOI is held constant):

• The levered return on Rogue Value mall is approximately 63%. If the buyer defaults on the loan at its maturity date, then the levered return is still nearly 59%. NOI would need to decline by 10% per annum starting immediately and the company default on the loan maturity before the levered IRR declines to 15%.

• The levered return on Newgate Mall is approximately 50%. If the buyer defaults on the loan at its maturity date, then the levered IRR falls to 28%. NOI would need to decline by 10% per annum starting immediately and the company also default on the loan at maturity.

While GGP boasted on it's earnings call about selling the properties at a "high single-digit cap rate" Morgan Stanley puts that into perspective saying that cap rates would need to be closer to 20% if the projects were levered at a normalized 60% LTV. This is a point Mr. Hill says "reinforces the view that many CMBS 2.0 loans secured by malls may be at risk of realizing significant losses."

Cap rates are closer to 20% if debt isn't assumable. If we assume a more reasonable 60% LTV and a 4% coupon (even if the loan is interest only for 10 years), then the cap rate would need to be around 20% in order to produce a similar levered return (again assuming NOIs are held constant).

Unfortunately all of this could be starting just a new regulations make it more difficult for banks to underwrite new CMBS issuances.According to Bloomberg:

Starting Dec. 24, new regulations require issuers of commercial mortgage bonds, and similar securities backed by loans, to hold onto 5 percent of the debt that they sell. That requirement is known as risk retention and was originally part of the 2010 Dodd-Frank financial reform law. It is designed to encourage lenders to make better lending decisions by forcing them to eat losses if loans go bad, and comes after bad subprime mortgages were packaged into bonds and helped inflate a housing bubble last decade.

Retaining these securities threatens to reduce banks’ profits because they have to fund any assets they hold. If the portion a bank retains is classified by banking regulators as bonds, they will have to use more capital to fund them, and the accounting treatment is worse.

“There are some really interesting questions that remain to be answered,” said Brian Olasov, an executive director at Carlton Fields Jorden Burt who helps craft the Commercial Real Estate Finance Council’s approach to new legislation and regulation.

"The deck is being shuffled and some people are going to win and some people are going to lose," he said. "Some people are going to be brought into CMBS that haven’t been in CMBS before and others are going to leave CMBS."