"Bondholders Face Losses From Commercial Mortgages (Update3)
June 11 (Bloomberg) -- Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.
Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.
With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.
“The worst is yet to come,” MetLife Inc. Chief Investment Officer Steven Kandarian said yesterday in a Bloomberg Television interview. “Typically there’s a lag between when the economy softens and when the defaults actually occur.”
Investors have already seen prices on top-rated senior debt drop below 70 cents on the dollar from 95 cents a year ago, according to Aaron Bryson, a commercial mortgage-backed securities analyst at Barclays Capital in New York.
Just a Stopgap
Interest-only mortgages were designed as a stopgap to allow owners to do renovations and absorb other costs. Owners delay paying principal for the first several years, lowering their initial monthly expenses. Partial interest-only loans allow for postponement of principal payments for a portion of the term. Full-term interest-only deals require the principal at maturity.
Loans that postpone principal payments had become the norm by the time the commercial-mortgage bond market peaked two years ago, said Frank Innaurato, managing director of analytical services at Realpoint LLC, a Horsham, Pennsylvania-based credit- rating service.
“The proliferation of interest-only loans was symptomatic of the loose underwriting standards of that time,” Innaurato said. “Borrowers were taking advantage of the best terms possible.”
Property owners turned to Wall Street to finance office towers, apartment complexes and hotels as banks bundled the debt and sold it to investors. A record $230 billion in commercial mortgage-backed securities were sold in 2007, up from $93.3 billion in 2004, according to Morgan Stanley data. About $750 billion of such debt is outstanding, bank data show.
A similar type of loan fueled the U.S. residential housing boom, allowing people to borrow more than they could afford as they assumed home prices would keep going up. The collapse of the subprime mortgage market, which led to almost $1.5 trillion in losses since the start of 2007 at banks and financial companies worldwide, was triggered in part when owners defaulted as their payments rose.
Interest-only loans raised concerns “as an example of excessively aggressive underwriting during 2006 and 2007,” said Kent Born, senior managing director at PPM America, an investment manager in Chicago. “But commercial real estate fundamentals were good, and there was a huge demand for these bonds.”
The jump in monthly payments on commercial property won’t be as severe as in the residential market, though it will still sting, according to a May 1 report from Bank of America Merrill Lynch in New York. The mortgages may be one of the “significant contributors” to delinquencies on loans in commercial mortgage- backed bonds, the analysts said.
Concern that commercial real estate is poised for a protracted slump comes as credit markets thaw. Borrowers have sold a record $615 billion of investment-grade U.S. corporate bonds this year, according to data compiled by Bloomberg. Junk bonds, which are rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s, have rallied 33 percent since March 9, Merrill Lynch & Co.’s U.S. High-Yield Master II index shows.
The yield gap, or spread, relative to benchmark interest rates on top-rated bonds backed by commercial real estate has fallen 3.8 percentage points to 7.8 percentage points since the Federal Reserve said on March 23 that it would lend to investors to purchase securities sold before Jan. 1, 2009, as part of its $1 trillion program to unlock credit, according to Bank of America Corp. data. Spreads on the debt have widened 1.5 percentage point since before S&P said on May 26 that it may cut ratings on top-ranked commercial mortgage-backed debt, rendering the bonds ineligible for the program.
A year ago, the debt was trading at about 1.6 percentage point more than the benchmark.
While the U.S. services industry contracted at a slower pace in May and the number of Americans collecting jobless benefits shrank for the first time in almost five months, unemployment will continue to depress non-residential real estate, said Mitchell Stapley, chief fixed-income officer for Fifth Third Asset Management.
“The notion that the rate of decline has slowed, and that we are seeing improvement, doesn’t change the fact that the consumer is retrenching,” said Stapley, who oversees $22 billion in Grand Rapids, Michigan. “We need job growth, not just slowing job losses. There are massive fundamental issues.”
Defaults More Likely
Delinquencies on commercial mortgages placed into securities have climbed to the highest levels ever, according to data from RBS Securities Inc., the Royal Bank of Scotland Group unit based in Stamford, Connecticut. The late payment rate on them is 2.77 percent, up from 0.47 percent at the end of 2007.
The U.S. Treasury Department is considering issuing rules to allow lenders to modify commercial real estate loans without triggering tax penalties on investors as the industry braces for more defaults, according to people familiar with the matter.
“Interest-only loans will be a problem for borrowers who can’t reach targets on rent growth, or have been hit by vacancies,” said Morgan Stanley’s Day, who is based in New York. “The added burden increases the likelihood of these properties defaulting, translating to losses on CMBS investments.”
Scaffolding surrounds the ground floor of a 26-story tower at 1775 Broadway in New York. The 1928-vintage building on 57th Street is being refitted with a glass facade and renamed 3 Columbus Circle.
Newsweek, the magazine that’s cutting the circulation rate base of its U.S. edition by 42 percent to 1.5 million by January, vacated 203,000 square feet of the building last month. The unit of Washington Post Co. accounted for 34 percent of the space, according to loan documents. The publication relocated downtown to 395 Hudson St. in Greenwich Village.
Cheaper to Wait?
“Filling that much space will be extremely difficult in this environment,” said John Levy, a principal at John B. Levy & Co., a real estate investment banking firm based in Richmond, Virginia. “That will require several good-sized tenants in a market where most people aren’t making decisions. There is no penalty for indecision. There is no pressure to do anything, and people think it might get cheaper if they wait.”
Overall occupancy has decreased to about 30 percent, according to loan documents. The building was 98 percent occupied in January 2006, when the Moinian Group took out a $250 million interest-only mortgage, according to loan-service documents reviewed by Bloomberg. When principal starts coming due early next year, the monthly bill will climb by $225,000, or 18.4 percent, to $1.45 million, the documents show.
‘In Good Standing’
“The loan for 3 Columbus Circle is and will remain in good standing,” said Roxanne Donovan, president of Great Ink in New York, which represents the Moinian Group. The firm “is currently executing a comprehensive $65 million renovation” and “is confident it will lease the property to a credit tenant that will appreciate the exciting design, quality construction, new systems and excellent location at Central Park.”
Joseph Moinian, 55, the chief executive officer of New York-based Moinian Group, declined to be interviewed, Donovan said.
Moinian Group owns more than 20 million square feet of space in office, residential, retail and hotel properties, 13 million of which is in Manhattan, according to the company’s Web site.
$3.9 Billion Bond
The 1775 Broadway mortgage was wrapped into a $3.9 billion bond with 304 other commercial property loans across the U.S. and marketed in February 2006 by Wachovia Corp., now part of Wells Fargo & Co., according to the prospectus. More than half of those contained in the bond delayed paying principal for part of the term, the documents show.
Across the U.S., office vacancies climbed to 15.5 percent in the first quarter from 13.3 percent a year earlier, according to CB Richard Ellis.
The U.S. government has made reviving the market for commercial mortgage-backed bonds a cornerstone of the program to get credit flowing and end the recession. Sales of the bonds plummeted as investors shunned the debt and the cost to sell them became too high for investment banks to profit, choking off funding to borrowers that need to refinance.
There have been no sales of the bonds so far this year, and only $12.1 billion were sold last year, according to Morgan Stanley.
The mortgage bonds due this year and next “are coming up against capital markets not active enough to deal with those maturities,” Federal Reserve Bank of Atlanta President Dennis Lockhart said today in a speech.
“Even with government support, the commercial real estate fundamental picture will continue to get worse before it gets better,” said PPM America’s Born, who holds about $7 billion in commercial mortgage-backed bonds as part of a fixed-income portfolio. “Interest-only loans that start to amortize in this environment are one more piece of that picture.”