A Pending Problem With Commercial Real Estate

By Aaron Levitt | January 30, 2012 AAA

After being one of the worst hit sectors during the credit crisis and global recession, commercial real estate came back with a vengeance. Broad-based funds like the First Trust S&P REIT ETF (ARCA:FRI) saw assets swoon as investors rushed into the beat-up sector. With high dividends and low interest rates, REITs have become a go-to choice for many retiring baby boomers. However, a potential problem is brewing.

Billions of dollars worth of commercial real estate loans made during the boom year of 2007 are about to come due this year. Considering the contracted lending environment, softened real estate values and minuscule economic growth, refinancing all the debt could be a major problem. For investors, it's something to consider and potentially act upon.
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A Looming Problem
There's plenty of anxiety facing the commercial real estate sector moving into the new year. A plethora of commercial loans and commercial mortgage backed securities (CMBS) are due for payment in 2012. Nearly $580 billion in commercial debt will mature this year. This includes roughly $55 billion worth of CMBS bonds. The New York City real estate market alone will experience more than $70 billion worth of maturities throughout the year. A huge chunk of all of this debt was mortgages originated in the boom year of 2007. According to S&P, these loans are cause for concern due to many of these mortgages having high loan-to-value ratios. (For related reading, see The Risks Of Mortgage-Backed Securities.)

Under normal conditions, a firm would purchase a building worth $100 million with 80% debt. Loans were typically interest-only, meaning zero was paid on the principal. At the time of maturity, the borrower owes $80 million. However, as property values have softened, most buildings are only worth a fraction of the original purchase price. This means that the ratio of the loan to the value of the property is now extremely high. Analysts at CoStar (Nasdaq:CSGP) estimate that total average loan-to-value of 2012's maturing debt is around 94.1%.

Given the extremely tight lending environment, most finance firms and banks have zero appetite for high leveraged loans. S&P estimates that between 50 and 60% of the five-year term loans may fail to refinance. Already, 579 loans originated in 2007, worth around $5.33 billion, have experienced some losses. Add the slowing global economy to the mix and you have a recipe for potential disaster.

Where to Focus
With real estate and REITs making their ways into more portfolios, there could be potential problems on the horizon for many investors. Defaults in the CMBS sector could rise and we could see another wave of dwindling property values. To that end, investors may want to hedge their real estate bets. The ProShares Short Real Estate (ARCA:REK) allows investors to bet against the Dow Jones Real Estate Index and could provide a safety net, if things really turn sour. In addition, those investors who are really worried, the Direxion Daily Real Estate Bear 3X ETF (ARCA:DRV) adds leverage to the mix.

Not everyone will run into trouble refinancing. For example, Vornado Realty Trust (ARCA:VNO) was recently able to refinance a $430 million loan, easily. Analysts cite mall operator Simon Property Group (NYSE:SPG) and SL Green (NYSE:SLG) as being able to navigate the new lending environment with ease. The common point between these firms is that they are giants in the REIT industry. To that end, the mega-cap focused iShares Cohen & Steers Realty Majors ETF (NYSE:ICF) could be an investor's best bet. The fund tracks 31 of the nation's largest REITs and this focus on quality should help protect against any "funding" mishaps. The ETF also yields a healthy 2.97%. (For related reading, see Using ETFs To Build A Cost-Effective Portfolio.)

The Bottom Line
With billions of dollars worth of commercial real estate and CMBS loans coming due in 2012, REIT investors could be in for a bumpy ride. Most of these debts originated in 2007, when the market peaked. Analysts expect that the refinancing will be difficult and defaults will rise. For investors, focusing on quality or adding a hedge will be key during the new year. The previous ideas are great ways to do just that.

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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