When commercial real estate pros in the U.S. rolled out of bed on Monday, December 17, they were greeted with a shock: Centro Properties Group, an Australian limited property trust that built up the fifth largest portfolio of U.S. shopping centers in just four years, announced it was teetering on the brink of insolvency.

The firm made waves in the spring of 2007 with its $6.2 billion acquisition of New York City-based New Plan, the last in a series of deals giving it more than 700 properties in the United States. In the process, it built up a considerable amount of debt, including a $1.1 billion bridge loan maturing in December and $2.3 billion more in debt maturing in early February.

At the time of the deal, Centro execs figured they could phase out the short-term bridge loans with permanent financing via a combination of new lines of credit and the use of commercial mortgage-backed securities (CMBS) loans on its properties. But that was before the bottom fell out of the U.S. credit markets.

In the interim, Centro was able to cobble together some deals. In August, the firm refinanced A$1.1 billion worth of debt and completed a $300 million issue in 10-year CMBS notes. But it held off from doing more deals because of how badly the CMBS market got rattled.

Spreads to 10-year Treasuries have increased from 50 basis points in January 2007 to 617 basis points today. And the volume of originations has plummeted. When things were sizzling, CMBS originators pumped out $40 billion worth of loans a month. Halfway through December, CMBS issuance in the U.S. was a fraction of that — just $3.5 billion.

With so few deals taking place and costing so much, Centro waited and waited, hoping the market would return to some semblance of normalcy. In the end, it simply ran out of time. The firm now has until February 15 to line up financing, raise cash by other means (read: asset sales), or else default on its loans. (See more on Centro's situation on p. 10).

Centro's troubles sent the Australian stock market to its worst one-day drop since September 11, 2001. More ominously, it showed that the tumult in the credit markets can lay waste to firms with even solid assets. After all, the problem isn't in Centro's portfolio, which consists of a solid mix of neighborhood and community centers generating good cash flow. That's a sobering message for anyone invested in CMBS bonds. Previously, rating agencies and commercial real estate pros pointed to solid fundamentals as one of the reasons why the carnage ripping through the single-family housing market and causing massive write-downs in residential mortgage-backed securities and collateralized debt obligations would not spread to income-producing property. (In fact, Centro's debt in the U.S. and Australia retained high ratings right up until its announcement.)

But Centro's saga shows that problems in the credit markets that started in the residential sector are spreading to commercial real estate. The question is whether Centro is an exception or the tip of a large iceberg.

Other companies have debt maturing in the next 24 months. How will they fare in refinancing those loans and lines of credit? And what will happen to CMBS pools that contain loans featuring the aggressive pricing and underwriting assumptions prevalent right up until midway through this year? Many deals were based on the assumption that borrowers would generate healthy rent and NOI growth on their properties. But there are signs gathering that this may not happen.

To be sure, there's a strong argument that Centro is a victim of bad timing. It happened to make its deal for New Plan right before the market turned. At the time, few analysts voiced concern about the firm's high debt load. No one foresaw that it might have issues lining up permanent financing. Moreover, most of the large U.S. REITs are not heavily indebted, meaning the likelihood of them defaulting on lines of credit remains a remote possibility unless things go seriously haywire. In fact, the day after Centro's announcement, General Growth Properties announced that it had completed $1.4 billion of mortgage financings since the end of the third quarter, including $366 million of debt maturing in 2008. It also has binding commitments for secured financing worth another $900 million that will close in January. And even if some firms face problems with expiring short-term debt, no one else is sitting on as large a pile as Centro. All of those are big reasons why market observers maintain the view that commercial real estate will not suffer the same fate as residential real estate.

“We have a long way back to the delinquency levels we had four, five years ago, when nobody was particularly concerned about the performance of CMBS loans,” says Thomas A. Fink, senior vice president and managing director with Trepp, LLC, a New York-based provider of CMBS and commercial mortgage information. “Right now, the problem has nothing to do with real estate performance. The problem is that people have a hard time determining fair pricing for the loans.”

Investment outlook

So, if you're an investor in CMBS — particularly, CMBS backed by retail real estate — should you be worried? Parsing through some recent news, the answer is yes — at least a little.

“We saw some disastrous effects this year because of the underwriting issues on the residential mortgage side,” says Kris Niswander, associate director for financial institutions with SNL Financial LLC, a Charlottesville, Va.-based market research firm. “I think it's very possible we will see spillover into the retail sector.”

Centro's news wasn't the only troubling development coming from Australia. One week prior, Bloomberg reported that credit default swaps on Westfield Group bonds and loans — worth more than $14 billion — rose more than 3 basis points to 87 basis points, an all-time high. Translated, that means rating agencies believe there is an 8 percent chance Westfield's loans will default in the next five years.

Meanwhile, there are other erosions taking place. The delinquency rate for all loans in the commercial market has nearly doubled since the second quarter of 2006, to 1.92 percent, reports REIS, Inc., a New York-based provider of commercial real estate performance information. Still, that's in line with historical levels — in late 2003/early 2004, the delinquency rate exceeded 2 percent.

Within the CMBS world, the delinquency rate for retail properties reached 0.37 percent in October, according to statistics compiled by Trepp, though November showed a decline, to 0.28 percent. In January 2004, the number was 1.43 percent.

Those figures are nowhere near the levels of delinquencies and defaults on residential properties. But the fact that they are rising is troublesome. At the same time, returns on A-rated CMBS loans are down 2.7 percent year-to-date, according to Lehman Brothers, while returns on BBB-rated loans tumbled 14.9 percent.

The changing market conditions are leading to some wildly differing opinions on the stability of individual loans. Moody's Investors Service, for example, has been at odds with other ratings agencies for months now about the appropriate subordination levels, a measure of credit support based on principal outstanding for CMBS loans, according to a recent report from the Commercial Mortgage Alert, a newsletter that tracks the CMBS market. Concerned about the possibility of sloppy underwriting, Moody's demands subordination levels between 13 percent and 15 percent for AAA-loans, while other agencies rate them at 10 percent to 13 percent.

The good news is that spreads on all notes in the CMBX index, a synthetic CMBS index made up of 25 conduit/fusion deals completed during a six-month period, began to come down in recent weeks. Spreads on CMBX-NA-AAA 4 loans now equal 62.21 basis points, down more than 41 basis points from a high of 103.33 basis points. Spreads on CMBX-NA-A 4 notes have decreased 161.19 basis points to 382.14 basis points, and spreads on CMBX-NA-BBB 4 notes went down 239.04 basis points to 804.29 basis points.

Going forward, however, investors' skittishness about CMBS loans might spell new difficulties for the CMBX index. To function, the index needs to include fixed-rate securitizations containing at least 50 individual mortgages and a minimum value of $700 million, according to a December 14 report in Real Estate Finance & Investment, an industry publication. But with only 10 deals valued at $23.5 billion scheduled to come on-line before January and an expected 50 percent drop in CMBS volume in 2008, the index covering the period between October and April might not meet the necessary requirements.

Contained damage

For now, most observers expect that the fallout from the credit crunch will be moderate. One sign of hope is that developers exercised restraint in building new properties during this cycle, compared to the rampant overbuilding of the 1980s, says Sam Chandan, chief economist with REIS. Another is that plenty of money remains in the market, if on different terms than those practiced in 2005 and 2006.

“Retail defaults have been rising for about five, six months, but the rise is minimal,” says Robert Hopkins, senior economist with CBRE Torto Wheaton Research, an independent research firm owned by CB Richard Ellis. “In our outlook, the multi-family sector will be hit worse than retail.”

So far, default rates on CMBS loans stand at 0.4 percent, according to Moody's. Moody's researchers believe that figure could triple, but even so, it will remain comparable to the historical CMBS default average of 1 percent.

Meanwhile, default rates on all loans in the retail sector will rise to approximately 5 percent over the next several years, still a low number compared to the record highs experienced in the aftermath of the savings and loan crisis of the 1980s, says Chandan. Back in 1991, the delinquency rate in the commercial mortgage sector reached 12.57 percent, according to REIS.

One way to judge whether problems may emerge in CMBS bonds already in the market is by gauging the fundamentals in the industry and borrowers' projected ability to continue to pay down their debts. Of course, as Centro shows, solid fundamentals aren't the catch-all that many believed, since having a too-high debt load or needing to refinance at the wrong time can be disastrous. For most operators, however, the ability to pay down debt off solid cash flow is the key metric.

The problem is that in some cases, CMBS lenders were too optimistic about how strong that cash flow would be over the coming years. In the third quarter of 2007, the average commercial loan was worth 118 percent of a property's value, according to Moody's. In agreeing to leverage that high, lenders figured that commercial property values would continue to rise at the same levels experienced at the height of the market in 2004 and 2005. But for the past four years, CMBS-leveraged properties have been performing below expectations, missing targeted NOI returns by an average of 6 percent in 2006, according to data compiled by Holliday Fenoglio Fowler, a commercial real estate financial intermediary with offices nationwide. Back in 2003, CMBS-leveraged properties outperformed NOI expectations by more than 1 percent.

On that front, things will likely get worse because of the obvious, if moderate, slowdown in retail real estate. In the third quarter of 2007, shopping center and power center vacancies in the U.S. rose 10 basis points, to 7.4 percent, the highest level in more than five years, according to REIS. The vacancy rate, however, is still low compared to historical levels and has been creeping up slowly enough not to cause dramatic shifts in rental rates.

At $19.32 per square foot, average national rents still show an increase of 2.9 percent over last year. But there are signs that the market may be at its peak. Rents grew just 0.4 percent from the previous quarter, signaling that they may be reaching a plateau.

For some borrowers, that could still be an issue. “A lot of loans out there have been made under very aggressive assumptions,” Chandan says. “They are dependent on fundamentals for commercial real estate being more than just healthy.”

The full extent of the problem won't reveal itself for some time, Chandan adds. Commercial default rates tend to peak five or six years after the high point in the real estate cycle. That means investors will only begin to glimpse the effects this year.

How connected to housing?

Another determining factor in how high default rates will go is the extent of the housing crisis, according to Niswander. If the fall of 2007 marked the bottom of the cycle in the residential sector, retail fundamentals will remain at equilibrium and most owners will be able to make their mortgage payments, he notes.

“However, if we have only started on the housing correction, to me that would be of great concern,” Niswander says.

And right now, it's not looking like the housing sector has hit bottom. In early December, the Mortgage Bankers Association reported that delinquencies on mortgages for one- to four-unit residential properties rose 47 basis points between the second and third quarters of 2007, to 5.59 percent of all outstanding loans, the highest rate since 1986.

A week later, several major financial institutions, including the Bank of America and Wachovia Corp., revealed a new round of write-downs connected to subprime debt and both said the damage would affect 2008 results. To date, the world's banks lost approximately $60 billion in write-downs related to the U.S. subprime crisis, according to Thompson Financial. But economists worry the figure represents only a third of the banks' total exposure and will grow to $200 billion or even $300 billion.

One of the most-quoted metrics pointed to in assessing how bad things will get this year is the huge volume of loans that will reset in 2008 — an estimated $350 billion. That's more than in 2007. And thus far a big chunk of defaults and delinquencies have occurred when adjustable-rate loans reset from low teaser rates.

More troubling still, the crisis appears to be spreading out of the subprime sector. In fact, in the third quarter of 2007, prime fixed-rate residential mortgage foreclosures rose 4 basis points, to 0.22 percent, and prime ARM foreclosures rose 40 basis points, to 1.02 percent, according to the Mortgage Bankers Association.

To date, the effect on consumer spending has been measured, with positive same-store sales growth in 2007 (though the projected increase of 1.5 percent for December is far below the growth of 3.3 percent in December 2006). But data from REIS points out that consumption patterns change slowly, meaning we haven't seen the full effect of the housing crisis reflected in retail sales yet.

The wild card in all this is what happens with the federal government's various proposals to try and alleviate the pressure. But right now, it's unclear which one will be enacted.

LOAN PERFORMANCE BY PROPERTY TYPE
Type June Delinquency % Total July Delinquency % Total August Delinquency % Total September Delinquency % Total October Delinquency % Total November Delinquency % Total
Co-op Housing 0.05 0.12 0.08 0.07 0 0
Health Care 0.35 0.26 0.37 0.38 0.58 0.36
Industrial 0.25 0.23 0.22 0.27 0.28 0.21
Lodging 0.63 0.52 0.69 0.65 0.48 0.51
Mixed-use 0.06 0.04 0.03 0.01 0.02 0.02
Mobile Home 0.15 0.15 0.19 0.18 0.19 0.13
Multifamily 0.77 0.71 0.77 0.78 1.2 1.11
Office 0.21 0.18 0.16 0.17 0.14 0.14
Other 0.55 0.48 0.47 0.39 0.38 0.37
Retail 0.23 0.24 0.25 0.35 0.37 0.28
Self Storage 0.09 0.2 0.13 0.16 0.14 0.11
Unknown 0 0.02 0.01 0.01 0.01 0
Warehouse 0 0 0 0 0 0
Source: Trepp LLC