Doug Cornelius .com

While commercial property owners are worried about property market, much of the commercial property market remains stable or strong. In contrast, the residential market is still spiraling down and take lots of people and companies with it.

First up, the summary of REIT earning reports show that most of the public real estate companies are still hitting their earnings targets: REITs Cautious Despite Strong Quarter.

Given fears that a sagging economy and a crippled credit market might wreak havoc on the commercial property market, real-estate investment trusts delivered surprisingly strong earnings for the first quarter, with many companies beating analysts’ estimates.

The implosion of the residential markets is taking down builders: Falling Prices Hit Builder Horton – Home Cancellations, Write-Downs Spur $1.31 Billion Loss.

The implosion is also showing the weakness in the underwriting and origination processes for mortgage lender. It was apparently bad enough at Countrywide that it is giving Bank of America second thoughts about its takeover: Acquisition of Lender Is Possibly in Jeopardy. According to an older WSJ.com story, Loan Data Focus of Probe:

The investigators are finding that Countrywide’s loan documents often were marked by dubious or erroneous information about its mortgage clients, according to people involved in the matter. The company packaged many of those mortgages into securities and sold them to investors, raising the additional question of whether Countrywide understated the risks such investments carried.

Many of these companies mentioned are clients of The Firm. I have no knowledge of the background except what was in these stories.

In another sign that the commercial real estate sector is not in the same trouble as the residential sector, many REITs still have good ratings from S&P.

According to Business week in the first quarter of 2008, the group posted a 0.8% total return, at a time when the S&P 500 index fell 9.4%. (REITs Show Strength)

Business Week put together a list of 17 REITs that have a 4- (buy) or 5-STARS (strong buy) rankings from S&P Equity Research:

(Disclaimer: Some of these REITs are clients of my employer.)

Yesterday, I posted that commercial property prices are still increasing. Of course that does not mean there are many properties selling at these prices. As the Boston Business Journal reported, commercial real estate sales have ground to a halt in downtown Boston:

The city saw $57.3 million in office-building sales during the three-month period, compared to $4.3 billion a year ago. Total commercial sales — which included offices, retail, apartments, industrial and hotel properties — fell 97 percent to $152.6 million during the quarter, compared to $5.2 billion in the same period in 2007, according to figures from Real Capital Analytics, a real estate research firm in New York.

Sellers are sitting on the sidelines waiting for the debt markets to get back to some normalcy. Buyers are still thirsting for deals, but can’t line up the debt to get the deals done. If the debt markets do not come back soon and sellers get tired of waiting, then prices will start dropping .

Even though residential property prices are dropping like rocks around most of the country, commercial properties are still holding their value.

The press release on the S&P/GRA Commercial Real Estate Index shows that prices are up from a year ago.

The National composite reported annual price appreciation of 7.0%, versus January of 2007, up from the +6.7% reported in December’s data, but still significantly below from this cycle’s peak of +14.5%, reported in June of 2006. . . The Northeast had the highest return over the month and has the highest annual return over the past 12 months. Each of the regions reported lower monthly returns in January December/November returns.

The raw data for the Index Values is in this Excel spreadsheet.

There is a great article by Roger Lowenstein appearing in the Sunday New York Times Magazine: Triple-A Failure. It runs through the process for converting mortgage loans into mortgage securities.

In one example, the author is taken through the rating and structure process for a pool of 2,393 mortgages with a face value of $430 million. All of the loans were sub-prime loans originated in the early spring of 2006 by a non-bank lender. Seventy-five percent of the loans were adjustable-rate.

What I found it staggering was that 43 percent of the loan were no-doc loans. The borrowers did not provide written verification of their income. No-doc loans were originally intended as an alternative loan for small business owners (especially cash businesses) where it is difficult to put together the paperwork for showing their income. But when you here no-doc loans, you should think mortgage fraud.

As WSJ.com is reporting, Wachovia Swings to Loss, Plans to Raise Capital.

I noticed that Wachovia was retreating from some its lending relationships. The retreat made little sense because they were good borrowers with very solid sponsors. I assumed that Wachovia was trying to preserve capital. That turned out to be true as Wachovia admitted that they are trying to sell stock to raise another $7 billion in capital.

I think there will be a few more banks looking to raise capital in the next few months. Many banks just blew their risk analysis. There is a great piece by Adam Davidson on NPR: Why Risk Models Failed to Spot the Credit Crisis.

“Every big bank has a risk management team whose job it is to keep the banks out of trouble. The teams use complex computers to guide the banks away from financial danger. But as the global credit crisis shows, those models failed to keep many major U.S. and foreign financial firms from making bad bets on mortgages.”

There is nice piece in next month’s Forbes on Kimco Realty Corporation and Milton Cooper: Beyond the Big Box.

“REITs have to follow certain rules in order to avoid most corporate income taxes. Chiefly, they must pay out 90% of their income to shareholders in dividends. Many REITs are content to own buildings and collect rent. Others, like Boston Properties, have also moved into developing their own buildings. But Cooper gets 45% of his earnings from sources like managing real estate for pension funds, lending to bankrupt retailers and buying distressed properties. Only a few other REITs, such as Developers Diversified and ProLogis, have branched out like this.”

“So in 1998 Cooper had a brainstorm: go into business with pension funds, developing and managing shopping centers for funds such as New York Common Retirement Fund and G.E. Pension Trust. Here was a bunch that was happy with returns as low as 6%, if the investments were safe. Many also were required to have some capital in real estate. Typical partnership deal: The pension funds contribute 85% of the project cost, Kimco the remainder. Once the center is built Kimco earns a fee for managing the properties, around 4% of rents.”

According to Bloomberg, Morgan Stanley and Bear Stearns Cos. sold the first commercial mortgage backed security of the year: Morgan Stanley Sells First Commercial Mortgage Security of 2008.

It was a $1.2 billion dollar package of which $630 million was in the senior position. As you might expect the spreads were very high and the subordination was very high.

The Chain of Fools is the title of The Economist‘s Economics Focus column. The article points to the increasing evidence that securitization lead to lax mortgage lending in the United States.

The column is based largely on the study by Atif R. Mian and Amir Sufi of the University of Chicago’s Business School: The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis.

In the end the problem was severing the origination of mortgage loans from their ongoing management and servicing. The originators were motivated to increase the flow of mortgage paper, not necessarily to increase the quality of that mortgage paper. As evidence, you can look at the increase of NINJA loans (No Income, No Job or Assets) on the residential side of mortgage lending and the light covenant loans on the commercial side of mortgage lending.

Mortgage lenders farmed out the mortgage origination to brokers. The mortgage lenders in turn packaged the mortgage loans and securitized them. As a result, the broker and the lender were focused on the short term origination and not on the long term value of the mortgage debt.

In representing the borrowers of loans to be securitized, I often heard that the statement: “I can’t sell that in the market.” I never heard, “that will be affect my ability to manage or service the mortgage loan.”

The underlying economic problem is that the originating lenders did not keep any “skin in the game.” Nearly all of their economic return was in the origination, not the long term success.

According to the Wall Street Journal, Harry Macklowe is still battling his lenders and his lenders are battling each other over his New York skyscrapers: Macklowe, Lenders Seek a Deal. At stake are: 717 Fifth Avenue, Worldwide Plaza, 1301 Avenue of the Americas, Park Avenue Tower, 527 Madison Avenue, 1540 Broadway, 850 Third Avenue and Tower 56 with about 6.5 million square feet of space.

It looks like his senior debt with Deutsche Bank is due shortly. Given the state of the debt markets he is no position to refinance that senior loan. On top of that, he needs to satisfy his subordinate lenders in mezzanine and other higher tranches of debt. According to the article, there are 20 other lenders holding subordinate debt.

I would assume that Mr. Macklowe is trying to turn over the buildings to Deutsche Bank, but the subordinate lenders (who have the most to lose) want to control the sale process.

My guess is that the lawyers for the lenders and Macklowe are working around the clock trying to evaluate who can do what to who in the process. According to Square Feet Blog, Macklowe personally guaranteed $1 billion of that debt and is putting his trophy GM Building up for sale to make good on the guaranty.

It seems that Blackstone’s acquisition of Equity Office was the high-water mark of the real estate capital markets. Macklowe’s acquisition of these 7 properties was a flip from Blackstone as part of the large acquisition of Equity Office Properties. [Blackstone Makes Quick Cash]