Wednesday, December 26, 2007

Credit Downturn Hits the Malls

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When I first clicked on this story on WSJ.com [Credit Downturn Hits the Malls] I thought it was going to be a story how strapped consumers were running out of space on their credit cards, or how their housing problems were hitting their spending... but lo and behold the first stories of commercial real estate slowdown are finally hitting the press.

One important method to make money is to be ahead of the pack. I have been touting the issues that a slowdown (even if its not an official recession by "government reporting") will have on commercial real estate. Put bluntly even with a static economy we have way too many stores - too much of everything - where I live there is a CVS next to a Walgreen next to a Rite Aid... every 2 miles... in every direction. Malls every 6 miles. Strip malls galore. Small restaurants everywhere. I truly don't know how these companies keep any profit margin at all with all the competition, but in a booming economy I suppose it is possible. In high growth states where people are fleeing too (southeast, and southwest) it will still be possible to continue to build out, but in the slower growth states or older areas of the country (much of the midwest and east) everything really seems 'built out'.

Anyhow, the first "round" of financial issues is probably at this time "priced in" the banks - that being "subprime". While I argue this is only stage 1, and we will have the next rounds of alt A mortgages, and prime mortgages, along with credit cards, along with auto loans, along with student loans - that's a problem for another day as the foreign Middle East/Far East cash infusions has people singing a sweet tune (I believe this is the 9th "this is the bottom!" call by CNBC). While that will be proven to be wrong in my opinion down the road, for "now" the financials seem able to hold a bid. But real opportunity is found in places people are not talking about. Hence I anticipate early 2008 will be the time I actually am overweight Ultrashort Real Estate (SRS) over Ultrashort Financial (SKF) - the latter being a big winner in the fund this year. [Top 10 Winners and Losers so Far]. While I will hold both in varying degrees, I don't see UAE or Singapore or our central banks coming to the resuce of commercial real estate developers. The coming slowdown will happen, and we won't have to worry about the "invisible hand of bailouts" in this sector as much as we have to worry about it daily in the financial arena (if you are short the sector). Further, it is not something people are talking about... aside from a few sources [Commercial Real Estate Dominoes Collapse], the mainstream press and investors seem to be ignoring it. Hence I see real opportunity here, just as I did in the Ultrashort Financials back in August before the "invisible hand" started its maneuvers to make sure a day of reckoning never happens...

Back to the story....
  • The credit crunch triggered by the downturn in the housing market is creating problems in commercial real estate, driving down prices of office buildings, shopping malls and apartment complexes, and leaving some owners scrambling for cash.
  • One victim is Centro Properties Group, the fifth-largest owner of shopping centers in the U.S. The Australian real-estate company saw its share price fall by 90% in two days last week as it struggled to refinance short-term debt it took on to fund its $6.2 billion acquisition of New Plan Excel, one of the biggest owners of strip malls in the U.S.
  • Centro had planned to pay off the short-term loans by selling long-term debt via the commercial mortgage-backed securities market, but the lack of buyers forced it to get a two-month extension from its creditors. Commercial mortgage-backed securities, or CMBS, are pools of loans that are sliced up and sold to investors as bonds.
  • Residential mortgages are packaged and resold much the same way, but so far the CMBS market hasn't had any significant problem with defaults.
  • In another high-profile case, the clock is ticking for Harry Macklowe, the New York developer, who is struggling to raise financing by February to replace $7.1 billion in short-term money he borrowed to finance his heavily leveraged acquisition of seven Manhattan office buildings this year.
  • The predicament facing Centro, Mr. Macklowe and numerous others underscores the state of the once-unflappable commercial real-estate market. For the past few months, the sector has been in a state of near-paralysis, as financing has nearly dried up. The number of major properties sold is down by half, and many worry that the market will continue to deteriorate as property sales remain slow, prices continue to drop and deals keep falling apart.
  • The CMBS market was the engine that drove the commercial real-estate boom. Over the past few years, the issuance of CMBS allowed banks to get rid of the risk on their books, lend with cheaper rates and looser terms and that made it easy for private-equity firms to do huge real-estate deals. (hmmm, sounds vaguely familiar)
  • Real-estate investors aren't the only ones feeling the pain. Many big banks issued short-term loans to buyers and planned to sell them off later, much the way they do with loans made to private-equity buyout shops. But the banks have gotten stuck with an estimated $65 billion in fixed- and floating-rate loans on their books, according to J.P. Morgan. Some of the largest issuers have been Lehman Brothers Holdings Inc., Credit Suisse Group and Wachovia Corp.
  • Prices, however, haven't appeared to fall, though much like residential real estate, there is often a period where buyers stop buying but sellers refuse to lower prices. There is "cognitive dissonance" between buyers and sellers, says Dennis Russo, a real-estate attorney for Herrick Feinstein. "There's a period of time in which the seller cannot psychologically move his price down. They haven't accepted what's happening in the market."
  • According to Real Capital Analytics, sales of significant office properties plummeted to $7 billion in November, a 55% drop compared with November 2006. So few deals are getting done that many market experts say they don't know how to put a value on many buildings right now -- but almost everyone is in agreement that the valuations are dropping.
Again, we are in the denial phase. The 'shoe dropping' phase will come sooner or later. Unless you are in the camp of a booming economy returning by spring 2008 and if everyone just closes their eyes for the next 2 quarters, everything will return back to 'abnormal' as it was in 2003-2006, all over again. I wouldn't take that bet.

Long Ultrashort Real Estate, Ultrashort Financials in fund; long Ultrashort Real Estate in personal account

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