REAL ESTATE - Commercial Contagion

Residential mortgage woes are hurting commercial real estate, despite strong fundamentals.

INVESTORS WATCHING FOR signs of broader economic damage from the housing market’s collapse now have something else to be wary of: the commercial real estate sector. Turmoil in the market for residential mortgages is bleeding into the Þnancing of commercial properties, causing some sales to fall apart and prices to be renegotiated downward.

The contagion is related to collateralized debt obligations, pools of loans that are sold to investors in slices, supposedly to limit risk. CDOs containing residential mortgages have suffered huge losses in recent months, as home-loan defaults have spiked. CDOs are also a small but critical component of the Þnancing for many commercial real estate transactions. In the Þrst half of 2007, lenders originated some $19 billion in CDOs comprised of commercial real estate loans, according to Deutsche Bank, setting the market on a pace to increase its 2006 issuance of $34 billion by 12 percent. The problem now is that sellers of commercial CDOs market these vehicles to many of the same investors that have been battered by the residential mess. These buyers, many of them hedge funds that have had to sell other securities to meet investor redemptions and broker margin calls, have pulled in their horns.

As a result, institutions that typically purchase the bonds and equity issued by CDOs, driven by a greater aversion to risk, are reluctant to put their money to work in the CDO market. That hesitancy, in turn, is prompting managers to hold off on new issues and reduce or even suspend their lending to commercial property buyers. One initial casualty of the liquidity crunch has been Hartford, Connecticutbased CBRE Realty Finance, which makes loans to commercial property buyers and hedges its risk by issuing CDOs. In early August, Wachovia Corp. requested $26.7 million of additional equity for one of CBRE’s credit lines. The company stopped making new loans in August, citing unstable market conditions. The Federal Reserve Board’s reduction of short-term interest rates last month improved conditions slightly, but the market is still mostly on ice.

“A number of CDOs are not lending at all right now,” says Scott Bottles, a principal at Los Angelesbased real estate advisory Þrm George Smith Partners, which arranges Þnancing on behalf of borrowers. “Their balance sheets are full, and they need to go to market.”

Adds Emile Van den Bol, who oversees the commercial real estate CDO group at Deutsche Bank, “I haven’t seen such a lack of liquidity for a very long time.”

One consequence of the slowdown in CDO issuance is that commercial property buyers can’t raise as much debt to Þnance purchases today as they could earlier this year. That, in turn, is keeping a lid on prices. In August, for example, Starwood Capital Group Global called off its planned $1.8 billion acquisition of Mission West Properties after its lending commitments fell apart.

Experts don’t expect the CDO market to fully rebound for several months. “I don’t think the market will be back to where it was last June -- at the absolute peak of liquidity -- anytime soon,” says Tad Philipp, a managing director who runs CMBS and CDO research at Moody’s Investors Service. “But it should come back in a functional sense in the near term.”

Some securitizations are getting done. Centerline Capital Group, for instance, expects to issue a CDO backed by mezzanine notes and other loans later this year. The Þrm completed two CDOs in the midst of the subprime meltdown in July but had to sell the deals at slightly wider spreads than anticipated, says vice chairman Lee Cotton.

“There will be an opportunity next year for distressed debt or properties that are good properties that have too much debt on them,” says Cotton.

The good news is that the fundamentals underlying commercial real estate are far healthier than those of its residential counterpart. SpeciÞcally, the defaults and delinquencies that prompted huge losses in securities based on home loans and have sent housing prices plummeting are virtually nonexistent in the commercial market, investors and lenders say. Consequently, once CDO buyers regain their footing, the commercial property market should bounce right back.

“You can always Þnd pockets that aren’t doing well, but by and large, fundamentals are good,” says Moody’s Philipp. “If anything, the capital markets disruption might slow down the pace of new construction,” reducing the chances that prices will get out of control.

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