Commercial realty is next to feel the pain

The subprime mortgage crisis is hitting the once-comfortable confines of
commercial real estate. To be sure, commercial real estate defaults are low, with a rush of capital into the market in the past five years. Still, even the largest portfolios are financing most of their deals through traditional and new debt instruments, making many nervous about such leverage at a time when mortgage debt is in trouble. The leverage has fueled profits, but also could place future returns in jeopardy.

“The pain will not be easy for those using a lot of leverage,” Jacques Gordon, global strategist for LaSalle Investment Management Inc., Chicago, a real estate investment management firm. “Investors have to be careful in a frothy market. What happens when liquidity dries up or when lenders start tightening their criteria?” Mr. Gordon said. There are already small warning signals. Capital from institutional investors might slow this year as pension plans, endowments and foundations have already invested much of their increased allocations.

...

Some investment managers are becoming concerned with the increased spreads between secured real estate instruments (such as CMBS and CDOs) and Treasury bonds. “CMBS, the below-investment-grade piece, is the worst place to be today,” Mr. Coyle said. “Five years ago, it was a great place to be.”
The next two years will be significant for CMBS, said Larry Kay, director in structured finance at rating agency Standard & Poor’s, New York. A large number of the loans used in CMBS — about $40 billion— will be coming due, and the question is whether they will be paid off or go into default, he said. “We have to wait and see.”
CDOs carry the most risk because unlike CMBS, they are not regulated by the Internal Revenue Service, Mr. Kay said. They are not fixed vehicles, meaning the collateral can be sold off during the course of the loan to pay off any underperforming portions of the debt instrument. Some investors see them as bundled junk bonds sold off as higher-grade debt, and they’ve become very popular with private equity and hedge fund buyers for extra financing on deals above what a bank would lend, especially in the past year.