High Yield Mortgage REITs: The Perfect Storm?

Volume of Maturing Mortgages to be Low in 2008 and 2009, Reducing Refinance Risk Even Further, but Mark to Market is Discounting REITs to the Depths of Atlantis.

After a couple of alarming headlines in Seeking Alpha related to commercial real estate, the most recent of which was "Commercial Real Estate Collapsing", REITwrecks decided to do some digging. Sherlock Holmes may have had Watson, but who better than REITwrecks to sleuth the truth in real estate?

One of the first articles appeared last week and was prompted by a study issued by the Johns Hopkins Carey School of Business on the short term future of commercial real estate markets. Despite Seeking Alpha's clumsy attempt to connect the report to potential nation-wide troubles, the report actually focused almost entirely on the the Baltimore/Washington area, and then primarily on certain development projects within that area.

It was a comprehensive report, but with such a narrow focus it hardly qualified as meaningful commentary on the market as a whole. In addition, the John's Hopkins report itself was very positive overall.

However, the SA article focused on the negative comments of several experts, who worried that the Baltimore-oriented report was overly optimistic. One of those experts was David Fick, who covers REITs for Stifel Nicholas. For that reason, the story deserved further attention, and that attention exposed some very interesting market data.

According to the story, Fick said that $236 billion in equity investments have already been written off as a result of the subprime mortgage crisis, and that "most of that investment has been in the commercial, rather than the residential, market". By the end of the credit crunch, he said he expects to see at least $400 billion in write-offs.

“The oxygen, the mother’s milk of commercial real estate, is capital,” he said in the article. “Try to get a construction loan now — it’s virtually impossible.”

In one of the more confusing paragraphs, the article quoted Fick as saying that "more 10-year, commercial mortgage-backed securities were issued in 1998 and 1999 than ever before, and that most of them would not be financed". I'm not sure what that means, but Fick went on to predict that the result would be "the demise of many of the region’s existing real estate investment trusts within the year".

Unfortunately, the author didn't attempt to clarify whether Fick meant these deals wouldn't be financed in today's market, or whether these deals wouldn't be refinanced in today's market (as the loans mature). Asserting that a development deal would be more difficult to finance today's market is not particularly insightful, nor is it relevant to a question dear to the heart of REITwrecks: what is the health of Mortgage REIT portfolios, and is the market pricing the intrinsic value of these cash flows rationally?

So I continued an investigation into refinance risks that resulted in a previous article, which disclosed that 99% of all CMBS deals maturing since the credit crunch began in August had been successfully refinanced. Thus, the supply of credit for commercial real estate appears to be holding up even in this credit-stressed environment.

Alas dear readers, that good news on supply is naturally only one side of Adam Smith's beautiful yet invisible hand, and REITwrecks unintentionally left some astute readers clinging frantically to their mousepads for even more. What about the demand side for credit in this environment? More importantly, would a huge supply of maturing paper in need of refinancing put even more pressure on the commercial real estate debt market?

I found the exact opposite to be true. According to a report issued by the Mortgage Bankers Association, the volume of maturing mortgages will be low in the coming years, which would expose few commercial loans to these refinance risks.

"There's been a general impression that a large volume of commercial/multifamily mortgages are coming due this year and next," Jamie Woodwell, MBA's senior director of commercial/multifamily research, said. "The reality is that 2008 and 2009 will see a relatively small volume of maturing mortgages, with the majority of CMBS loans not maturing until 2015 or later."

Capturing data from JPMorgan and Wachovia Capital Markets, the report found that there is more than $600 billion of outstanding loans in fixed rate commercial mortgage-backed securities (CMBS). Of this, only $16 billion is scheduled to mature in 2008 and another $19 billion in 2009.

The surge in sales, financing and refinaning volume during 2005, 2006 and 2007, coupled with the fact that CMBS loans tend to have a 10-year term, mean that the majority of CMBS loans will not mature until 2015 or later -- $98 billion of loans are scheduled to mature in 2015, $128 billion in 2016 and $127 billion in 2017.

Of the loans due in the coming years, the majority is well seasoned and have been amortizing, meaning that they now have lower loan-to-value ratios and will be more attractive to lenders. JPMorgan reports that $14 billion of the $16 billion maturing in 2008 is fully amortizing, as is $14 billion of the $19 billion coming due in 2009. According to Wachovia Capital Markets, more than two-thirds of the volume of loans coming due prior to May 2009 was originated prior to 2000.

In addition to the fixed-rate conduit deals described above, the report noted that Wachovia Capital Markets has identified $30 billion of large-loan floating-rate deals that will be coming due prior to May 2009. The maturity dates of these loans are spread throughout the period, with relatively larger volumes -- $3.5 billion and $3.3 billion, respectively -- coming due in August and October 2008.

These numbers all appear to be manageable given Fitch's report that over $21 billion in CMBS fixed rate loans had been refinanced just since August of 2007, when the credit crunch began.

The MBA report focused on maturing mortgages in the same CMBS market. Banks and thrifts will be more likely to have shorter-term and adjustable-rate loans, while life companies will tend to have longer-term fixed-rate loans, but with much lower leverage and thus easier to refinance. Each group's maturity patterns will also be affected by the ups and downs of its originations experience, but each group's originations generally fell as the CMBS market grew.

So what we appear to have is the equivalent of a hurricane hitting during a spring tide. The storm's turbulence is no less intense, but the extremely low tide is preventing the storm waters from getting anywhere near the beach.

Nevertheless, the market is pricing a force 5 hurricane hitting during a full moon flood tide, and it is conspiring with mark to market accounting to discount prices by Poseidon-like proportions. The resulting price dislocation is almost unprecedented, and for long-term, opportunistic investors it really is the perfect storm.