The coming disaster in US commercial property

Something nasty and ugly is in store for the US commercial property markets. The spike in high yield MBS (mortgage backed securities) risk premia and the plunge in "asset light" hotel chain shares like Hilton and Marriott mean buyers can no longer finance asset purchases in an overheated market. This means US office, hotel and mall prices will fall in 2016 and loan delinquencies will rise, as credit risk continues to spike, especially in oil and gas centric states like Texas, Louisiana and North Dakota. The spillover from the high yield (junk bond) bloodbath and the drastic drop in Asian/Gulf sovereign wealth fund demand for trophy assets will only accelerate price declines. When China sneezes, the New York, LA, San Fran and Boston markets catch influenza. The magic of marginal demand curve shifts, my dear Watson.
I am aghast at the financial distress in the global banking system. This will hit property prices really hard since banks will ration credit to property developers and asset owners, exactly as happened in the UAE in 2015. Loan pricing will go up. New MBS issuance volumes will fall. Refinancing risk will become a sword of Damocles. The new normal in bank finance/MBS markets is the reason Morgan Stanley did a U-turn and now forecasts flat/lower prices in US commercial real estate, not a sunny five-seven per cent rise in 2016.
A number of bearish omens haunt the market. Donald Trump just won the South Carolina and Nevada primaries (though the next Prez is a rock star Manhattan developer!). No less than $200 billion of commercial mortgage backed securities (CMBS) must be refinanced in 2016-17. The cost of property refinancing will only rise for borrowers. Asset securitisation is the lifeblood of US office, shopping mall, apartment tower and hotel/resort project loans are rising. With institutional investors not willing to catch a falling knife on complex property MBS debt, bank finance will become almost impossible for developers. Wall Street is glutted with commercial MBS paper in any case, with $100 billion in new issue in 2015, the highest post Lehman level.
The Street's grapevine contends George Soros and some Swiss ultra-high net worth family offices are sellers, as are embattled banks in Brazil (BTG Pactual?) to GCC/Asian funds. When credit markets turn sour, even the Lion City turns into Pussycat City! The smart money is bailing out from Western commercial property markets, if the bloodbath in retailer/hotel bonds on my Bloomberg screen is right. This alarms me because retailers and hotel debt in West should have strengthened on the $3 trillion windfall from the oil crash. When asset classes peak, I heed the old Victorian surgeon adage. When in doubt, cut it out! After all, even the Federal Reserve warned the world that there was "frothiness" in property values.
Commercial real estate prices depend on corporate demands, rental trends, investor sentiment and buyer borrowing costs. With global banks pressured by Basel III/Dodd Frank to boost capital ratios and petrocurrency/Asian sovereign wealth funds net sellers, borrowing cost and refinancing risk in commercial real estate will only rise. This asset class delivered a fabulous 12.7 per cent return in 2015. Yet all good things come to an end and so will this sector's bull market. With the market 17 per cent above its "Lehman moment" peak, I expect at least a 10 per cent fall in the next twelve months. It is suicidal to boost loan to value ratios or bet on exotic interest only loans. I remember the leveraged madness of 2008 far too well. When this illiquid puppy sinks, it drowns.
Hotel shares have turned ghastly even though US hospitality fundamentals are good. This is a cyclical business vulnerable to a "growth scare" and tighter financing. Unlike office landlords or mall operators, there are no multi-year tenant contracts for hotel owners travel is at the mercy of macro/FX cycles and AirBnB boosts supply. Wall Street's iconic hotel brands Marriott, Hilton Worldwide and Hyatt are down 25-30 per cent in the past year. Aint no sunshine when she's gone!
Researched and compiled by Matein Khalid. Mr Khalid is a global equities strategist and fund manager. He can be contacted at: matein@emirates.net.ae