Ailing Commercial Mortgage Securities Deepen CRE Woes

Hawaii’s Maui Prince Resort offers white sand beaches, acres of lush tropical forest, two golf courses and even a hotel featuring cascading waterfalls. What it doesn’t provide is a return on investment.

The property, which Morgan Stanley Real Estate and local developers bought only two years ago for $575 million, is in foreclosure after defaulting on a $192.5 million loan. Its investors, which also includes Swiss banking giant UBS, may be wiped out on the deal.

The loans behind Maui Prince were financed by commercial mortgage-backed securities, or CMBS. The resort’s failure reflects the troubled market for these bonds, which are backed by a pool of mortgages on commercial properties. The market for CMBS is one leg of the stool supporting the commercial real estate sector, providing a vital source of funding for mortgages on hotels, offices, shopping malls and other business properties. And as we’ve been saying a lot of late, that stool is collapsing.

The CMBS market has yet to revive after seizing up last year. In 2007, sales of commercial mortgage-backed debt rose to roughly $240 billion and accounted for nearly half of all commercial lending. Today, sales of CMBS have sunk to just over $12 billion.

Loans underpinning CMBS are deteriorating fast. As of August, delinquency rates were seven times their level of a year ago, and 12 times the rate shortly before the real estate bubble burst in 2007. Unpaid balances on CMBS investments, which are typically held by banks, insurance companies, pension funds and other large investors, exceed $28 billion, up a startling 592 percent from 2008 (click on chart to expand).

In a sign of how quickly things are unraveling, credit rating agency RealPoint expects that figure to rise to $50 billion by year-end. Deutsche Bank in a July report estimated that total losses on all CMBS could reach 12 percent, and as high as 15 percent for commercial mortgage securities backed by more recent loans.

The trouble with CMBS indicates not only the sinking price of commercial property, but also ongoing concerns with securitization, in which loans are sliced up and sold to investors. After freezing up in 2008, certain segments of the securitization market have shown signs of life. Yet CMBS sponsors remain gun-shy about taking on the risk of pooling loans for securitization.

Here’s why all of this matters (and thanks for sticking with me). With CMBS investors on the sidelines, it becomes all but impossible to refinance maturing mortgages. That squashes the price of commercial property and hurts sales of distressed assets. More borrowers are thrown into default. Banks, already reeling from losses on residential mortgages, get creamed (they also lose out as major servicers of CMBS), further choking off credit for commercial development.

Whole loans festering on their books remain the principal problem for banks. But the deterioration in CMBS loans isn’t helping.