Checking in on the CMBX index

What does the CMBX index now suggest about the future health of the commercial real estate industry? I've been interested in this index for quite some time - see my earlier posts:

• CMBX
  
• Markit CMBX
  
• How Vulnerable is Commercial Real Estate?
  
• What is CMBX exactly?
  
• CMBX Index
  

CMBX is a derivative index that shows a market assessment of the risk for default for various classes of commercial mortgage backed bonds. In an efficient and rational market, this should be a good indicator of the future performance of the commercial real estate sector. Of course, these are not rational times.

This is what the index looks like today:

What does it mean? The index tells us what traders at hedge funds and investment banks have thought about the future of the market at various times in the past.

• At the beginning of the year, these bonds were considered to have almost no risk.
  
• In March, they were thought to be junk! Investors expected significant defaults. Perhaps commercial real estate would follow on the heals of the residential melt-down?
  
• Now, commercial mortgages carry a moderate risk premium.
  

Recent events are so far supporting the view that commercial real estate will suffer far less than the residential sector. Take for example the case of the Harry Macklowe, who bought several New York office buildings at the top of the market from Blackstone. He used $50 million of his own money and $7 billion of debt from Deutsche Bank. With that much leverage in a shaky economy, he soon ran into trouble. But he worked it out. Deutsche Bank took several of the buildings, but Macklowe retains a sizable real estate portfolio. The bank was then able to turn around and
sell the buildings very quickly. And the price they got was no more than 20% - 30% less than the value at the market peak.

The lesson is that unlike in the residential market, there are buyers for distressed property which offers significant protection for bond holders.

On the other hand, the general economic downturn in the U.S. will have an impact on the sector. Office Tenants are taking less space. Vacancies continue to rise in retail centres.

Even if there are far fewer structural problems in commercial real estate, risk in the sector is increasing due to the general economic downturn.

How to Read Financial Statements

This post is for people who don't have a financial background, but still need to analyze corporate financial statements from time to time.

Like a lot of people, you don't deal with finance most of the time. When you do need to review statements it can seem intimidating and confusing. Even after you figure them out you are left with the question: are they good? Or are they bad?

I Googled for a good simple explanation for how to read Financial Statements. The best result I got was this one from the SEC - but it's still pretty complicated! The following is an attempt to describe them in basic terms so that you can get a quick understanding about what is going on in a company - and to give you a guide for how to ask intelligent questions.

Step 1 - Focus. Financial statements are often divided into four reports, but for an initial quick overview, we only need to look at two. Look for the Balance Sheet and the Income Statement (sometimes called Profit & Loss)

Step 2 -try to get a sense of the big picture before you drill down on details. Look for subtotals. If you need to compare companies to each other, you can only do this with the bigger groupings of accounts.


The main groupings and sub-totals of an income statement

Step 3 - look at profitability. Turn to the Income statement. The income covers a period of time. At the top is the total revenue that the company took in, at the bottom is what is left over as either a profit or a loss during that period of time. In between there are some very important sub-totals:

• The first expenses at the top apply to the expenses incurred to deliver the product or service. Often there is a sub-total for 'Cost of Goods Sold' and 'Gross Profit'. These lines give you a good sense of how profitable the 'business' is.
  
• Underneath the 'Gross Profit' section are listed all the other expenses of the company. Here you can see what management is doing with expenses that are somewhat discretionary. Are they investing in the business? Do you think management is being wasteful in certain areas? Or are they under-investing in others?
  
• The net profit is the 'bottom line' - the amount of profit that is kept in the company over the period of time that the statement covers. A decent number here can either mean a good profitable business, or it could mean a business that is being milked for cash. Don't look at this number before you understand the numbers above!

Typical main sections of a balance sheet statement

Step 4 - look at financial health. Turn to the Balance Sheet. This is a very confusing statement. It is stacked as two sets of accounts that add up to the same number. Unlike the Income Statement (which covers a period of time) it is a snapshot of the company as of a specific date.

• To understand this statement, you have to understand the concept of the Fundamental Accounting Equation: Asset = Liabilities + Shareholders Equity. The way to think of this is like this: what a company owns has to equal the way in which the company paid for what it owns. Assets are all the valuable things in a company: cash, receivables, inventory, furniture, land and property. The company acquired these assets either by taking a loan (liabilities) or by using the owners capital to pay for them. The capital can be the cash invested originally or it can be profits that have been left in the company. The Fundamental Accounting Equation says that the assets have to equal the debt and equity used to pay for the assets.
  
• How do you determine the financial health of the company? You need to look at the at the 'short term' debt - which means things that have to be paid soon such as payables and compare it to liquid or near liquid assets - which are cash and receivables. For these items liquid assets need to be a fair bit more than short term debt for the company to be comfortable.
  
• You should also look at the ratio of total debt and equity, but there is no absolute rule about the best relationship. Too much debt can be risky, but too much equity can be inefficient. The ideal balance can depend a lot on the industry and the type of business. If these seem out of wack, you should find out why.

Step 5 - Put the pieces together. Think about the net income on the Income Statement. Think about the liabilities on the balance sheet. Is the company earning enough to pay its obligations? And now think about the business itself. Will the income be steady or variable? If the revenue grows, will more capital and debt be required?

I hope these very basic steps will allow you to leverage Financial Statements into useful management tools that can help you better understand the workings and performance of a company.

In a future post, I will cover financial ratios which are very useful in comparing two or more companies in the same industry.

Canada: World's Most Transparent Real Estate Market

Each year, Jones Lang LaSalle publishes a report on 'real estate transparency' that covers 82 countries. in their latest study, Canada was found to be the global leader!

Transparency is an economic concept that measures the amount of valid information that a buyer is able to access about a market. Transparency is an essential prerequisite for a free and efficient market.

The Jones Lang Lasalle Global Real Estate Transparency Index
looked at five key attributes of real estate transparency - performance measurement, market fundamentals, listed vehicles, legal and regulatory environment, as well as the transaction process.

For investors a high degree of transparency means that there is less risk. Laws are consistently applied and interpreted. Professionals have high ethical standards and accurate comparable market information is available.

For sellers of real estate there is also good news because a more efficient and transparent market will attract investment. The inflow of capital drives up prices. There is value in quality.

Congratulations to Canada's commercial real estate professionals - world leaders in their field!

CMBX Predictions

Readers of this blog know I have an ongoing fascination with the CMBX index. What is it exactly? Why was it so high? And why has it come down again? What exactly does it tell us about the future of commercial real estate?

Here are links to my earlier posts:

• Markit CMBX
  
• How Vulnerable is Commercial Real Estate?
  
• What is CMBX exactly?
  
• CMBX Index
  

Well, here's an updated picture of what it looks like today:

Apparently the CMBX index - the oracle that it is - no longer believes that there is a high risk for defaults in commercial real estate in the coming year. Remember that when the CMBX goes down, it indicates a lower 'spread' and therefore the prediction of a lower risk for default. This trend is happening just as real economic data is emerging that contradicts this sentiment: take a look at this post on Mish's Global Economic Trends. Here are some highlights:

Vacancies in commercial real estate is increasing rapidly -it is expected to peak at 18% in 2008. Architectural billings in the US are down almost 78% over one year. look at the right-hand side of this chart :

Shopping centre vacancies are increasing rapidly - already at 28%:

And yet the CMBX index seems to suggest that the likelihood of defaults in commercial real estates has now gone down? Is this realistic? Or is this index too heavily influenced by short selling and speculation to be meaningful?

I found an interesting opinion on this on another blog. Myles Lichtenberg writes on
Maryland Commercial Title's corporate blog about this. He quotes a report by Moody's:

“If sellers were forced to sell, as can occur when banks foreclose on loans and subsequently sell off the collateral property, a more dramatic drop in prices would likely result.
However, when sellers are not compelled to sell, prices do not or can not adjust. In fact, prices can hover at some level in nominal terms for an extended period before responding to a changed market environment.”

The insight here is that even though the performance of commercial real estate might decline on a cash-flow basis, this will not mean that prices will fall. Large financial and institutional investors will choose to weather the storm. the number of transactions is likely to drop off, but prices are likely to remain much more stable than in residential sector. Asset price stability and the presence of well capitalized buyers will protect even the over-leveraged in the commercial real estate market. If the market value of the assets remain and as long as there are a few buyers, an cash strapped owner can get out by selling. The value of the asset as collateral will also help in any 'work-out' with lenders.

So have investors realized this difference? And has this insight been reflected in the CMBX index? Or am I reaching here? -just to maintain my faith in the value of a derivative index?

Factoid: Markit, the creators of the CMBX index is a spin-off from the TD bank - a Canadian connection!

What Real Estate Can Teach Banking

There's a lot that banking can learn from the real estate industry. I still vividly recall the real estate driven recession in the early nineties. This was the environment I graduated into with a fresh, new architecture degree! There was no work around. Real estate had collapsed as a business and was dragging the rest of the economy down with it. Rampant speculation had led to massive over building. There was a glut of empty office space that could not be leased. Solid reputable builders and owners were destroyed and lenders lost billions.

Look at real estate in Canada now. It is probably one of the most open and transparent sectors that you can find. Long term investors such as pension funds and REITs have brought financial discipline to the industry. Buildings are bought and sold on verifiable financial metrics. Tenants lease space based on the expectation of accurate areas (which has contributed to Space Database growth!) and they expect landlords to justify and disclose all operating expenses. This stable sector is able to develop in close coordination with market demand. Our open and transparent market has become very attractive to foreign investors which has led to an inflow of capital and a stable rise in prices.

But it was not easy to get to this situation. Our biggest and boldest developers went bankrupt. The builders of all today's prestigious addresses in Toronto have been wiped out. The fallout included huge financial losses and a major recession, but in the end we have in Canada a mature, healthy and safe commercial real estate industry.

So what lessons can the banks learn from real estate?

The first lesson is that losses have to be taken to clean up the system. Failures have to happen for there to be a turn-around. In order for pension funds, foreign investors and REITs to reshape the real estate industry, the old developers had to be dismantled. In banking we must expect more firms like Bear Sterns to disappear. Protecting them will only extend the agony.

The second lesson is that reality will always catch up. In the late eighties, there seemed to be no limit for developers. New, big buildings were appearing at a furious pace. The problem was that the underlying economy was not growing at the same pace and there were not enough tenants for the space. Similarly today, finance has rushed ahead of the economy. According to The Economist, financial services companies in the U.S. accounted for around 40% of all corporate profits in 2006! This grew from a more reasonable 10% share in the early eighties. Just as there turned out to be no real tenants to pay for the new buildings in the eighties, so too now, it turns out that there are no real backers of the 'products' that banks have created.

The third lesson is that real value survives its creators. If you look at the skyline of Toronto, we still have the TD Centre, Scotia Plaza and BCE place. The builders are bankrupt, but what they created had real and lasting value. We are likely to benefit from what these developers created for another hundred years. What value does a company like Bear Sterns leave behind? Does securitization create value? Is it the concept or the implementation that was flawed? An industry that does not create, but only redistributes wealth is not sustainable and will hurt us all in the long run. If anything is to be salvaged, then banks have to figure out what elements of what they do create real value for society.

Leases Are Confidential?

It's common knowledge that leases are highly confidential. They are one of a landlords most carefully guarded assets. Leases are secret. Everyone knows that.

Except for publicly traded companies! They have to file everything with the SEC. And the SEC posts everything online at http://www.sec.gov/edgar.shtml If, for example, you want to find out what Corel is paying for space at 1600 Carling Ave in Ottawa, you can find it here. It's $22.03 a square foot plus operating costs of around $16.77, by the way. It's the whole lease, so you can see all the terms and conditions.

Clearly the SEC's EDGAR system is not easy to search - it's not exactly user friendly. It's not easy to find loads of lease information, but it's there. If you are curious what tenants are paying in a building, take a look and see if there are any publicly traded tenants and do a search.

Interestingly, I looked to see if I could find leases on the Canadian system: www.sedar.com/ I could not find them there. I'm not sure if the disclosure rules are different, or if they are just filed differently. But chances are that any large public entity will have to file with the SEC anyway and the information will be on the U.S. system.

Markit CMBX

Look what happened to the CMBX today! After climbing to a height of 275 a few days ago, it is now down to 150. Basically this means that the spread on triple AAA commercial real estate bonds was north of 2.75% over the risk free rate but now only has a risk premium of 1.5%. As an indicator of risk, this would mean that the risk of default has just been cut in half. Half as many commercial defaults are predicted.

But how realistic is this?

The actual number of commercial defaults is at an historical low. Are the bond prices falling because they have a lower expected return? Or are the prices falling because there are no buyers? And what about speculation: is short selling having an influence?

An article in the Economist suggests that the CMBX and other indexes may be overly sensitive to downward distortion.

And why did CMBX so dramatically improve?

There are two pieces of news that influenced this. First, the offer for Bear Stearns was increased from $2 per share to $10, which would suggest that there is still some value in some of their financial assets. The other piece of news was that housing sales in the U.S. had risen slightly in February - even if prices had continued to fall.

The market does not seem to be behaving rationally. "Psychology has now overwhelmed economics," wrote Alan Blinder, former Fed vice-chair, in the Washington Post.

How Vulnerable is Commercial Real Estate?

There are rumors of trouble on the horizon for commercial real estate. The CMBX index (see earlier post) suggests that we can expect a substantial increase in defaults of commercial real estate backed bonds in the next year.

If we look at the current economy, we can see that there are three factors that will put pressure on commercial real estate. The first is the slowdown in the U.S. economy which is likely to put pressure on many classes of tenants. Some will be pushed into bankruptcy and others will be forced to scale back operations. We can therefore expect a substantial increase in vacancy rates. The second is that recent high valuations on commercial real estate have justified the use of significant leverage - it's been easy to take on debt. The third factor is that debt capital is drying up. Loans will be harder to get and interest rates will be higher as lenders worry about risk.

So how much pressure can owners withstand? We can build a simple model to analyze the effect of increasing vacancy and rising interest rates. Here's the scenario:

• Building X is a 100,000 sq. ft. commercial building.
  
• The operating costs are $10 per sq. ft.
  
• Tenants pay $20 per sq. ft. (S10 for operating costs and $10 as rent)
  
• The building is 95% occupied
  
• Current cap rates are at 7%
  

Based on these parameters, the building would generate $900,000 in cash flow each year. It would be valued at $12.86 million. In our scenario, we will purchase the building at this price using a conservative capital structure of 50% equity and 50% debt.

• Total debt will be approximately $6.43 million
  
• Invested equity will be approximately $6.43 million
  
• Interest rate: approximately 6%
  
• Annual interest payments: approximately $386,000
  

With this scenario we will generate a return on equity of around 8% each year. Our cash flow is more than twice our debt obligation, so the project seems secure. But what happens if the vacancy increases and the interest on our debt starts to creep up? The following table shows what will happen to our return on equity (ROE) as these conditions change:

The yellow colour indicates where we would exceed our debt coverage ratio (in this case 1.2) and the red fields indicate negative cash flow. As you can see, if interest rates rise by 2% (realistic since the CMBX has risen 200 basis points recently) and if vacancy increases by 20% (realistic in light of an economic slow-down) we will have negative cash-flow. At the same cap rate of 7%, our building is only worth $7 million. If cap rates also increase a bit, we will have lost all of our equity and we'll be in debt to the bank.

Keep in mind that this example is conservative. There are many buildings that have been purchased at less than a 7% cap rate. And there are many buildings that have more than a 50% mortgage against them. As credit dries up and as vacancies increase, many landlords will feel the pain.

What is CMBX exactly?

If you search for information on this index, you will see that it is used a great deal on the web but I have not found a simple explanation for what it actually is and the precise role that if plays in finance. Here's what I have been able to piece together.

The CMBX is an index published by a company called Markit . It is simply an index that tracks performance of several baskets of bonds. The CMBX AAA index tracks the yield on a group of triple A bonds that are backed by real estate loans.

So, first we need a quick explanation of yield. Current Yield is the ratio of the annual interest payment and the bond's current price. If a bond costs $100 dollars and has an annual coupon Interest payment) of $10 the yield is 10%. If the price falls to $80, then the yield increases to 13%. The value of the bond would fall if the market believed that the bond became more risky. Riskier investments have a higher yield to compensate the holder for the risk of default.

To make things more confusing, the CMBX does not track the bond yields directly. The index is expressed as a 'spread'. In this case this is the difference (spread) between the yield of the bonds being tracked and the current yield offered by government bonds (commonly called the 'risk-free' rate).
The result is that when the bond prices fall, the spread increases and the index goes up. A high index value means that the financial community sees these bonds as being at a higher risk of defaulting. We can see from this chart that the spread for triple A rated bonds has increased from less than 0.5% in October to over 2% in February.

And how is the CMBX used? It is not a product you can buy directly. See CORRECTION in comments. This index is used as a benchmark for pricing other financial products: Credit Default Swaps. A CDS acts like an insurance policy on a bond. The seller of the product will assume the default risk of a bond. If the bond defaults, the seller will pay the buyer the value of the bond. For this insurance, the buyer pays the seller a periodic premium that is related to the riskiness of the bond. And how do they agree on the riskiness of the bond? The use the CBMX index!

You don't have to own the bond in question to buy a CDS against it. If you want to, you can bet against the commercial real estate industry. When real estate companies default, you will collect a windfall!

CMBX Index

A recent Wall Street Journal article discusses the CMBX index and it's use in predicting the default risk of commercial real estate. Even though there are very few current defaults, this index now suggests that there is trouble to come.

This is a derivative index that is based on the pricing of bonds backed by commercial real estate. In simple terms it represents to cost of insurance against default - which is a good measure of risk.

The alarming thing is that this index has been going up of late which would seem to indicate a stormy future for commercial real estate.

This chart shows the index for AAA rated commercial real estate bonds:

Tech Note: I could not find this index on popular finance sites. The above chart is published through an iframe that is fed from Markit.com, the creator of the index.