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.

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!

Space Database Stacking Plans

The Space Database stacking plan is a back-end service that supplies content to many commercial real estate websites. It is one of our key technical innovations that facilitate getting marketing drawings out to prospective tenants as quickly and easily as possible.

Our stacking plan is a website tool that seamlessly blends into a clients leasing and marketing site. This can look any way clients want it to look:

Here is a sleek and cool version that includes a tabular report as well as leasing contact information:

And here is a version that gives you a great sense of what the building is actually like. In this case the vacancy information is semi-transparent and 'floats' over the building image:

In both of these cases the diagrams are integrated with live data from the Space Database drawing management application. Any changes made within the program are automatically and instantly updated. Links in the stack will pull up PDF file drawings of the available space.

In addition to measuring buildings, creating re-usable CAD files and calculating areas in accordance to BOMA 96, Space Database also provides the software and services to make all of this information accessible and useful. Our software and services streamline and speed up the leasing process. We help landlords find new tenants and we help speed up the process of getting them moved in.

Are Residential Brokers Technology Leaders?

There's a stereotype that residential real estate agents are amateurs; that most of them work part time and they have nowhere near the business sophistication or sales skills of commercial brokers. This might be true in some ways, but in one aspect residential brokers are way ahead of their commercial peers: the use of the interactive web to build a network, market themselves and generate more revenue.

I've come to this conclusion by rather unsophisticated means - only web browsing really - but here are some examples of what I have found:

Residential brokers are keen on technology and there is a lot of online support to help them leverage new web tools. Here are three:

• A blog by Loren Nason called Future of Real Estate Technology, focuses on technology for real estate agents. "you will find some technology products are a waste of your time and money, and others are the best investment you can make." Loren will help you tell the difference.
  
• Here is another site that helps agents leverage technology. On My Tech Opinion you can learn about new real estate sites and services. They have tips on social networking and you can find out, amongst other things, how to use web based mapping and how to insert YouTube video into PowerPoint.
  
• Joel Burslem's blog The Future of Real Estate Marketing examines the impact of the Internet on real estate and real estate marketing. He offers lots of information that allows agents to harness web 2.0 technologies.
  

Then there are a whole host of web based services and applications that support residential agents. Here are three:

• Trulia is a real estate search engine that incorporates some interesting web technology. There are map based searches that are built as mash-ups on top of Google Maps. You can take virtual walks in neighbourhoods - using Google Street View. Agents can showcase their expertise by participating in the 'Advice & Opinions' community.


• Home Gain is a service that connects real estate professionals. It also now provides a blogging platform for real estate agents to build their online communities.


• Zolve is a social network for real estate professionals. Agents can chat and share tips and ideas. They can also write blogs and promote themselves in various ways. This site has some nifty interface features.

So why do residential agents seem to be so far ahead in the use of interactive web technology and social networking? I can think of three reasons:

1. First, most of these people work independently. Where do they find help? Most likely, they will turn to a web-search to find tools that they can use. They cannot rely on IT departments and are therefore keen on web based solutions.


2. Second, residential agents do not know who their next customer will be - but they know it someone that knows someone they know. Web based social networking is a natural extension of how a good agent operates anyway: build a network and keep it warm.


3. Third, many large companies with big offices are working hard to control web 2.0 applications. Many IT departments block these tools at the firewall. These sites are seem as a threat to corporate security and control. Perhaps commercial agents, who work in offices, are discouraged, if not prevented, from using the social web for work?

Of course there are exceptions. There are commercial brokers who are using the new tools effectively. Here's a good example. Look at what Hans Hansson is doing on his blog at Starboard TCN.

Hans candidly shares his experience in the business and he offers very good advice to prospective clients. It's surprising that more commercial brokers don't have a web presence like this.

What do you think? Are commercial real estate agents, brokers and landlords missing out on the social web? Or is it not a medium that they would benefit from as much as the residential folk do?

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.

HotPads

Here's another really cool map based real estate mash-up. In this case the subject matter is rather depressing. HotPads, a residential real estate listing site in the U.S. has created a 'heat map' to illustrate areas of high foreclosure rates. Using map data from Microsoft's virtual earth and combining it with listing data, they have created colour-coded maps to show the density of foreclosures.

This is cool for what they have been able to achieve by putting two data sources together on the web. But it is very depressing when you see what it tells you. Here is a map of Detroit. Most of the city has foreclosures on more than one in 150 houses. Here's a link to this view.

If you click on the houses, you get a pop-up that gives you details on the listing. If the map is depressing, these listings are absolutely alarming. Here's a nice big three bedroom house for $9,900:

And here is a map of the Niagara Falls / Rochester area. This is just across the lake from us. Even here there are regions where there are over 1 in 600 houses that are subject to foreclosure.

Take a look at this nice house in Buffalo: yours for $32,000

I love what they have done technically with this site. They've pulled in a ton of data. The mash-up conveys information in a clear way. It's simple to navigate and drill down to the listings. Unfortunately it creates a very vivid picture of how deep and serious the housing market crisis is in the States right now.

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.

Rotten Reputation

There's a new site that has recently been launched. It is a mash-up that uses the Google Maps api and adds on a layer that allows users to comment on their neighbours. The comments are usually negative and the site is called Rotten Neighbor.

I'm not sure how useful this will be. It will simply be a site to vent anger and hatred; or as a way to play pranks on friends. It's fun as a bit of entertainment but I doubt it will be a useful tool to help pick a neighbourhood in which to live. But it still may be successful in terms of web traffic!

This site does illustrate an interesting point however. Our reputations are vulnerable online. If we do not have a strong online presence, we do not have a voice to defend against sites like these. As the web becomes increasingly interactive and social, it will be very easy to trash someone else. As individuals we need to be involved in the discussion in order to protect our own reputation.

Take these two landlord reviews for example:




Mold Problem:

Landlord renovated basement without permits. Black mold problem that has spread throughout three units of house, making previous tenants sick. Building not maintained well, freezing cold in winter. Landlord is also quite sexist and derogatory to female tenants.




Tight Ass:

The owner is a slum lord. Doesn't like to spend money to fix his investment.

Who knows if these statements are true or not. The landlords are unlikely to know that these comments exist and they're unable to give their side of the story.

Landlords rely on their reputation to attract and retain tenants. To protect themselves, they need a strong online presence. They need to be aware of where discussions that affect them are happening. As in the real world, landlords need to be approachable and responsive online. If landlords are not available to engage in an online conversation, if they can't address their critics, disgruntled individuals will take their comments elsewhere.

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.