Fire Up the Chainsaws

With the Dow now pushing nose-bleed heights at the 8000 level, the markets have suddenly gone from worries about the next Great Depression to talk of "green shoots" and "glimmers of hope."

And in an uptrend that has seemed to defy gravity every step of the way, fear has given way to greed, causing one bad tape after another for the bears.

In fact, two weeks after I wrote about these mysterious "green shoots" myself, the markets have jumped even higher, led by the financials.  One by one now, the banks have gone on to beat expectations, giving the bulls the upper hand.

But despite these balance sheet miracles the banks have pulled off lately―thanks largely to TARP money―it is safe to say the banks aren't exactly out of the woods yet.

And by extension, neither are we.

That's because even if the banks have temporarily put their troubles behind them, the next shoe is now lining up to drop. 

I'm talking, of course, about a deteriorating commercial real estate outlook, where all signs now are pointing to a much steeper decline.

In fact, just this morning the industry was hit with a virtual bombshell, as time finally ran out on General Growth Properties Inc. (GGP), the second largest mall owner in the country with more than 200 properties. Before the bell, they filed the biggest real estate bankruptcy in U.S. history after amassing $27 billion in debt during the run up.

The Beginning of the End in Commercial Real Estate

That makes GGP the equivalent of a dead canary in a coal mine, as this cycle of distress will undoubtedly take others down with it. General Growth Properties will certainly not suffer alone.

"This is kind of the beginning of the end," Dan Fasulo of Real Capital Analytics said. "This bankruptcy will drive down the values of mall assets in the United States. It's going to put, I believe, more supply on the market than can be absorbed by investors."

Of course, this is something we have been warning our readers about for some time now.

In fact, our own Ian Cooper has been playing the downside in commercial real estate for months now, warning his Options Trading Pit readers:

"The meltdown at some of the biggest commercial REITs will be another blow to a financial system teetering on the brink of disaster. And nothing may be able to stop the slide. . . One reason for concern is that the CMBS market (commercial mortgage backed securities) has just about dried up. And if buildings can't be refinanced, we could see further distress, driving real estate values even lower."

That was two months ago. Since then it has only gotten worse, which Mr. Greenshoots himself, Ben Bernanke, admitted yesterday with the release of the Fed Beige Book.

In an otherwise "less awful" report, the Fed was considerably less rosy on commercial real estate noting:

"Nonresidential real estate conditions continued to deteriorate over the past six weeks. Demand for office, industrial and retail space continued to fall, and there were reports of increases in sublease space. Rental concessions were rising. Property values moved lower as reality 'set in.' Construction activity continues to slow, and several Districts noted increased postponement of both private and public projects. Nonresidential construction is expected to decline through year-end, although there were some hopeful reports that the stimulus package may lead to some improvement.

"Commercial real estate investment activity weakened further. Contacts said a decline in credit availability and markdowns on commercial property were keeping buyers and sellers on the sidelines." (Emphasis mine)

Commercial Real Estate Outlook

Translated, that means "look out below," an opinion shared by David Henry, president of U.S.-based Kimco Realty Corp.

Henry told the CIBC real estate conference this week, "We have a massive wave of debt maturities coming, at least in the U.S. . . and there will be a massive amount of workouts, there will be some extensions, but there will also be some very high-profile bankruptcies, and very high-profile forced sales."

In short, it's the vicious cycle all over again. And as in residential properties, the troubles in commercial real estate revolve around loans gone bad and falling property values―off by as much as 50% from the peak.  

In fact, some analysts now estimate defaults on commercial loans could go as high as 6% by 2010. Sound familiar?

One way to play this inevitable trend lower is to short sell hotel REITS, since they are doubly vulnerable these days. For them, it's not just CMBS worries but a big drop in room revenues as consumers retrench.

So, how bad has it gotten for hotels these days?  Well, here's the quote of the day for you by DRBS.

The bond rating agency recently said, "News coming out of the hotel market is, quite simply, not good. Well, bad actually. No, make that terrifying. Predicting hotel performance over the next 12 to 18 months is like juggling chainsaws while riding a unicycle."

That makes Starwood Hotels & Resorts Worldwide Inc. (HOT) and Intercontinental Hotels Group (IHG) good candidates to move further to the down side.

So, enjoy those green shoots for as long as they last. The brewing troubles in commercial real estate have really just begun.