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Saturday, July 28, 2007

Other shoe drops on REITs

REITs focused on commercial real estate have been dropping due to rising interest rates and the fear of a credit crunch that might put a damper on the lively pace of buyouts in the sector. With rates coming down, I expected these REITs to at least slow the rate at which their stock prices have been falling. As we saw this past week, though, selling actually accelerated.

What's going on? Opening the Wall Street Journal this weekend, I believe I found the answer. There is an article detailing the increase in delinquencies in the commercial real estate sector. Previously, delinquencies and foreclosures are things that were only being discussed in relation to residential real estate. Now it seems they are spreading to commercial real estate, as well.

There have been some articles in the business press about how vacancies are low and rents rising in commercial real estate. Thus, it initially comes as a surprise that there are delinquencies. In looking into the details, however, the cause of the problem is the same as we are seeing in the residential sector: shoddy lending practices.

There has been a wave of real estate transactions as REITs have been taken private and property has changed hands. All these transactions take place, of course, with borrowed money. Underwriters overvalued the real estate backing the loans and overestimated borrowers ability to repay. The properties and the borrowers are now loaded with more debt than they can support. Sounds familiar, doesn't it?

In another familiar twist, the loans were bundled to create commercial mortgage backed securities, known as CMBS. Now, as underlying loans experience delinquencies, some of these bonds are being regarded as riskier than initially thought.

So far, the rate of delinquencies has not reached serious proportions; however, there is no assurance that it won't. Indeed, as we are seeing more delinquencies it appears they are occurring earlier than usual.

REITs have been in trouble for a while now. First we had bad credit conditions. Now we have rising delinquencies. The other shoe has dropped.

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