Jenga Time in CRE

 (Image courtesy of http://www.hasbro.com/games/family-games/jenga/)

In the classic Milton Bradley/Hasbro game of skill, players take turns removing a wooden block from a tower of such blocks and balancing it on top, creating a "higher and increasingly unstable structure as the game progresses." The game ends when the tower falls in any way, with the loser being the one who made it happen.

Arguably, the commercial real estate market is a bit like a teetering Jenga tower, with blocks of leverage wobbling precariously atop the gaping holes where equity used to be. Unfortunately, as the structure comes crashing down, the losers won’t just be those who set the collapse in motion.

In "Towers of Debt," The Economist discusses the potentially far-reaching fallout from what looks like the next big disaster du jour.

Concerns are switching from the residential to the commercial sector

From a distance Potsdamer Platz looks a bit like its old self. Once the central hub of Berlin, before it was turned into a rubble-strewn no-man’s-land divided by the Wall, it is now surrounded by shiny new towers. Get a little closer, however, and it becomes clear that many buildings are just façades painted onto giant hoardings that rise ten stories high between actual office blocks.

This subterfuge makes for a far more pleasant view than that provided by vacant lots. It also points to an unusual degree of restraint among developers in Europe’s second-largest property market (by transactions). The commercial-property market in most other parts of the developed world is in deep trouble.

Unlike other property busts, this downturn has not been driven by speculative overbuilding but by investors’ overenthusiasm. Commercial property was a popular asset class for much of this decade. Institutional investors who lost a lot of money when the dotcom bubble burst were persuaded that switching from the stockmarket into property would diversify their portfolios and reduce their risk. Cheap finance was plentiful. Investors could indulge in a version of the “carry trade”—borrowing at a low interest rate to buy buildings and counting on the rental yield and capital growth to more than cover their financing costs…

Property prices have also been badly hit. Moody’s, a rating agency, estimates that American commercial-property prices dropped by 7.6% in May alone, leaving them almost 35% below their peak in October 2007. Prices would have gone down even further had not transactions dried to a trickle (see chart). Owners are loth to sell into a falling market, although some distressed sales are occurring.

All this sounds like a replay of the downturn in the residential-property market, where easy borrowing terms allowed homebuyers to push prices to extreme levels. To add to the sense of déjà vu, property loans have also been bundled into complex financial instruments, known as commercial mortgage-backed securities (CMBSs). The riskiest of these, mainly those issued between 2005 and 2007, are now running into trouble….