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What Dubai Means for U.S. Commercial Real Estate

Written By Brian Hicks

Posted December 1, 2009

You’ve heard about the Dubai meltdown. But what the mainstream press isn’t telling you could have serious implications for the U.S. commercial real estate market.

It was only a few years ago that Dubai floated the Bubble City idea — built on dreams, hysterical public relations campaigns, and billions in debt. It was supposed to be a "suspended architectural marvel, stationed 200 meters above the ground, powered by two helium balloons and an anti-gravity reaction motor."

But the idea never left the ground. And rightfully so…

Dubai did, however, build artificial islands in the shape of the continents; an island in the shape of a palm; a ski resort with five trails, encapsulated in a glass dome with chilled air; two of the tallest buildings in the world; and skyscrapers as far as the eye can see… all in the middle of a desert.

And it fueled these absurd development projects by issuing piles of debt… about $60 billion.

Yep, past times of prosperity were good to Dubai. The city grew rapidly. Property prices were exploding so fast that it was impossible not to make quick cash. And once a building — occupied or not — was finished, it could be used as security to borrow even more money to build something bigger and better.

This cycle went on for years.

But the boom would soon bust, as people decided (after watching the world financial crisis unfold), that they were no longer interested in buying into the luxurious life in the middle of the desert… leaving the area scarred with a lack of demand, no money, unfinished projects, and a depressing atmosphere.

So Dubai World, a state-owned sovereign investment fund, asked creditors for an extension on billions in debt payments.

And depsite what analysts would have you believe, all is not okay. Defaulting on billions is a big deal for a sovereign nation. The Government of Dubai just said it would not stand behind Dubai World… wiping out that long-held belief that sovereign nations don’t default.

Fortunately, We’re Not Looking at a Crisis Here… Yet

Dubai World’s attempt to restructure debt will have a "manageable impact" on HSBC Holdings and Standard Chartered, according to Goldman Sachs. Analysts estimated that potential credit losses at HSBC would come in around $611 million and about $711 million at Chartered. As for loans and commercial real estate losses, the analysts believe that in worse-case scenario, they "expect a manageable impact at less than 1% of equity, less than 5% of net profits."

Still, what we’re seeing in Dubai is part of the commercial real estate crisis we’re seeing elsewhere.

There are too many commercial projects up in areas where they’re not needed. Prices have plummeted as vacancy has risen. And a lot of the buildings were built on serious debt… with questions now arising when or even if that debt can be repaid.

It’s only a startling reminder of how fragile U.S. commercial real estate is, especially with certain U.S. properties sitting in Dubai World’s portfolio. These include MGM Mirage and the $8.5 billion CityCenter project; the Mandarin Oriental and W hotels in New York; a 50% stake in the Fontainebleau Miami beach resort; and Barneys New York Inc.

All Dubai has to do is unload some of its properties… and commercial real estate prices will plunge. It’s already seen its commercial real estate prices cut in half from 2008 highs.

Sure, it’s still too early to tell what Dubai will do. But it’s another look into how close we are to a complete commercial real estate meltdown.

Things Could Deteriorate Further

Without a doubt, this problem has emerged as the biggest threat to our economic rebound and banks — especially regional banks, which hold more than $1 trillion of mortgages backed by CRE, which is quickly losing value.

The sector will suffer from two things, one of which is bad underwriting. CMBS owners were lent money on the assumption that occupancy and rents would keep rising. But that never happened. The opposite did: "The result is that a growing number of properties aren’t generating enough cash to make principal and interest payments."

And with values sinking, vacancies soaring, and a recession making it unlikely for us to see demand pick up, banks aren’t exactly jumping up to refinance deals.

My colleague — Steve Christ — sees this as a recipe for disaster… and industry leaders have estimated that 200,000 businesses and 10 percent of the nation’s shopping malls will close their doors over the next year. (You can read more about Steve Christ’s views on commercial real estate here).

That means that we’re maybe only in the second inning here as this crisis unfolds.

So, with roughly $530 billion in commercial mortgages coming due for refinancing in 2009-2011, and some estimates showing that as many as 68% of loans maturing during that time will fail to qualify for refinancing, Steve says one has to wonder how it will all get done.

The brutal answer: it won’t.

"Federal Reserve and Treasury officials are scrambling to prevent the commercial real estate sector from delivering a roundhouse punch to the U.S. economy just as it struggles to get up off the mat," said a recent Wall Street Journal article. But "their efforts could be undermined by a surge in foreclosures of commercial property carrying mortgages that were packaged and sold by Wall Street as bonds."

And, according to Deutsche Bank AG, "as property value declines and scarce credit continue to drive commercial property developers and investors into default, total lifetime losses on banks’ $1 trillion ‘core’ commercial-mortgage holdings, or those backed by income-producing properties, would reach between 11.6% and 15.3%, or $115 billion and $150 billion."

"So far, banks in general have been reluctant to take losses on their commercial books," says the Wall Street Journal. "This ‘delay and pray’ strategy is preventing most banks from issuing new loans as they prepare their balance sheets for potential future losses… "

Stay Ahead of the Curve,

Ian L. Cooper
Wealth Daily