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Notes from Jim Haughey

Reed Construction Data Chief Economist Jim Haughey discusses how current developments in construction markets and the ecomony will bring opportunities and challenges for designers, contractors, and materials and services providers. His reports will cover near-term building demand, cost and financing changes, and will provide early notice on changes in the detailed two-year construction forecasts elsewhere on this site. Feedback and questions from readers are encouraged.

Thursday, October 11, 2007

Commercial Real Estate Braces for Another Financial Shock

Oct 11 2007 8:29AM | Permalink | Email this | Comments (1) |
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The commercial real estate market has yet to fully recover from the suddenly higher cost and reduced availability of funds for commercial mortgages that spilled over into their space a few months ago when lenders withdrew from the fraud-ridden subprime residential mortgage market. Most of that problem, however, is now behind us. But now the market is bracing for the scheduled end on December 31st of the federal governments’ no fee reinsurance program for terrorism insurance.

This temporary program began in 2002 in the absence of a private alternative and was extended through 2007. Reinsurance shifts the huge financial risks of terrorist attacks that destroy or damage commercial buildings from the owners of commercial buildings to the US Treasury Department. After large deductibles, insurers recoup some of their casualty losses from the Treasury. Taxpayers are at risk for $100 Billion of reinsurance claims.

Without reinsurance, a huge casualty loss from an act of terrorism would first bankrupt the insurance carrier and then possibly the building owner. The mortgage holder would be left with a worthless piece of paper. The temporary federal program was designed to prevent commercial mortgage lenders from demanding a large premium in the interest rate to cover their terrorism risk. The recent boom in commercial construction would not have been possible with the reinsurance program. New construction would not have become financially attractive to developers three years ago if the commercial mortgage interest rate had been substantially higher.

The current situation is that the Senate is considering a 15-year extension of the Terrorism risk Insurance Act (TRIA) and some broadening of the governments’ guarantee. The House is waiting for Senate. President Bush has promised a veto, demanding that insurance carriers buy private reinsurance. That was not possible in 2002 when the risk of another terrorist attack was believed to be larger than it is generally believed to be now.

Everyone loves a freebie and fights hard to keep it once they get it. The fight to keep the taxpayers on the hook for terrorism casualty losses is being lead by the Commercial Mortgage Securities Association. They own the $800 Billion of commercial mortgage backed securities (CMBS) that would drop sharply in value in the absence of terrorism reinsurance.

The outcome is not yet clear. President Bush probably has the votes to prevent the no fee reinsurance program from becoming permanent. Two outcomes are possible. First, the ideological battle may be deferred by enacting a short, probably 1-2 year, extension of the current law. While this would seem to leave the situation unchanged, CMBS interest rates would creep up later this year as holder get nervous whether any extension will be enacted. Second, the president prevails, forcing insurance carriers to scramble for private reinsurance. This would also produce at least a several month period of uncertainty and higher CMBS interest rates. Casualty insurance premiums would rise to cover the cost of private terrorism reinsurance. In turn, this would reduce the net operating income from owning a building and make building additional space less attractive to developers.

Either outcome results in some market turmoil in the coming months with the unavoidable negative consequences for commercial building construction starts. As of now the solution to this problem, whichever choice is made, is not likely to cause any more delays or cancellations than the spillover of the residential mortgage problems did a few months ago. But remember that successful investors prepare for the worst case outcome. And that could be as big a negative to commercial construction as was feared possible a few months ago during the subprime mortgage crisis.

What should Congress do? It is tempting to ignore the consequences of assuming a $100 Billion contingent risk on behalf of the taxpayers. Note that Florida did this recently for residential hurricane casualty losses to bring down homeowner insurance premiums and prevent an exodus from homes on the Florida coast. The immediate impact on Florida housing has been very positive. But is this shortsighted? Does it encourage people to take more risk — making the casualty loss from the next hurricane even larger — because they do not pay for the cost of the risk?

Reader Comments

at 10/11/2007 2:00:43 PM, Paul said:
Here is a rare case where I agree with Bush. Veto the bill. The US tax payer can not afford another drain on the treasury. This sounds like a opportunity for fraud for the insurance companies. Lets take personal responsibility people, isn't that what the republicans/conservatives stand for?

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