COVER STORY, DECEMBER 2007

MONIED INTEREST
Despite tightening lending standards, investors can rely on the national market's long-term strength.
William E. Hughes

Hughes

The capital markets have settled and lender spreads have eased moderately since this summer’s disruption stemming from residential subprime mortgages. The Federal Reserve’s move to slash its funds rate on September 18 immediately eased investors’ nerves, but the longer term effects of the most recent quarter-point cut on October 31 have yet to be seen. The credit markets, which took a major hit this summer, are starting to stabilize. Nevertheless, commercial real estate investors face a liquidity squeeze and conservative underwriting standards when pricing deals, despite healthy commercial real estate fundamentals. The cycle of increased liquidity began in the aftermath of the dot-com bust and the September 11th terrorist attacks. The availability of low-cost capital propped up the global economy, increasing investment activity and fueling price appreciation, particularly in housing. Global liquidity and the need for higher yields produced a higher tolerance for risk among investors, which would eventually require realignment.

In addition, in the past 20 years, the concentration of balance-sheet debt held by banks has been reduced substantially through the securitization of mortgages. Loans are placed into pools and sold off as Commercial Mortgage-Backed Securities (CMBS) to investors. This distribution of risk has been a positive force for the financial system; however, it has also obscured the identity and exposure of investors, particularly in subprime mortgages. This uncertainty caused investors to pull out of the CMBS market this summer, as several funds announced problems with subprime mortgage holdings, and concerns spilled over to commercial securities.

AAA CMBS spreads initially rose from 30 to 66 basis points over swaps, but narrowed to around 53 basis points in third quarter 2007. Conduit lender spreads increased from 110 basis points over the 10-year Treasury yield to 220 basis points between late July and mid-August, but came down to the 175- to 180-basis-point range as of third quarter 2007. Loan-to-value (LTV) and debt service coverage (DSC) requirements have tightened substantially. As conduits substantially reduced lending, commercial banks, life insurers, credit unions and agencies increased activity. Interest-only (IO) loans have all but disappeared and higher-risk transactions are receiving the most scrutiny. Property quality, actual performance and location are driving lenders’ decisions.

Unlike the liquidity crunch in 1990-91, property fundamentals are healthy. Although moderate increases in CMBS delinquencies are expected, they are currently near historical lows. CMBS 60-day delinquency is at 0.21 percent, the lowest rate reported since 1999. Life insurers are reporting delinquency of 0.1 percent, compared to 3.6 percent in 1990 and 7.3 percent in 1992. The Fed’s infusion of cash this summer and a reduction in the discount rate helped to correct the market.

Conduit lenders accounted for approximately 45 percent of commercial lending in the past 12 months ending in third quarter 2007 and have been impacted the most by the liquidity crunch. Fortunately, the 10-year Treasury yield declined 60 basis points at the end of the third quarter from its mid-June peak, helping to offset higher lender spreads. It is interesting to note that spreads today are relatively close to historical norms, but the rapid shift in the market is nonetheless proving to be a challenge for investors. Some conduits have temporarily pulled out of the market in anticipation of the return of additional liquidity. As a result of lender uncertainty, some borrower applications are being returned and confirmed rate locks are being broken.

CMBS Market Faces Challenges

Clearly, spreads have increased across the board, but the CMBS market has been the most affected. Local and regional banks are taking advantage of this opportunity to gain market share, and some are offering loans without prepayment penalties. Borrowers can also look to life insurance companies or to Fannie Mae and Freddie Mac for multifamily loans. A variety of solutions are being implemented with these lenders to facilitate transactions, including seller carryback, bridge debt, short-term variable debt and assumable financing. Although the CMBS originators took a hit, they are eager to step back onto the playing field.

Lenders mitigated risk by underwriting new loans based on actual NOIs, raising debt service coverage (DSC) ratios and lowering LTV requirements to the 60 to 70 percent range in October, compared to 75 to 80 percent in July. In some cases, borrowers are finding that loan applications previously accepted based on strong DSC of 1.25x or higher are being re-priced with reduced loan proceeds, as underwritten cash flows no longer meet minimum DSC requirements. Some transactions fell out of contract this summer as a result of leverage gaps, requiring more buyer equity. Lenders are driven by asset quality, strength of the local market – as defined by employment and demographics – and the financial strength of the buyer.

In October, the financial markets showed signs of stabilizing, which was evidenced by the increase in transaction velocity recorded in third quarter 2007. A 12 percent increase in sales volume by one real estate investment firm during a time of global capital markets crisis when more than 100 hedge funds and 5 of the top 10 mortgage brokers went out of business is significant. It is also a time when investment banks were unable to unload more than $240 billion in financing for buyouts they had committed to.

Sound fundamentals across major property types will help to sustain investors’ interest in the long term. Furthermore, with a healthy supply/demand balance and expectations for continued rent growth, liquidity is forecast to return to the market well ahead of the residential sector. While there was a momentary decrease in sales volume, that decline was due almost entirely to changes in the lending environment. The number of deals falling out of contract spiked in July and August, but the dollar volume of deals under contract also increased, suggesting that many closings were delayed and not cancelled.

Nonetheless, some risk premium did in fact return to real estate, with cap rates for all property types expected to rise by an average of 20 to 50 basis points by year’s end. Higher-quality assets in strong markets and those with assumable or seller financing will be affected the least. While increased borrowing costs and limited price appreciation will put upward pressure on cap rates, a dramatic correction is not expected.

Buyers and lenders have become more discerning, causing a greater distinction in cap rate and pricing trends based on quality and location. Lenders have become more selective, showing a strong preference toward historically tight markets and top-quality properties that can show current strong occupancy and rent growth. Local market factors play a much more critical role once again, as opposed to the broad-based cap rate compression from 2001 to 2006.

Investors Will Look to Lower-Risk Investments

On average, commercial real estate prices have increased 60 to 90 percent in the past 5 years, resulting in a significant build up of equity. The current disruption to capital flows and higher financing costs will be overshadowed by investors’ opportunities for attractive cash returns and building long-term value. Furthermore, the tremendous amount of equity in the market is helping to offset lenders’ lower LTV requirements.

For many investors, mitigating risk has become a primary objective. As baby boomers near retirement, demand for lower-risk investments that offer stable returns will rise substantially. For investors with a higher risk tolerance, there are still opportunities in the market that offer above-average upside potential: deals that rely heavily on future rent and occupancy growth, however, will require borrowers to put more cash down to satisfy current DSC requirements and will face higher rates.

Mortgages originated as recently as this summer could easily have more favorable rates in place than those available today. When assuming a loan on a property with significant equity, borrowers may be able to obtain secondary financing to help fill the gap. Given the tighter financing environment, low leverage buyers and cash investors will be better positioned for buying opportunities. However, healthy property fundamentals will prevent major price reductions. Higher risk in the CMBS and corporate debt markets, along with stock market volatility, will keep commercial real estate higher on investors’ lists of options. Furthermore, total returns in the U.S. real estate market have surpassed the stock market by a wide margin during the past 10 years. Real estate offers investors a level of intrinsic value that cannot be found in the stock or bond markets. When companies fail, stocks become worthless, but when a property loses tenants, it still has residual value and retains upside potential. Even when assets become outdated or obsolete, investors have the opportunity to reposition or redevelop to improve or renew income streams.

On average, it has taken 5 to 6 months from the start of a liquidity crisis to return to more normalized conditions. In 1998 and 2001, it took between 1.5 to 2 months for CMBS spreads to peak and an additional 4 to 6 months to recover. We are several months into the current widening cycle if we start tracking from May 2007. There is an estimated $40-plus billion overhang of commercial loans in the CMBS pipeline, which may take a few more months to clear. The rate of recovery depends on how quickly investors regain confidence in CMBS, which is difficult to predict given that any one economic variable could sway the direction of the market.

Despite the summer lending market disruption, the capital markets have started to stabilize and spreads have contracted, demonstrating a return to stability. At the beginning of the fourth quarter, even conduits had expressed an interest to step back on to the playing field. The greatest risk faced by investors is an extension of the credit crunch due to further financial market disruptions. In addition, if the negative psychology in the housing market intensifies, consumer spending could be adversely affected. If these two hurdles can be overcome, the commercial real estate market should continue to strengthen in the first half of 2008, although more conservative underwriting standards are here to stay for some time.

William E. Hughes is the senior vice president and managing director of Marcus & Millichap Capital Corp.

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