COVER STORY, JANUARY 2008

FINANCIAL FORECAST
What happened in 2007? What's next?
Daniel J. Smith and Brent Wessel

Smith

Commercial real estate finance changed so quickly in 2007 that even experienced borrowers were mystified. Almost overnight, stable spreads, aggressive underwriting and favorable loan structures vanished, replaced by tighter liquidity, strict underwriting and deal structures, and volatile spreads that widened almost daily.

What happened? The answer is as simple as investors disappearing and as complex as a detailed analysis of the many forces that drive global capital markets. Between these two extremes, a high-level exploration of the capital markets’ role in financing commercial real estate, how investors and rating agencies responded to the subprime meltdown and the impact of the resulting liquidity crunch can help borrowers better understand how commercial real estate finance is likely to play out in 2008.

A Secondary Market

Wessel

The relationship between global capital markets and commercial real estate is extremely complicated. On the simplest level, the capital markets are a secondary market that buys commercial real estate loans and provides liquidity in the process. A capital markets lender pools commercial loans into securities and sells those bonds to investors. The lender receives new capital in return, which it then uses to make new loans that it securitizes and sells. In 2007, the market for commercial real estate loans nearly came to a halt when defaults on residential subprime mortgages spiked.

The Subprime Trigger

Defaults on residential subprime mortgages — and the ways in which investors and rating agencies responded to them — triggered much of the volatility in 2007’s commercial real estate spreads, as well as a liquidity crunch and significant changes in lending practices.

First, the specter of widespread subprime mortgage defaults heightened fears about broader real estate markets and the economy. Housing prices had increased so rapidly in recent years that many feared subprime mortgage losses would spread to housing and tip the economy into recession.

Second, there are many types of commercial real estate investors. Some of them also buy bonds based on other collateral, including residential mortgages.

In mid-2007, some investors who experienced large losses in subprime residential mortgage bonds or who were concerned about the larger economy stopped buying all real estate-based bonds, including those collateralized by commercial real estate loans. Others continued to buy commercial real estate bonds, but insisted on earning much higher yields. In many cases, these yields were dramatically higher than the spreads under which the loans were originated.

The yield investors demanded for the investment-grade CMBS bonds increased by as much as 60 percent between January and August 2007. The prices for lower quality bonds increased hundreds of times over in 2007. Lenders suddenly faced losses on loans they had originated just 6 to 8 weeks prior. Some stopped lending altogether. Other lenders quickly widened origination spreads in hopes of protecting future returns.

The agencies that rate CMBS bonds added to the uncertainty, beginning to more closely examine the commercial real estate loans that backed bond offerings. To address investors’ concerns, rating agencies issued new criteria for evaluating bonds collateralized by commercial real estate mortgages. Lenders responded immediately by tightening underwriting standards and loan structuring practices. Rating agencies also raised the subordination level on CMBS securitizations, which made every pending securitization unprofitable and contributed to widening spreads.

The Liquidity Crunch

The profitability of a lender’s securitizations may not seem relevant. But a lender that cannot renew its liquidity though the capital markets has fewer funds with which to make loans. When this happens to many lenders simultaneously, as it did in the second half of 2007, the total amount of capital available to borrowers is significantly diminished. In other words, there is a liquidity crunch.

When a desirable resource such as liquidity becomes scarce, its price usually increases – as did origination spreads on commercial real estate loans. Lenders’ need to meet investor demands for higher yields on commercial real estate bonds also contributed considerably to widening spreads.

Scarce resources also tend to be allocated more carefully. In 2007, lenders began to use limited liquidity to fund the highest quality, least risky deals – which, in addition to new rating agency guidelines, contributed to stricter underwriting standards, additional equity requirements, and the end of aggressive structures such as 10-year interest-only loans and pro-forma underwriting. These were also the deals most likely to appeal to investors who were still buying bonds collateralized by commercial real estate loans.

What’s Next?

With the market still exhibiting some volatility as of this writing, the outlook for commercial real estate in 2008 is somewhat uncertain. On the one hand, spreads are less volatile and many CMBS lenders have returned to the market. On the other hand, some investors remain wary of bonds collateralized by commercial real estate; many are taking a wait-and-see approach.

In light of this uncertainty, 2008’s commercial real estate market will likely be characterized by the following:

• Conservative underwriting and structuring. The more cautious underwriting standards, deal structures, equity requirements and wider spreads that appeared in 2007 will continue throughout 2008. Lenders will look more favorably on borrowers with a proven track record.

• Reduced CMBS originations. CMBS originations in 2008 will be approximately 50 percent of those in 2007, due partially to an expectation gap between buyers and sellers that is especially wide in the western region. Sellers whose properties are performing better cannot understand why they should reduce prices; buyers who must invest more equity and borrow at wider spreads cannot pay 2007 prices.

• Potential cap rate changes. Most market experts project cap rate increases of 50 to 100 basis points in the foreseeable future. These will be market and property-type specific, but the unprecedented levels of cap rate compression the West Coast has experienced in recent years cannot continue in a softer market. 

• Possible retail challenges. If consumers restrict holiday and general spending in response to reduced home values, tenant credit quality and retail property prices could suffer.

• Growing demand for multifamily and self-storage. The multifamily and self-storage sectors stand to grow in 2008 as foreclosures rise and credit requirements increase for even strong borrowers. An increase in demand for apartments will likely also fuel demand for additional storage to accommodate overflow belongings. Many markets are already experiencing reduced vacancy rates and increased rents.

Clearly, the repercussions of 2007’s disruption will linger and drive lending decisions well into mid-2008, when many expect stability to improve. However, greater stability does not mean a return to the underwriting standards, loan structures and pricing of early 2007. More traditional underwriting will be the norm as the market ends 2007 with a high degree of volatility.

Dan Smith is managing director and Brent Wessel, based in Newport Beach, California, is the western region director of RBC Capital Markets’ Real Estate Mortgage Capital.

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