About $1 trillion of frozen loans are in the system and cannot trade near marked value. This problem will be around for several more years.
The U.S. Federal Reserve System is dealing with the most complicated set of circumstances in at least the past 25 years, said speakers at ULI’s 17th annual McCoy Symposium on Real Estate Finance, held in New York City in December. The following are some of the observations and predictions offered during the event, which was attended by 35 real estate capital markets leaders.
Recovery from the severe economic recession will continue to be slow, and several more years of financial disruption are possible. The Fed’s current program of purchasing securities in order to provide liquidity to the markets—known as qualitative easing, or QE2—is to date less effective than increased government spending and has had the unintended effect of inflating asset prices. There is some danger that the policy could create another bubble in asset prices rather than jobs.
The Federal Deposit Insurance Corporation (FDIC) sees a slowing of small to medium-size bank failures, which peaked in 2010. Larger banks are continuing to attract capital, and they are moving off the watch list. Smaller banks have very little credit card business or corporate lending, and thus focus on local real estate, which comprises 70 to 80 percent of their loan portfolios. About $600 billion has been committed to date by the FDIC to rescuing troubled banks, of which half went to Washington Mutual. The bulk of the balance has been organized as loss sharing through a bid process. Such loss sharing, which can be structured for as long as ten years, constitutes a moral hazard exposure of "heads I win, tails you lose" for the government, speakers warned. The large windfalls of the early 1990s from asset sales are less likely this time because there is excessive liquidity in the system and the bidding is competitive. Clearing prices have ranged from 30 percent of par in the beginning to as high as 80 percent; they currently are at around 60 percent.
Life insurance companies are very active in the debt markets, putting out close to $30 billion of real estate mortgages in 2010, which compares to $35 billion in the peak year of 2008. New money accounted for 60 to 75 percent of the total, and the rest was rollover loans. Mortgage loans are limited to best-in-class assets in New York City and Washington, D.C., creating a bifurcated market, with many properties unable to access this market. Insurance companies will lend to "nothing outside the bull’s eye," speakers said. Loan-to-value (LTV) ratios have increased to 60 percent from 50 percent, with many insurance lenders prohibiting mezzanine debt behind them.
Apartments may have a 70 percent LTV ratio. Cash flow has become the important metric in underwriting loans, making LTV less significant. Debt yields—net cash flow, after capital expenditures and tenant allowances, available to pay debt service, divided by the debt principal—must be 10 percent for life insurance companies. Pricing is 175 to 200 over the ten-year treasury notes. Club deals, with two or more companies, may get the loan amount up to $500 million on a particular property. At present, life companies are competitive with the commercial mortgage–backed securities (CMBS) market, but this will change over time as CMBS begins to regain market share.
CMBS cannot compete with life insurance companies other than for properties deemed somewhat inferior, but CMBS poses a potential threat on both underwriting and pricing. Maximum size for a CMBS pool at present is about $1.5 billion, with a single property limit of about $250 million. LTV is 50 to 65 percent, with a debt yield of 13 percent, thus greatly limiting the pool of eligible properties. As much as 80 percent must be Aaa rated, though buyers are relying less on rating agencies and doing their own due diligence. This market will not come back in volume until the life companies run out of money and CMBS buyers relax their standards. Volume of $10 billion to $12 billion is predicted for the first quarter of this year, with full-year volume garnering an optimistic prediction of $50 billion.
Pricing can be as low as 50 basis points over treasuries for bull’s-eye properties in New York City and Washington, D.C., and 200 basis points over elsewhere. CMBS rollovers loom as a massive problem for the next five years when underwriting standards will require large equity infusions. Regulations now being drafted under the Dodd-Frank Wall Street Reform and Consumer Protection Act require CMBS issuers to retain a risk position of about 5 percent in deals, thus putting a strain on required capital ratios. Some participants think this will kill off the CMBS market; others think third parties will be formed as proxy underwriters.
Commercial banks have deleveraged their commercial real estate loans, with money-center banks taking as much as $25 billion each out of the system through runoffs, writedowns, and note sales. Note sales that have occurred are at as much as 90 percent of marked value. In addition, about $1 trillion of frozen loans are in the system and cannot trade near marked value. Such loans are being kicked down the road until there is a capital need for tenant improvements and the like, at which point the issue is forced by foreclosure, write-offs, and renegotiations, and the loan becomes unfrozen. This problem will be around for several more years.
In terms of equity sales, capital is not the issue; the issue is demand growth and tenants. New York City has negative absorption of office space. Usually it has high office vacancies caused by overbuilding, but this time, it has high vacancies with no overbuilding. Lack of job growth is a huge depressant for commercial real estate markets, and the effects have not yet shown up in the data. There is much shadow space occupied by healthy corporations that have downsized. When their leases run out, this space will come back on the market, increasing vacancy ratios. Pricing remains difficult because projections have little value. The market is churning and focused on the bull’s-eye properties. An irony would be the combination of excess capital flows and low interest rates. Federal stimulus and lack of overbuilding would cause yet another commercial real estate bubble in the midst of a frozen market.
The basic question is, how long will it last? Many of the symposium participants have been saying three years—but they have been saying that since the 2006 symposium. I feel comfortable saying the current situation will last another three years, through 2013, but I would feel just as comfortable saying five more years, through 2015. Plenty of buyers and lenders exist right now for lower-leveraged bull’s-eye properties; that market even has a bubble. But it will be three to five years before a "normal" market returns in which Class B properties can be financed, construction lending obtained, and cash-flow projections believed, and in which demand for new product exists.
The key is job growth. Ten million Americans are unemployed. If 5 million unemployed can be considered normal, then 1 million new jobs a year will be required for five years to make up the difference. But because the population is growing, an additional 1 million jobs or more will be required each year—or 2 million jobs a year for five years. This makes the prediction of recovery in five years not unreasonable—though it could take ten years to produce the 10 million jobs needed.
So, at least part of the commercial real estate market will remain frozen for three to five more years. The ice cap is melting, however. There is a hint of warmth in the air. Just don’t get out your swimsuit and shades yet. Keep that old topcoat handy—and deleverage.