During the Commercial Real Estate Finance Council’s January Conference titled, “Commercial Lending: The New World Order,” participants spoke of many important and revealing themes. Some remarks were encouraging, others were discouraging, while a few were eye-opening. For example, there was talk of deteriorating underwriting standards and pricing that was already getting ahead of itself. It is hoped that those types of comments don’t fall on deaf ears. Unfortunately, the conference left me with the feeling that while everyone seemed aware of the importance of moderation, the pressure that comes from an artificially low supply of properties could already be overtaking moderation.
Talks underscored how financial institutions have seemingly shifted from worrying about bloated balance sheets and impending write-offs to “finding more loans.” Also, one participant mentioned that “with such a competitive marketplace, we are now working harder to keep loans we currently have on our books.”
With an estimated $1.4 trillion of loans coming due over the next few years, this is certainly a welcome comment for existing borrowers and for the market as a whole.
This all points to significant improvement in the financial markets. As one participant noted, commercial mortgage–backed securities (CMBS) spreads have shrunk from 1,248 basis points on November 21, 2008, to 200 basis points. CMBS debt yields were noted as being in the 14 percent range. It is expected that loan-to-value ratios will rise from 60 percent at the beginning of 2010 to 70 percent by the end of the year.
However, there is still uncertainty in regard to just how deep the pool of capital actually is. Up to now, the financial markets haven’t really been tested. While sales volumes have certainly improved, they are still relatively subdued. Further, the impending refinancing tsunami is not here yet, but looms on the horizon. Whether the pool of capital can expand at a rate equal to the increase in demand remains to be seen.
In the meantime, given the discussions at the conference, there does appear to be a supply/demand imbalance between lenders and high-quality loan requests. Conference attendees were quoted as saying that “pricing is getting ahead of itself”; that “deals are beginning to get priced to perfection”; that there’s “a lot of erosion in credit enhancement already”; and “wouldn’t be surprised to see some originators go BK due to the thin margins on the loans they are originating.”
This has led to the return of interest-only components that many certainly did not expect to see so early in the recovery. As another participant pointed out, “Today there are four times as many originators [firms], yet most product is bottled up in banks via extend-and-pretend. So this is just creating another bubble.”
Panel member comments also raised an apparent contradiction: current investors have a voracious appetite for multifamily properties, while multifamily CMBS pools are now the worst performing CMBS pools. This contradiction has a couple explanations. First, because multifamily properties are considered to be less risky than other property types, underwriters of these loans underwrote multifamily pools more aggressively. This, in effect, negates the risk advantage that multifamily real estate offers. Second, because life insurance companies “cherry-picked” the best deals and nobody wants to default on a government-sponsored entity (GSE), the multifamily properties that went into CMBS pools were often of lower quality. And if the multifamily loans that went into CMBS pools did stumble, borrowers were less likely to put additional dollars into those properties than if it were a GSE loan.
Lenders appear eager to increase their loan volume this year. Citigroup, for instance, plans to triple its CMBS lending in 2011. Estimates for 2011 CMBS issuance among all issuers range from $25 billion to $50 billion, with $40 billion the most often cited number. For comparison purposes, it is estimated that $48 billion of CMBS will come due in 2011, 44 percent of which is currently “underwater.”
The most often cited risk to the current recovery in commercial real estate is the anemic rate of job growth. Multifamily properties need renters and renters need jobs. Office buildings need employees. Retail centers need customers who have money to spend. And industrial properties need healthy companies to utilize their distribution buildings.
So while the refrain of the 1990s was, “It’s the economy, stupid,” today it seems to be, “It’s the jobs, stupid.” It is hoped that corporations realize that the sustainability of the economic recovery rests squarely on the shoulders of their hiring plans.
The second most often cited risk to the current recovery in commercial real estate was rising interest rates. This puts pressure both on properties that are currently just able to meet their debt-service obligations and on property prices as buyer returns decline as their underlying cost of capital rises. Depending on the rate of increase, this twofold pressure may eventually have to be released in the form of higher capitalization rates. It will be a race between rising interest rates and rising rents.
A rarely mentioned risk to the commercial real estate market that could inflict severe damage is “hot money.” If you doubt the havoc that hot money can wreak, look at the convertible bond market’s experience with hot money.
Currently, CMBS loans offer a 70-basis-point spread over single-A corporate bonds. If CMBS issuance does not increase at the necessary rate to offset the increase in demand for CMBS, the spread between CMBS and alternative investments will shrink, reducing the relative value advantage of CMBS loans. This is critical because as one conference participant stated, “I’m not a real estate person. Rather, I’m just moving money around from product to product to get yield.” For hot money, there is no loyalty to or inherent preference for real estate.
There were also specific ideas to improve the performance of future CMBS issuances, which is necessary because CMBS has a reputation problem. “CMBS delinquency rates are currently running at about 9 percent, while bank delinquency rates are running at about 4 percent.” In no particular order, there seems to be agreement that:
- Loan pools became too large;
- It became impractical to underwrite the jumbo loan pools that typified the peak of the market;
- There were just too many loans to underwrite in the amount of time that was available to underwrite them; and
- More information was needed on the individual loans, underlying real estate, and borrowers.
These points resulted in many proposals regarding future CMBS issuance. Below is a sampling of those proposals:
- Greater loan-level detail;
- Moving sources and uses from the footnotes to a position of greater prominence, at least for the ten largest assets;
- Making intercreditor agreements available; and
- Providing operating expense history for the top ten assets.
Lastly, there was a recurring mantra regarding the importance of B-piece buyers remaining in deals. As one participant noted, “Many B-piece buyers became 24-hour investors thanks to collateralized debt obligations [CDOs].” CDOs allowed B-piece buyers to quickly take their profit and exit the deal. They were able to significantly limit the amount of time in which they had “skin” in the game. This was devastating because B-piece buyers were considered the check on the system. When they figured out how to almost eliminate their risk, the last hope for rational underwriting was lost. Hopefully, new CMBS underwriting standards will maintain a level of rational underwriting in the face of competitive pressure.
