So much for the forecast that shoddy subprime lending was an isolated event. What started as a spike in residential mortgage delinquencies and foreclosures early this year quickly degenerated into a rash of bankruptcies among subprime mortgage lenders, spawning a global credit crunch.

The fallout has been nothing short of incredible. Hedge fund investors could sustain up to $125 billion in subprime losses, according to Moody's Economy.com. Meanwhile, bankruptcies of subprime lenders resulted in nearly 12,000 layoffs from Aug. 14 to Aug. 23 alone. Short-term liquidity virtually seized up, prompting the Federal Reserve to cut the discount rate from 6.25% to 5.75%.

The big question on the table as of late August: Were similar careless underwriting practices at work in the commercial real estate market that could lead to borrower distress? If so, the worst-case scenario could be that there is a second storm approaching the real estate market, this time with commercial mortgages in its path.

Only time will tell, but for now it's clear that at the very least the subprime maelstrom has roiled the commercial real estate debt market. By the end of August, there was a backlog of $35.2 billion in unsold commercial mortgage-backed securities (CMBS).

“The CMBS market has really come to a standstill over the past few weeks,” remarked Clay Sublett, senior vice president and CMBS director at KeyBank Real Estate Capital, during an interview in late August. “When people get nervous, they become hesitant to pull the trigger on deals.”

CMBS isn't the only securitized debt product to have been hit: Issuers of commercial real estate collateralized-debt obligations (CRE CDOs) have scrambled to find buyers as growing concerns of subprime exposure and widening credit turmoil nix demand. Commercial real estate CDOs are packages of high-risk loans that are sold as bonds to hedge funds, pension funds and institutional investors.

Indeed, many recent buyers of these real estate securities have either sold off their positions or demanded higher yields from issuers. In turn, panicked lenders almost overnight altered loan terms, making it more expensive to finance deals.

Adding to the potential for more credit turmoil is the growing backlog of CMBS deals due to come to market. Some $56 billion in CMBS deals were scheduled to price by the end of September, reports Citigroup.

With so many issuers sitting on large CMBS portfolios, wider spreads and volatility are making it extremely hard to sell the underlying bonds. In mid-August, AAA CMBS spreads were almost three times as high as February's low of 26 basis points over the 10-year Treasury yield (see chart, p. 24).

“It's not clear to me how long it will take to work this CMBS backlog out of the system,” says Stacey Berger, executive vice president at Kansas City-based Midland Loan Services, which oversees a $284 billion loan-servicing portfolio. “The real question is where the liquidity comes from as spreads have widened tremendously in the past few weeks.”

Short-term bond buyers such as hedge funds typically use leverage to buy CMBS, and higher borrowing costs have reduced their purchasing capacity. Even worse, placing the B-pieces of CMBS has only gotten tougher. B-piece buyers agree to hold the riskiest portion of the CMBS transaction in return for a higher yield.

Industry newsletter Commercial Mortgage Alert reported that average B-piece buyers were demanding yields of 26% or more in August, well above the 20% yields they tolerated in the spring.

  • What's more, several high-profile commercial real estate players have been dinged by this turbulence. Among the most recent examples:

  • Tishman Speyer Properties and Lehman Brothers delayed their $15.2 billion acquisition of apartment REIT Archstone-Smith Trust from August to October after lenders balked at financing terms.

  • Wachovia executed a $27 million margin call on CBRE Realty Finance, prompting the mortgage REIT to suspend all new investments.

  • KKR Financial Holdings, a major buyer of AAA-rated residential mortgage-backed securities (RMBS), delayed repayment of roughly $5 billion in short-term debt.

The share prices of two major brokerages fell dramatically. CB Richard Ellis shares were off 33% from their 52-week high near the end of August. Jones Lang LaSalle shares were off 18% over the same period.

Borrowing costs for one-off assets to multi-billion dollar real estate investment trusts (REITs) have also increased as lending underwriting standards tighten. It all adds up to a daunting task ahead for commercial real estate investors, who plunked down $469.8 billion on commercial properties during the 12 months that ended in July.

That dollar volume in transactions is up 38% from the preceding period, according to Real Capital Analytics, which tracks sales of $5 million and above. Some of those investors are keeping a wary eye on the horizon.

Early signs of trouble

Storm clouds actually began to gather over commercial real estate early in the year. Lenders who routinely agreed to finance deals at 95% loan-to-value (LTV) before February dialed back their underwriting to the 60% LTV by mid-summer. Even the red-hot hotel market, which benefited from excessive liquidity in recent years, has felt the effects of shifting credit standards.

“It's much harder for my clients to get 80% leverage on any new hotel deals today,” says Reginald Heard, president and CEO of mortgage brokerage Bankers One Capital based in Danbury, Conn. Heard specializes in lining up financing for buyers of limited-service hotels. “It's also much harder to secure mezzanine financing for deals today. That market has slowed down a lot.”

To be clear, many deals and projects are getting completed, particularly in the hotel sector. There were 196,332 hotel rooms under construction at the end of July, up 20% from the 163,583 rooms being developed a year ago, reports Smith Travel Research.

“Everybody still anticipates building their projects and going forward,” says Scott Smith, senior vice president of PKF Consulting. “Interest rates are still historically low.”

But “low” is a relative term. Interest rates on new hotel projects have jumped by as much as 100 basis points while banks are demanding more equity from borrowers. Even so, Smith notes that owners and developers of projects valued in the $10 million to $20 million range are largely moving forward with their plans, given that local fundamentals drive the hotel sector.

For now, real estate services firms are working overtime to advise buyers and sellers. “Buyers and borrowers alike would be well advised today to expect more conservative underwriting,” says Brian Stoffers, president of CBRE Capital Markets, the investment sales and financing arm of real estate services giant CB Richard Ellis. “Ample funding is currently available for loans underwritten at 70% to 75% of the purchase price using a 1.20 debt-coverage ratio.”

That's a far cry from the deals with 95% leverage. And the transition from unbridled underwriting into a far more conservative era has indeed left many investors puzzled about how to proceed.

A false sense of security?

Unlike the embattled residential market, where excess supply has clobbered values, commercial real estate fundamentals remain generally strong. The national office vacancy rate has declined every year since 2003, for instance, and Reis expects it to drop as low as 12.8% by the end of December.

In addition, effective rents are projected to climb 9.1% this year in the office sector, the highest since 2000. Such favorable market conditions persuaded many commercial real estate lenders to execute “frothy” deals requiring little equity from borrowers.

On the credit side, delinquencies among commercial borrowers remain low — for now. Fitch Ratings' U.S. CMBS delinquency index fell for the fifth straight month in June to 0.29%, or two basis points lower than May's rate of 0.31% (see related story p. 10).

Sally Gordon, senior vice president of CMBS at Moody's Investors Service, says that CMBS upgrades have vastly outnumbered downgrades in recent years. The late 2006 and early 2007 vintage CMBS deals included some of the most aggressive loans to hit the market in some time, however, including an increase in interest-only loans. It will take several months to determine if borrowers overextended themselves on these deals.

“A lot of the underwriting late last year and earlier in 2007 was based on very aggressive cash-flow assumptions,” Gordon says. “But underwriting has already improved since this spring, when we adjusted our ratings system because of the frothiness in the market.”

Despite commercial real estate's seemingly solid footing, some critics believe that subprime and commercial lending standards weren't all that different. They cite the condo market glut as an early example of reckless development.

By the end of 2006, condo developers owed commercial banks more than $30 billion — a record volume of debt for this development niche.

At the end of the first quarter this year, the volume of defaulted construction loans — most of which can be traced to condo projects — hit 2.3%, up from 1.6% at the end of 2006, according to Foresight Analytics.

“There was a real compression of risk spreads among both commercial real estate lenders and borrowers up until recently,” says John Kriz, managing director of the REIT group at Moody's Investors Service. “But the commercial real estate market is a lagging indicator, so it takes awhile for this increasingly optimistic underwriting to show up in the market.”

The optimism among borrowers and lenders was based on aggressive rental growth projections, Kriz says. Echoing that sentiment, CEO Edward Padilla of commercial mortgage banking firm Northmarq Capital also believes risk was being mispriced until recently.

He says that interest-only loans and excessive leverage sent the wrong message to many borrowers. “This also drove sale prices up so high that people weren't seeing the risk in these deals,” he says.Like other finance shops, Northmarq hasn't ridden through this choppy market unscathed.

As of late August, Padilla was struggling to close a $1.5 billion pipeline of CMBS. Padilla says that many CMBS buyers, including foreign investors, have grown reluctant to buy real estate bonds in recent weeks. Instead, they are fleeing to the safety of U.S. Treasuries.

Bucking the trend

Attractive yields have lured some buyers into this tricky market, however. On Aug. 8, for example, Manhattan-based Gramercy Capital Corp. successfully closed a $1.1 billion commercial real estate CDO, which was well received by investors. The company retained the non-investment grade portions of the CDO and sold off the AAA through BBB- bonds.

“It was quite an achievement to get this deal done given the market,” says Hugh Hall, chief operating officer of Gramercy Capital Corp., which has no plans to issue another commercial real estate CDO this year.

Like other mortgage REITs, Gramercy's share prices (NYSE: GKK) were down 23% for the year through Aug. 14. Average total returns for all commercial mortgage REITs were down 28% during the same period.

Silver lining

Many market sources hope this credit downturn lures long-term investors back into the CMBS market. It's possible that if rising bond yields hit a plateau, investors could seize the moment as a buying opportunity before spreads start narrowing again.

Spreads on super-senior AAA CMBS jumped by more than 15 basis points during the week of Aug. 13 alone to hover 54 basis points over the 10-year Treasury. Fear of further widening is preventing many investors from diving back into the market, however.

The CMBS markets may ultimately benefit from this credit upheaval, says Len Mills, head of risk management at Property & Portfolio Research. After all, lax underwriting helped create the crisis, so the correction could herald a more transparent era of CMBS. “I do think that the CDO market will come back as buyers start to take advantage of pricing,” he says.

“The market is clearly shell-shocked right now,” Mills says. “But investors are learning how to manage their risks better, and that's ultimately a good thing for the market.”

Parke M. Chapman is senior associate editor.

How the credit crisis of '98 hobbled CMBS

The 1998 bond crisis proves that prompt action by central banks and value-driven buyers can rescue markets from a liquidity crunch.

In August 1998, Russia defaulted on $40 billion of ruble-denominated bonds after the value of the ruble tanked by more than 60% in one day. The event was sparked by speculation from foreign investors, particularly in the oil exploration and exporting industries, which spilled into banking and commercial real estate.

Fallout from the event swiftly unnerved the global asset-backed credit markets. By October 1998, U.S. investors were demanding yields of 205 basis points over 10-year Treasuries for AAA-rated CMBS — the safest tranche — compared with a spread of 98 basis points in July.

Central banks acted swiftly. In the U.S., the Federal Reserve lowered the benchmark Fed funds rate by 75 basis points. Agency lenders Fannie Mae and Freddie Mac also snapped up billions of dollars in mortgage-backed securities, bringing needed liquidity to a shunned market.

In 1998, the agency lenders were seen as “bulletproof,” says Todd Rodenberg, director of agency lending at Dallas-based KeyBank Real Estate Capital. He also says that it's no surprise that agency lending volume has tripled in the past few weeks as investors increasingly crave security. Fannie Mae benefits from the U.S. government's tacit backing of itsmortgage-backed securities.

Similar efforts rescued the CMBS market by spring 1999. Value investors who swooped into the bond market in late 1998 were also critical to this recovery.

“The people who bought bonds in late 1998 ended up looking pretty smart,” says Tad Philipp, managing director at Moody's Investors Service. “What we've seen recently is that spreads can drift up very fast. But that's also a buying opportunity for many investors.”

In the end, what many saw as a meltdown nine years ago in fact turned out to be a market correction. By May 1999, the AAA-rated CMBS tranches were selling for roughly 102 basis points over 10-year Treasury yields. The spread continued to fall for the next three years as demand gradually increased. By 2006, CMBS issuance broke the $200 billion mark (see chart p. 24), a record for domestic issuance.

But it is cracks in the U.S. residential subprime market that are fueling this latest crisis. That explains why many CMBS veterans who weathered the 1998 crisis fear that the current credit downturn will linger into 2008 — or at worst 2009 — as few forecasters expect housing fundamentals to promptly snap back.

It's unclear how a protracted slump would impact demand for commercial real estate collateralized debt obligations (CRE CDOs), short-term, closely-managed pools of mortgages that are securitized and sold as bonds. It's also ironic that these leveraged instruments were created in 1999 as an innovative way to diversify risk after the 1998 crisis.

“It's unfortunate that many people have painted CDOs as a very negative tool,” says Citigroup analyst Darrell Wheeler. “But the reason that these vehicles were created was to diversify collateral risk among property types and markets.”

Wheeler believes that the CMBS market will recover faster than the younger CDO market. Both markets have an overlapping buyer base, which could ultimately bode well for CDO issuers.

“What we tell investors is this: Look at the collateral,” says Wheeler. “If you do that, you realize that there are some good buying opportunities out there. That's what many investors did in late 1998 and early 1999, too.”
Parke M. Chapman