This summer's credit crunch brought the days of easy money to an end--and the commercial real estate industry is still suffering a hangover from that party--but things have begun to loosen up and finance pros are assuring owners that today's pain won't last too long into tomorrow.

A sign for optimism came in the form of Holliday Fenoglio Fowler L.P.'s (HFF) third quarter conference call on Nov. 9. Executives from the commercial real estate financial intermediary pointed to strong fundamentals in the sector and an abundance of capital from pension funds, private funds and foreign players. So even though property investors that relied heavily on debt may be temporarily out of the picture, there is enough demand in the market from cash-flush players that cap rates may only rise a little in the coming months. Even the heavily-battered CMBS market will recover, they said, though the turnaround may yet be six to eight months away.

As proof of the industry's underlying strength, HFF executives pointed to the company's results for the third quarter. In spite of the current market conditions, the firm's revenue increased 23.8 percent, to $68 million, though operating income decreased 3.9 percent, to $13.6 million. Meanwhile, production volume rose 63.8 percent, to $11.9 billion in 300 transactions, from $7.3 billion in 309 transactions completed during the third quarter of 2006. The number included a 153.3 percent increase in investment sales, to $5.5 billion, and a 15.2 percent increase in debt placements, to $5.6 billion, among other items.

Those results came amid a scary two quarters of the industry, HFF leaders admitted, as troubles in the subprime mortgage sector threatened to roil all the credit markets. In commercial real estate, the problems were most acutely felt in the CMBS and CDO sectors. In both cases, lenders' loose underwriting standards have led to investor skittishness. As a result, CMBS lenders have radically altered the terms on financings, eliminating the riskiest loans from their offerings in order to try and get investors interested in buying CMBS bonds again.

The troubles in the CMBS sector are a stark contrast from recent years. Going into this summer, CMBS issuance in the U.S. grew at an average annual rate of 18 percent. Last year, the industry recorded $299.2 billion of new CMBS issuances, not to mention $35 billion of CDO issuances. Today, CMBS loans make up 22 percent of the $3 trillion U.S. commercial and multi-family real estate lending market, second only to commercial banks, which claim a 43 percent market stake, according to Torto Wheaton Research, a Boston-based provider of real estate research services.

But as demand for CMBS bonds became more voracious, CMBS lenders loosened underwriting standards in order to generate enough loans to meet the demand of bond investors. In many cases, CMBS issuers agreed to terms that were more aggressive than the conventional formula of 65 percent to 75 percent loan to value ratio, providing leverage of up to 90 percent, with no interest periods and similar perks, says Scott R. Lynn, director and principal with Metropolitan Capital Advisors, Ltd., a Dallas-based real estate investment banking firm. Many assets ended up grossly over-leveraged, with the average commercial loan worth 118 percent of a property's value in the third quarter of 2007, according to Moody's Investor Service.

In pursuing such aggressive terms, CMBS issuers bet on a continued rise in real estate values, but their bets did not always pay off.

For the past four years, NOIs on CMBS-leveraged commercial properties came in below expectations, missing targeted returns by an average of 6 percent in 2006, according to data compiled by HFF. By contrast, in 2003, CMBS-leveraged assets outperformed NOI expectations by more than 1 percent. Now, as the disconnect between cushy loan terms and real property values becomes clear, the real estate industry faces some serious consequences.

"There were some fairly substantial write-downs to get CMBS transactions to clear," Lynn says. "And it's caused a dislocation in the marketplace, where the participants are getting stung right now. They are backing away from making new loans or increasing their pricing. Risk has definitely been re-priced."

The CMBS market won't show a significant improvement until well into 2008, most likely, the second or third quarter of 2008, according to both Lynn and John H. Pelusi, Jr., CEO of HFF. In fact, CMBS volume will drop by 30 percent to 40 percent during that period, Pelusi estimates. But real estate entrepreneurs have no cause to jump out the window just yet.

For one thing, CMBS delinquencies remain low, at 0.35 percent for commercial properties overall and 0.25 percent for retail properties in particular. With lenders re-evaluating their recent overly generous approach to underwriting, those numbers are not likely to rise dramatically, according to Pelusi.

Furthermore, alternative sources of capital abound, as pension funds, private funds and foreign investors continue to hold vast reserves of cash, much of it earmarked for real estate, according to Lynn. The United States equity market currently stands at $1.3 trillion, with private investors representing a 46 percent stake; pension funds, endowments and foundations a 20 percent stake, and foreigners an 8 percent stake (the rest belongs to REITs, private financial institutions and life companies).

"We've seen a wave of new lenders come into the market that were sitting on the sidelines up till now and keeping their powder dry," says Lynn. "This gets back to the whole liquidity question and why I don't think cap rates are going to go up."

In addition, fundamentals in the commercial real estate sector remain in check, with a healthy balance between new supply and demand, and projected increases in rents and NOI levels through 2011, according to HFF. The numbers won't be as robust as in recent years, when rents in the retail sector increased from 6 percent to 8 percent on an annual basis, but growth will hover around 2 percent, according to Property & Portfolio Research, Inc., a Boston-based real estate research and portfolio strategy firm. NOI growth in the retail sector will range between 2 percent and 3 percent annually.

Those healthy fundamentals will preclude a rapid rise in cap rates for real estate properties, even as the debt markets continue to sort themselves out, according to Pelusi.

--Elaine Misonzhnik