January/ February  2009 VOL. 2

Slow Thaw:
Credit markets will continue to be "frosty"

For more than 18 months, the commercial mortgage industry has been in a deep freeze. Now, industry experts are hoping for a thaw this year, but much has to occur  in the minds of both lenders and investors for the action to begin. 
 
"I think 2009 is still going to be frosty," says Jeff Friedman, co-CEO of Mesa West Capital, a privately held commercial real estate lender based in Los Angeles.

John Pelusi, CEO of HFF Inc., a publicly traded mortgage banking and investment sales firm headquartered in Pittsburgh, agrees: "Unfortunately, we have a way to go. More losses are coming and financial institutions balance sheets are in need of additional equity capital just to keep the doors open and even more to start new lending. Hopefully, the financial institutions will complete their de-leveraging by mid-2010; however, at the asset level, it may take until 2014."

A recent survey from the Real Estate Roundtable indicates the commercial real estate industry is painfully aware of the challenges it faces. The 4Q 2008 Sentiment Survey shows senior executives’ confidence in the real estate market continued to deteriorate as 2008 wore on.

Nine out of 10 executives believe conditions were worse during the fourth quarter 2008 than they were during the same period in 2007. More than half stated conditions are “much worse” than 12 months ago. Of all respondents, 39 percent expect real estate market conditions to get worse in 2009.

Decreasing mortgage debt

The level of U.S. commercial/multifamily mortgage debt outstanding decreased 0.1 percent in the third quarter to $3.44 trillion, according to the Mortgage Bankers Association (MBA) analysis of the Federal Reserve Board Flow of Funds data. The $3.44 trillion mortgage debt outstanding recorded by the Federal Reserve was a decrease of $3.3 billion from the second quarter 2008.
 
Jamie Woodwell, MBA’s Vice President of Commercial Real Estate Research, contends "uncertainty surrounding the weakening economy, coupled with the continuing pressures of the credit crunch, led to a slight pullback among investors in commercial/multifamily mortgages in the third quarter."

The research guru adds government-sponsored enterprises and other finance companies have taken advantage of the limited competition to increase their holdings. But banks and thrifts are beginning to pull back on their holdings, while life insurance companies slow the growth of their portfolios, and the CMBS (commercial mortgage-backed securities) market continues to be relatively paralyzed.

Commercial banks continue to hold the largest share of commercial/multifamily mortgages, $1.49 trillion, or 43 percent of the total. Many of the commercial mortgage loans reported by commercial banks however, are actually "commercial and industrial" loans to which a piece of commercial property has been pledged as collateral. An MBA Research Policy Note found that among the top 10 commercial real estate bank lenders, 48 percent of their aggregate balance of commercial (non-multifamily) real estate loans was related to owner-occupied properties. 

CMBS, CDO and other ABS issuers are the second largest holders of commercial/multifamily mortgages, holding $758 billion, or 22 percent of the total. Life insurance companies hold $315 billion, or 9 percent of the total, and savings institutions hold $191 billion, or 6 percent of the total.

The GSEs, agency-backed mortgage pools and GSE-backed mortgage pools, including Fannie Mae, Freddie Mac and Ginnie Mae, hold $149 billion in multifamily loans that support the mortgage-backed securities. They issued an additional $179 billion "whole" loans in their own portfolios for a total share of 10 percent of outstanding commercial/multifamily mortgages. 

Nearly all the executives surveyed by the Real Estate Roundtable during the fourth quarter 2008 said access to capital has significantly decreased. Notably, 96 percent said debt availability is “much worse” than it was during the fourth quarter 2007. Nearly eight out of 10 executives said equity-financing conditions were worse than in past years.

Although the executives surveyed by the Real Estate Roundtable are mildly optimistic that capital market conditions will improve in 2009, approximately 25 percent of those surveyed expect conditions to worsen.

Friedman says it is entirely possible the credit crunch could worsen if the recession and rising unemployment cause real estate fundamentals to soften precipitously. "Weak fundamentals will almost certainly further scare off capital or make it more expensive," he warns.

Questioning property values

Today, it's not only expensive to obtain debt financing because lenders have concerns about their own balance sheets and exposure to real estate, but it's also difficult to find lenders who can get comfortable with real estate values.

"Lenders are so spooked today that they don't want to deal with problem properties or properties that underwriters cannot evaluate," says Jay Epstien, chair of the global law firm DLA Piper’s U.S. Real Estate Practice.

Unfortunately, there is a stunning lack of investment sales volume that makes it hard to pinpoint how the market is valuing real estate. From January through December 2008, there were just 1,410 transactions nationwide totaling $49.3 billion, versus 4,410 transactions totaling $207.2 billion, for the same period in 2007, according to the latest data from Real Capital Analytics, a New York City-based real estate research firm. It expects that sales will total $53 billion to $55 billion for all of 2008, after reducing its forecast from $61 billion.

Executives who participated in the Real Estate Roundtable's survey reported that asset prices are continuing to drop, a trend they expect to continue over the coming year. Nearly seven out of 10 executives said commercial real estate values would be lower next year, while 27 percent believe they will be "much lower".

However, Pelusi notes investment sales volumes in 2005, 2006 and 2007 were extraordinary high, driven primarily by cheap debt. Historically, about $80 billion to $125 billion worth of commercial property traded hands annually (in the four major sectors: office, industrial, retail and multifamily), which is why it's hard to estimate investment sales volumes in the future.

"Activity has been slow because sellers have not been willing to adjust their pricing expectations," Friedman notes. "As the year goes on, sellers will be forced to capitulate and there will be more investment sales activity. It will still be moderate, though, because we're looking at something that is going to persist for the next couple of years."

Back again, CMBS?

Even if investment sales don't increase, the industry still has to work though real estate valuations to handle the billions of dollars worth of loans that are maturing over the next couple of years. During the next 12 months, roughly $400 billion of commercial real estate loans will mature, and another $310 billion worth of loans are scheduled to mature in 2010.

"Borrowers that are in the best position are the ones with maturities well beyond 2009," says Earl Webb, CEO of Jones Lang LaSalle Capital Markets. "Borrowers with maturities in 2009 are under pressure and the value of the underlying assets has to be determined before lenders will make loans."

Even more importantly, lenders need to determine out exactly how much they can lend, says Ed Padilla, CEO of NorthMarq Capital, a mortgage-banking firm with 30 offices across the U.S. "Most lenders still need to get a handle on their own financial situations including issues related to mark-to-market," he explains. "Right not it's impossible to know which ones will be out there."

Even more troubling is the fact that many traditional commercial real estate lenders have seen their balance sheets balloon because of credit card debt and commercial paper that has been warehoused instead of securitized. And, we cannot forget the debt shortfall created by the stalled CMBS market. In 2008, CMBS issuance totaled just $12 billion, a whopping 95 percent decrease over the $230 billion in CMBS issuance in 2007, according to Trepp LLC.

Padilla predicts the CMBS issuance in 2009 will be larger than 2008, although he is hesitant to put a number on it. However, he is certain it won't be close to historic levels.

Today, the CMBS remains stalled, and the entire industry is waiting to see when it will gear up – assuming that it ever does come back. In fact, DLA Piper’s 2008 "State of the Market" Real Estate Survey, asked leading real estate industry executives when they expect securitized lending transactions to return to the market at prior levels and nearly half of respondents (47 percent) indicated they did not expect securitized lending to recover until after 2010. Roughly one-third of executives indicated the CMBS market would return in 2010 and 4 percent indicated it would return this year, but 16 percent believe that securitized lending will never again reach its prior levels.

Webb predicts that CMBS will reemerge, but it will only provide 20 to 25 percent of the liquidity to the market that it did before. "The banks that were in the business will continue, but they won't be able to take on such tremendous volumes," he says. Moreover, he believes that future CMBS issuances will need to have better underwriting and accurate ratings.

Desire for profit

In the meantime, the industry is waiting for lenders to reach the point where their desire to make money outweighs fear. Already, Padilla says several life insurance companies are talking about making loans at 7.5 percent interest rate – a spread of about 500 basis points over 10-year Treasuries. "From a historic perspective, that spread is incredible," he points out. "A year ago, the spread was 100 basis points so the deals today should be compelling investments."

Padilla concludes: "There's no question that lenders ultimately have a profit motive, and in order to best satisfy their shareholders, they will have to make loans. Once the profit motive really sinks in, lenders will be out there later this year, but the capital is not going to come in the tsunami that we saw in 2005 and 2006."