The credit crisis that started last year with revelations of suspect underwriting in the residential subprime mortgage market and led to more than $100 billion in write-downs at the nation's largest financial institutions has iced over the commercial mortgage-backed securities market and sent chills throughout the nation's real estate industry.

Amid symptoms of recession and possible write-downs in the value of CMBS, formerly active bond buyers, in a crisis of confidence, are opting out of the market, leaving many borrowers out in the cold and hunting for new sources of liquidity.

CMBS volume in the U.S. is projected to plunge from about $230 billion in 2007 to $110 billion in 2008, according to investment banking firm Bear Stearns & Co. “CMBS issuances, as tainted by the subprime mortgage fallout, have turned the entire industry upside down,” says Steve Collins, managing director for the Americas at Jones Lang LaSalle, and co-author of a report on the credit dilemma.

CMBS has been a powerful lending source for commercial property investors, offering hard-to-beat terms and pricing. CMBS and commercial real estate collateralized-debt obligations (CDOs) account for an estimated $710 billion, or roughly one-fourth of the $3.2 trillion in commercial and multifamily mortgage debt outstanding, according to the Mortgage Bankers Association.

In response to concern over the credit crisis, the industry is abruptly revising lax underwriting practices, and how brokers, lenders and property owners calculate the cost of debt.

With capital sources vanishing, some borrowers have been unable to refinance their short-term debts. Among the more notable examples of borrower hardship:

  • Las Vegas developer Ian Bruce Eichner defaulted on a $760 million construction loan from Deutsche Bank in January after he was unable to refinance the loan for his $3 billion Cosmopolitan Resort & Casino in Las Vegas. Eichner, who encountered similar difficulties in New York in the 1990s, is still searching for new financing.

  • Centro Properties Group of Australia has so far failed to refinance $3.4 billion in short-term debt due Feb. 15, and has put itself up for sale. The company's problems snowballed after it bought New Plan Excel Realty Trust, a U.S. retail giant with more than 700 shopping centers, in a highly-leveraged, $6.2 billion deal, and later was unable to repay short-term loans. CEO Andrew Scott stepped down Jan. 15.

  • New York developer Harry Macklowe encountered so many hurdles in trying to renegotiate nearly $7 billion in loans due in February for seven Manhattan properties that he put the 50-story General Motors Building on Fifth Avenue up for sale.

Distress spreads over financing

As loans come due, developers and investors are growing anxious over whether they will be able to refinance the maturing debt. Even industry behemoths like Indianapolis-based Simon Property Group, the largest shopping center REIT in the country with 256 million sq. ft. of gross leasable space, are not immune to today's lending barriers.

Simon is turning to German banks for help in refinancing $3 billion in retail mall loans and it is negotiating smaller deals under $100 million with insurance companies, according to Julie Reed, senior vice president of Simon. In January, Reed spoke on a panel at a Commercial Mortgage Securities Association conference in Miami.

“As a quality borrower, I would hope the history we have put out there would preclude us from being tapped out of the capital markets,” Reed said. “We're going to continue to be out in the marketplace, regardless of what is going on.”

Compared with $3 billion, a loan request for a $12 million property may seem paltry, but even financing at that level has its problems. Jim Doyle, president of Cleveland-based Capstone Realty Advisors, a financial intermediary which arranged $2 billion in 2006 loans, says the $12 million sale of a Cleveland office building illustrates a new dilemma for buyers.

The purchaser signed a contract last June. When the sale closed in late 2007, the office buyer's strategy was to borrow 80% of the purchase price, invest $1 million in improvements and reap a reasonable 8% return on his equity. But the buyer couldn't secure 80% financing or a full 30-year-amortized loan. Instead, he received a 25-year amortization.

“And he won't get credit in increased value for that $1 million he's putting in because it's mainly tenant improvements and leasing commissions,” says Doyle. “So the lending community today is going to loan 75% at most against that $12 million value, and drive his return on equity down from 8% to probably closer to 6%.”

Even the mighty feel pain

In the wider marketplace, the subprime debacle has ensnared some of the biggest institutions on Wall Street. Write-downs at Merrill Lynch totaled $22 billion by mid-January, and Citigroup wrote off $20 billion. Citigroup Chairman Charles Prince and Merrill Lynch CEO Stan O'Neal resigned.

Even mortgage financiers Freddie Mac and Fannie Mae, stalwarts of the secondary mortgage market, face potential write-downs of $16 billion for the fourth quarter of 2007, because of flawed subprime and other investments.

“A lot of big, strong, financial institutions were brought to their knees and are trying to survive,” says Mark Finerman, managing director of RBS Greenwich Capital, a Connecticut firm that is part of Royal Bank of Scotland Group. The shop provides capital to the commercial real estate industry and relied heavily on CMBS. Through September, Finerman says that RBS was doing about $1 billion in monthly volume. Today, that number is closer to $100 million. “What we've seen is a market that is basically in the freezer.”

With little capital to tap for loan repayments, some investors are digging into their own pockets for cash. New York developer Kushner Cos., for instance, recently repaid a $200 million loan in cash. The loan had been part of a financing package for a $1.8 billion office tower at 666 Fifth Avenue. In this case, the company chose to resolve the issue itself. Whether it will use the same tactic to repay another $200 million coming due this year remains to be seen.

The Fed's grand gesture

The threat of recession is also taking a toll on the market, further shaking the confidence of bond buyers and sellers. The Federal Reserve's startling, 75 basis point cut in interest rates on Jan. 22 — the largest reduction in more than two decades — quieted turbulent stock markets momentarily, but raised new questions.

“While it's meant to stabilize things, that to me is going to make people more nervous,” says Kim Diamond, managing director at Standard & Poor's, since it signals the Fed's deep concern over the economy. “A 75 basis point cut off-cycle is pretty extreme.”

The government proposed a $150 billion stimulus plan to jumpstart the economy that includes tax rebates, increases in food stamps and unemployment assistance.

The plan comes despite positive GDP, which increased at an annual rate of 4.9% in the third quarter of 2007, up from 3.8% in the second quarter, according to the U.S. Bureau of Economic Analysis. The unemployment rate experienced its largest monthly increase in six years in December, rising to 5% from 4.7% in November. Even with the jump, the rate is low by historical standards. In 1992, for example, unemployment stood at 7.49%.

Like many aspects of the economy, commercial real estate fundamentals are still healthy — for now. Demand for space has slowed a bit, but rents are relatively steady and supply is in check.

Fourth quarter reports, however, show early signs of trouble. In the office sector, for instance, the national vacancy rate rose for the first time in four years, by 10 basis points from 12.5% in the third quarter to 12.6% in the fourth, according to research firm Reis. The string of 15 consecutive quarters of lower office vacancies was critical in shaping underwriting and investor expectations of the sector's health. From 2004 to 2007, the average price per square foot for office properties increased by 68%, according to Grubb & Ellis.

The retail sector is also showing signs of wear. The vacancy rate for neighborhood and community shopping centers rose by 20 basis points over the third quarter to 7.5% in the fourth, the highest level since 1996, Reis reported.

Priced to perfection?

As prices skyrocketed over the past couple of years, many industry experts chalked it up to commercial real estate being undervalued in the first place. Now, a number of industry leaders are predicting that commercial property values will decline between 10% and 20% this year. “It's our view that commercial property prices are probably going to come down 15% on the national average,” says Tad Philipp, managing director of Moody's Investors Service. That would wash away much of the liquidity-driven gains of the last year or two, he says.

The specter of declining commercial property values has prompted fear of rising delinquencies, which would spark greater concern over perceived similarities to the residential market and would have a further dampening effect on lending and new construction. CMBS delinquencies are likely to double or triple by late 2008 from the current rate of 0.28%, but the rate would still be low, reports Fitch Ratings.

Sam Chandan, chief economist at Reis, warns that some lending practices raise the risk of delinquency and default. “We've seen the share of interest-only loans in our market go from less than 50% about two years ago to over 70% in the last quarter.” Those loans could be difficult to refinance three or four years from now.

And Jones Lang LaSalle's Capital Markets Group notes that $50 billion of five-year, interest-only loans could default if they can't be refinanced this year.

Strategies for rebounding

For borrowers, the call to action is to proceed cautiously and creatively, rather than sit on the sidelines. Forget about putting a spin on a credit request in an attempt to convince a lender to lift his pen. Forget about rent trending or trying to portray multifamily rental vacancies as assets — the lender won't buy it. Banks have gone back to basics — solid fundamentals, and nothing less will do.

Industry confidence can be regained if fear doesn't overtake rational decision-making. “We can talk ourselves into recession. If we continue to terrify ourselves, and let this drag out, then it's going to become a self-fulfilling prophecy,” said Randy Reiff, senior managing director of Bear Stearns, at the CMSA conference in Miami. The CMBS market was overheated and poised for a reversal, but losses can be kept tolerable, he maintains.

Industry executives, from lenders to financial intermediaries, developers and ratings experts are all stepping forward to offer insights for coping in current market conditions. Here are a few:

  • Borrowers with large portfolios may need to break mega-deal loan requests into smaller chunks that are easier for cautious lenders to digest.

  • If competitors in the CMBS market collaborated and pooled collateral to shepherd prudent deals through the bond market, it might go a long way toward restoring buyers' confidence, observes Diamond.

  • Commercial property buyers shouldn't expect fire sales, says mortgage banker Ed Padilla, CEO of Northmarq Capital in Minneapolis, which arranged $12.8 billion in financing in 2006. “We get calls occasionally asking if we have any foreclosed properties or clients looking to get rid of properties. We really don't see that we're in that type of market.”

  • Don't focus on national cap rates, says Chandan. Market activity is local. “Should Tulsa have an apartment cap rate 60 or 70 basis points higher than San Diego? Absolutely not.”

  • Forget highly leveraged deals, many say. They're simply too risky.

  • Sellers may need to get more realistic about prices to sell a property.

A silver lining?

Despite the psychological drama of the credit crunch — from tightening underwriting standards to the global stock market plunge on Jan. 21 — plenty of capital is still available for deals in the $20 million to $30 million range, the core industry size, brokers say. And alternative lenders are ready to fill the CMBS void, including foreign and regional banks, life insurance companies, pension funds, credit unions and government-sponsored enterprises like Fannie Mae and Freddie Mac.

As for the market freeze, Lee Cotton, president of CMSA, understands why so many investors and lenders are unwilling to buy or sell bonds. “Everybody's looking for a port in a storm,” Cotton says. But smart money is available, if one ventures out.

Still, Cotton knows investors fear that the bond they buy today could lose value tomorrow. “They don't want to be the last guy that bought the dumb bond. That needs to change. People need to say, ‘Yeah, I'm willing to make an investment. I'm willing to take a risk.’”

Denise Kalette is senior associate editor.

Turning the credit crunch into a golden opportunity

Some CEOs see today's credit environment not as a detriment to deal making, but as an chance to take risks that can pay off handsomely. Johnson Capital, an investment banker and mortgage brokerage based in Irvine, Calif., completed $4 billion in commercial real estate transactions in 2007, the same level as the boom times of 2006, and the company anticipates a healthy year in 2008, says CEO Guy Johnson.

“Our business actually changed from being very CMBS dominant in the previous years to switching to lenders that had money, like the GSEs (government-sponsored enterprises like Freddie Mac and Fannie Mae buy multifamily loans in the secondary market) and life companies.”

Recently, Johnson Capital's San Diego office arranged $39 million in financing through New York Life for a portfolio deal that included an apartment complex and three supermarket-anchored shopping centers at 40% loan-to-value. And Johnson Capital's Los Angeles office arranged $54 million in financing for a warehouse firm though another life insurance company.

Johnson Capital might have fallen victim to the precipitous drop in CMBS transactions had it not responded swiftly when trouble struck. Johnson recalls August 2007 as chaotic; his company was besieged with requests from frantic executives asking for help in renegotiating short-term commercial property loans with imminent deadlines. The borrowers had lost access to bond capital as CMBS transactions toppled by as much as 80% to 90% late in the year, Johnson says.

“We instantly became much more popular, although transactions were that much harder,” to complete given tougher underwriting guidelines. “People no longer could bank on future rent increases,” Johnson says. His company posted a record deal volume — just over $500 million — in the last two weeks of 2007.

To ease the transition, the commercial mortgage-back securities association firm re-established old relationships forged in the portfolio market before the days of CMBS domination. Earlier, it had set up offices in Spain and Mexico; now it hopes to put an office in Dubai and convert petro currency to U.S. real estate assets.

Tony Premer, a vice president of California-based Pacific Life Insurance Co., agrees that today's market offers great opportunities. Pacific Life originated $2.5 billion in loans in 2007, ranging from $50 million loans to portfolio transactions of $500 billion. Premer is optimistic about 2008. “We're seeing a lot of high-quality transactions.”

When the CMBS market crumpled, a big chunk of Pacific Life's competition left the playing field, says Premer. “This environment today, it's like ‘Revenge of the Nerds.’ The environment has not been this good in a long time for a mortgage lender.”
Denise Kalette