Widely regarded as a tale of two halves for commercial real estate lending, 2007 started off on a manic high and ended on a depressed note. Sales of commercial properties, which reached a sizzling $109 billion at the close of the second quarter of 2007, based on deals of $5 million and up, fizzled to just over $68 billion as the fourth quarter ended, the Mortgage Bankers Association reports.

What caused the drop in investment sales? After the meltdown in the U.S. subprime mortgage market, there was a global reassessment of risk that ultimately resulted in the disappearance of cheap debt. Investors demanded greater returns for perceived greater risks, leading to higher cap rates and lower property values. Property sellers, in turn, have been reluctant to reprice their assets, causing an impasse between buyers and sellers.

The subprime contagion widely shook the capital markets, and investors tarred commercial real estate with the same brush as its residential cousin. Even more distressing, about $245 billion of the $350 billion in capital available in 2007 can no longer be accessed in 2008, notes Jack Cohen, CEO of Cohen Financial.

The Chicago-based mortgage banking firm felt the impact firsthand. In 2006, it arranged $4.08 billion in financing, and ranked No.12 on NREI's list of top financial intermediaries. In 2007, Cohen Financial arranged $3.4 billion, a 16% drop from 2006, which placed it at No. 16 on the list of financial intermediaries.

For the entire market, Cohen predicts that 2008 lending activity from all capital sources will range between $100 billion and $120 billion. That means about two-thirds of the capital available in 2007 has vanished. And issuance of commercial mortgage-backed securities dropped dramatically to $5.95 billion in the first quarter this year, from $61 billion in the first quarter last year.

Cohen describes the events of the last 12 months as “certainly the most significant thing that has happened in the 27 years of my career and probably the history of the industry.”

Manic dealmaking

Of all the major deals financed in 2007, the most notable was The Blackstone Group's sale of the Equity Office Properties Trust (EOP) portfolio for $39 billion in February 2007. Eight of the properties were sold for $7 billion, or about $1,076 per sq. ft., to New York developer Harry Macklowe.

Edward Padilla, CEO of Minneapolis-based NorthMarq Capital, notes that the EOP deal came “at the top of the market” in terms of valuation, the point at which properties “were as valuable as they've ever been.” Since then, cap rates have risen. NorthMarq arranged $12 billion in financing during 2007 and ranked No. 8 on NREI's list of top financial intermediaries. That's down from $12.8 billion in 2006, when the company ranked No. 6.

For some lenders, however, 2007 was a banner year. Bank of America, which ranked No. 1 in the NREI lenders survey this year and last, financed $91.5 billion in 2007, up from $78.5 billion in 2006. The behemoth lender also acquired Chicago-based LaSalle Bank for $21 billion from ABN AMRO, last October.

Among the noteworthy deals in 2007: Tishman Speyer's sale of the 1.5 million sq. ft., New York trophy office tower, 666 Fifth Avenue, to Kushner Cos. for $1.8 billion. The financing was arranged by Cushman & Wakefield's Sonnenblick Goldman. For all of 2007, Sonnenblick Goldman arranged $7.34 billion.

About $135 billion in commercial real estate properties changed hands in the first quarter of 2007 alone, Padilla estimates. He calls the period “without question the largest quarter of sales transactions in the history of the country.”

In 2008, the general lack of capital availability will cause cap rates to rise and real estate values to drop off. JP Morgan Securities has projected a 20% drop in commercial real estate values from their recent peak. Meanwhile, appraisal firm Integra Realty Resources projects a 5% to 10% decline in property values this year.

CMBS market rattled

After last year's early high note, commercial real estate lending activity was jolted in April by a requirement from Moody's Investors Service and Fitch Ratings for greater levels of credit support for the highest-rated bonds in CMBS deals. This strongly signaled the market to pay closer attention to deal fundamentals.

But it was the subprime meltdown and ensuing credit crunch that really ended the party. Investors lost confidence as mortgage-backed securities teetered atop faltering subprime loans, and ratings agencies began to downgrade the securities last July, recalls E.J. Burke, group head of real estate and corporate banking for Keybank in Cleveland.

“A great deal of fear hit the market,” says Burke. KeyBank, which ranks No. 8 on NREI's survey of direct lenders, financed $21.9 billion in 2007, down slightly from $22.8 billion in 2006.

“As the story unfolded and people realized how badly underwritten many of the subprime deals were and how much greed there was, there was a general aversion to U.S. instruments,” Burke says. Many institutions marked down the value of their assets as market prices changed, in a move that hurt their capital structure.

There was “a general unwinding of leverage in a system that had thrived on leverage,” Burke notes. Padilla recounts that after August a lot of retrading occurred, and interest rates for many deals were adjusted. Some deal participants invoked legal loopholes that allowed buyers to walk out by citing significant changes that could hurt the deal's value.

The credit crunch is not over. It has hit conduit lending hard, and that sector is “dead in the water,” Burke says. But Fannie Mae, Freddie Mac, regional and local banks and life insurance companies now are in a position to cherry pick lending opportunities. KeyBank, for example, is becoming more selective about the types of loans it will generate.

This year, life companies will use up their commercial real estate allocations a lot sooner than in the past, Burke says, since their allocations have not increased.

The companies won't be dispensing any more financing than they did last year, and the available funds, estimated at about $35 billion, will go fast.

Six months ago, the conventional wisdom was that commercial banks would pick up the lending slack. But increased scrutiny by federal regulators will likely cause some banks whose portfolios are considered too concentrated in commercial real estate, such as Kansas-based Hillcrest Bank, to stop lending. Borrowers should refinance now if their loans are coming due, Padilla advises.

What lies ahead?

Cohen doesn't believe that today's lenders have the capacity to replace Wall Street. He expects commercial mortgage originations to retreat to 2004 levels of about $136 billion and that industry consolidation will accelerate.

While some commercial mortgage lenders with cash may find this a great time to build up portfolios, public companies whose stock value has decreased won't find consolidation to be an option, Padilla says. By the end of the first quarter, there were no significant consolidation deals in the industry.

With the industry in uncharted territory, the outlook is unclear. “We are in a period that nobody has gone through before,” Burke says. “We've had property market dislocations, but not accompanied by a capital market dislocation.”

A slowing U.S. economy in the remainder of 2008 doesn't bode well for lending activity. It is more likely to go down as the year conduit lenders hit a somber note, after a few years of unbridled spirits.
— Poonkulali Thangavelu