The commercial real estate investor may feel uneasy following the unfolding crisis in residential subprime mortgages. Is there direct or indirect exposure to subprime risk in typical commercial real estate investments, such as commercial real estate collateralized debt obligations (CDOs)?
It may surprise some investors to learn that a handful of commercial real estate CDOs do include subprime residential mortgages in their asset pools. A CDO pools debts, creates traunches and then sells securities, similar to commercial mortgage-backed securities. A chief difference is that CDOs allow a greater variety of assets, including short-term loans, whole loans, and even other securities.
“Over the last few months, some issuers have been putting small amounts of subprime into commercial real estate CDOs,” says Tad Philipp, managing director of the CMBS group at Moody’s Investors Service. “So we have seen it, but not to a level that concerns us.” In addition to rating CMBS transactions, Philipp’s group rates CDOs backed primarily by commercial real estate.
The vast majority of CRE CDOs consist entirely of commercial loans. However, there are a few exceptions in which subprime mortgages may make up 5% of the pool. In contrast, subprime assets make up an average of 45% of the assets in a structured-finance CDO. “Subprime has been an important part of the structured-finance CDO market generally, but not an important part of the CRE CDO market,” Philipp says.
The increasing number of subprime mortgages in CRE CDOs may be more a sign of investor caution than a cause for alarm among CRE CDO shareholders. “Some holders of subprime debt may be looking for multiple exit strategies, one of which is to place some of it in commercial real estate CDOs,” Philipp says.
A chain reaction to the subprime market, however, may be a rise in the cost of capital, according to Brian Lancaster, head of structured products research at Wachovia. That’s because spreads for asset-backed securities (ABS) in general have widened, as residential investors have demanded greater returns to reflect the increased risk associated with subprime mortgages.
Higher spreads for CRE CDOs limit the amount CDOs can pay for the higher-risk portions of CMBS . Because CDOs are the dominant buyers of the riskiest levels of CMBS, conduit lenders will eventually demand higher lending rates to compensate for the lower pricing of CMBS securities.
“Ultimately that filters up through to the guy that owns a shopping mall and finances himself through the CMBS market,” Lancaster says. “Conduit lenders will need to get higher rates from the borrowers. My sense is that it’s only been a few basis points, but that’s where we’ve seen the primary impact.”
Based on performance, commercial mortgages present a marked contrast to the residential market. In February, Fitch Ratings reported that CMBS delinquencies dropped three basis points to 0.34%.
“According to Fitch, delinquencies are down for every product type,” observes Jamie Woodwell, senior director of commercial/multifamily research at the Mortgage Bankers Association. “We’re seeing some things going on in the credit markets as far as appetite for risk, but when it comes to the fundamentals of commercial real estate, they remain extremely solid.”
Market observers agree that subprime fallout is unlikely to have a significant impact on commercial real estate in general, although downsizing or closure of subprime lenders could create vacancy issues in Southern California, where many of those companies are based.
In fact, multifamily owners could enjoy increased demand and higher occupancy rates in Dallas, Atlanta, and other markets where the monthly cost of owning a home is close to rental rates. In markets with a greater economic divide between owners and renters, such as those along the coasts, mortgage defaults are less likely to increase the number of renters.
The commercial real estate investor’s greatest fear in this case may be government reaction to fear itself, says Anthony B. Sanders, professor of finance at Ohio State University in Columbus, Ohio.
“The great fear, of course, is the deliberations in Congress about the dreaded R-word — regulation,” Sanders says. “While the subprime residential mortgage market could clearly use some improvements, such as fully disclosing the costs and risks of contracts such as teaser-rate adjustable-rate mortgages in clear language, it is better if the market corrects its own problems, which they have an incentive to do.”
Philipp hopes the recent scrutiny of subprime lending will cast a spotlight on credit quality in commercial real estate as well. “We’re far from hitting the panic button, but we do think it’s helpful for people to focus on credit quality,” he says. “Leverage has been rising and the share of amortizing loans has been falling. There’s plenty of work that needs to be done in commercial real estate to keep it from becoming the next subprime.”