After 17 straight rate increases, the Federal Reserve felt compelled to do something radical — an about-face. To help jump-start the economy and assuage the credit markets with a bit of relief, the Fed on Sept. 18 lowered the federal funds rate that banks charge each other by a half-percentage point to 4.75%. That marked the first drop in the benchmark rate dating back to June 2003.

While the rate cut will effectively lower short-term borrowing costs and shore up near-term confidence in the stock market thanks to a perceived easing in monetary policy, it is likely not enough to quickly erase years of unbridled exuberance in the commercial real estate finance markets. Layered on top are concerns about the health of the economy, which had been expected to grow about 2% in the third quarter prior to a dismal August jobs report and the Fed's subsequent rate reduction.

For now, many spooked commercial real estate investors are sitting on the sidelines until the debt markets stabilize. The commercial mortgage-backed securities (CMBS) market, which largely determines loan pricing across the industry, is in disarray. CMBS spreads began fluctuating wildly in recent months.

By September, the securitized investment markets had deteriorated more rapidly than many players had initially expected. Spreads on BBB bonds widened from 70 points in February to over 400 points by mid-September. Those bonds had become decidedly less attractive to investors due to the perceived risk of subprime contagion spreading from the residential sector.

The bottom line is that investors today want a much higher return for greater perceived risk. The swiftness with which this has happened, and the fluctuations in loan quotes these days, is leading to a general malaise across the industry.

“Tales of deals being re-traded, lenders backing out and buyers failing to close have become rife,” says Robert White, CEO of New York-based research firm Real Capital Analytics. “We have tracked a spike in the volume of deals falling out of contract, and many market players have adopted a ‘wait and see’ attitude and opted to just delay pending deals.”

But the truly measurable impact on buyer and seller activity will most certainly lag the current volatility in the debt markets by a few months. In August, investment sales transactions nationally were pegged at $25 billion, up from $18 billion in August 2006, according to Real Capital Analytics. So the recent past may belie future activity.

While trophy assets in core property markets are less likely to see steep price cuts and cap rate increases, some big-league investors are sounding a note of caution. “Overall we've seen a lot more competitors back away from buying even the quality assets because they are uncertain about the potential gap between present and future valuations,” says David Steinwedell, president of Wells Fund Management based in Norcross, Ga. Wells has acquired more than $7 billion of commercial property over the past five years.

Still, some strategic players with deep financial pockets are seeing opportunity. “I think overall, there will be less competition trying to acquire new buildings,” says David Cobb, president and CEO of Los Angeles-based BentleyForbes, an investment firm that owns and operates a 7.9 million sq. ft. portfolio valued at $2 billion. “If you are going to be a seller, I think you have to have more patience today than you would in the past.”

Economic penalties

During the dog days of summer, real estate investors faced a whole new playing field — a surprisingly deep credit crunch triggered by the subprime market implosion, higher short-term interest rates and recent, slowing economic indicators.

In fact, many economists worry that the U.S. economy could be on the precipice of a recession. Some of the latest data supports that view. Non-farm payrolls fell by an estimated 4,000 in August, the first decline since August 2003. Many economists had predicted moderate job gains of roughly 100,000. Adding insult to injury, the payrolls for June and July were revised downward by a combined 81,000.

“The macroeconomic view and the potential for recession probably have more power to affect real estate prices than the credit crunch,” says White. “All of a sudden people aren't underwriting 10% rent growth, they're underwriting 5%.”

Most analysts agree that the credit crunch is a short-term phenomenon, but the longer-term consequences of past underwriting indiscretions and a slower-growth economy will be more deeply felt, especially in the CMBS market.

Moody's risk manifest

Days before the Fed rate cut, commercial real estate finance veteran Tad Philipp's patience had run out. Six months ago the managing director of Moody's Investors Service co-authored a report that basically threw a penalty flag on the commercial real estate markets. The April manifest, “Conduit Loan Underwriting Continues to Slide: Credit Enhancement Increase Likely,” warned of dire consequences from overly aggressive underwriting during the recent three-year financing frenzy.

Now Philipp says markets are feeling the excesses of the past and a painful correction is underway. “Frankly I think this is going to be a more challenging period than the fall of 1998 because we're being affected by our own adjoining sector — U.S. residential mortgages — as opposed to Russian bonds,” he says. “The markets are more leveraged and the instruments more complicated, so the process of pricing the risk is harder than it used to be.”

According to Philipp, there will be fewer deals and a smaller volume of CMBS issuance in the fourth quarter of 2007 and well into the first quarter of 2008. But the volume of older, aggressively underwritten loans is so high that it will take at least several months for them to work through the CMBS system, being re-priced along the way but eventually landing with investors, albeit at higher prices.

“The pipelines are crammed and the issuers can't go out and make new loans until they've sold their bonds from their old deals, which they're having some trouble doing at the moment,” says Philipp.

Wesley Boatwright, managing director of Jones Lang LaSalle's real estate investment banking group in Washington, D.C., agrees that many buyers of subordinate classes of CMBS are sidelined. But buyers for the AAA classes of CMBS paper are testing the waters again, he notes. “We expect to see some back and forth on spreads as the current overhang of $30 billion to $40 billion of CMBS paper clears out of the market, and the divergence between the ‘bid’ and the ‘ask’ closes.”

Paying the price

For Kieran Quinn, chairman-elect of the Mortgage Bankers Association (MBA), the message to members is simple: financing exists for any transaction, for a price. “Lenders are not willing to push proceeds any more. The 70% loan [loan to value] gets much more favorable treatment than an 80% loan. And there is a food fight going on for the 60% loan,” says Quinn.

As the CEO of Atlanta-based Column Financial, a subsidiary of Credit Suisse that has financed $72.6 billion in commercial mortgages since 1993, Quinn understands the intricacies of both the asset transaction and the securitized markets.

“If you're a seller, could you have gotten a 6.25% cap rate a month ago and you're looking at 7% now? Yes,” Quinn says. “I don't expect cap rates are going to revert back to what they were 90 to 180 days ago. That was clearly fueled by our ability to fund 85% loans. People expect cap rates to trend up, slowly but surely.”

For both present and future CMBS issues, Quinn says investors in so-called “B pieces” or unrated bonds in CMBS deals continue to be key market regulators, forcing tighter overall lending standards and kicking marginal loans out of deals and to the curb. And unlike 1998, there are more of these investors to help ease the “workout” period. “The unrated B-piece community is fairly well capitalized right now,” says Quinn.

Grinding it out

Market watchers are divided on how much time is left before investors feel comfortable with repricing of valuations. “We need faith again in the valuation of the collateral that secures CMBS bonds,” says Gregory Leisch, CEO of research firm Delta Associates based in Alexandria, Va. “That will take time and re-pricing. Our view is from 120 days to perhaps well into the first quarter of 2008.”

Unlike the full downturns in 1991 and 1998, this cycle is mitigated by stabilized property fundamentals. “Here the problems are on the capital markets side, not the real estate side,” says Philipp. “We are starting from a position of strength.”

CB Richard Ellis reports that suburban and downtown office vacancies at the end of the second quarter of 2007 — 13.7% and 10.6%, respectively — achieved their lowest levels since 2001. And while retail is the most vulnerable property segment to falling consumer demand, apartment occupancies are poised for growth and rents are increasing, reports New York research firm Reis.

Still, the pain is getting more real by the minute. “What's different this time is that the losses are greater and they are across all sectors,” says Thomas Aschmeyer, director of real estate finance for RBS Greenwich Capital in Atlanta. “There is big money — in the billions — to be lost. There will be jobs that will be lost, and there will be business plans that will be revisited.”

Dr. Sam Chandan, chief economist with Reis, thinks the overall investment climate will remain unsettled before stabilizing later in 2008.

As Philipp opines in his Moody's report, “With apologies to Yogi Berra, the future isn't what it used to be.”

Ben Johnson is a Dallas-based writer.

UNDERWRITING STANDARDS SLIP OVER TIME

Overall loan to values (LTV) on commercial property loans in CMBS pools have increased to more than 100% of loan proceeds in recent years, and the percentage of interest-only loans has more than doubled in the last two years, according to the three rating agencies.

1st Half 2007 2006 2005
Fitch LTV 105.0% 96.5% 93.9%
S&P LTV 113.4% 101.3% 97.0%
Moody's LTV 110.9% 101.0% 96.9%
% Interest Only 59.0% 32.6% 26.2%
Source: J.P. Morgan

How transparent is CMBS collateral, anyway?

Guilt by assumption is how many investors view the relationship between the residential subprime debacle and the commercial mortgage-backed securities (CMBS) market.

With subprime losses reaching as much as $100 billion, according to Federal Reserve Chairman Ben Bernanke, investors have the right to ask: Just how transparent is the collateral in a CMBS pool, anyway?

“In the case of CMBS, there is a lot more information out there about what our underlying collateral is [versus a bundle of single-family home mortgages],” says Michael Berman, president of CW Capital. Based in Needham, Mass., the full-service lender is a major investor in so-called “B-pieces” or unrated bonds in CMBS deals.

But Berman laments the recent practice of “slicing and dicing” and loan repackaging and churning by CMBS issuers to the point where investors could no longer accurately gauge the value of the paper they were buying.

That's where the rating agencies come in. It is the job of the three major agencies — Standard & Poor's, Fitch and Moody's Investors Service — to objectively rate the underlying collateral in CMBS pools. These issues often include as many as 300 different properties, collectively totaling $4 billion to $5 billion in most cases.

Tad Philipp, managing director at Moody's, avoids comparing the CMBS market with the residential market, but believes commercial real estate is one of the most transparent of all sectors because of the detailed data available on rents, tenants and market conditions.

“I would say we are among the most transparent of all capital market sectors,” says Philipp. “And I think in our sector most people — borrowers, lenders and investors — understand the risk they signed up for because of the transparency.”

But some industry pundits blame the rating agencies for recent lackluster performance in the transparency department. That led Standard & Poor's to release an astonishing 16-page treatise in August, essentially defending its rating system and the role of rating agencies in general.

Brian Olasov, managing director of law firm McKenna Long & Aldridge in Atlanta and a board member of the New York-based Commercial Mortgage Securities Association, an industry group, admits the agencies have really taken their lumps over the subprime meltdown.

“Every financial crisis has its own scapegoat,” says Olasov. “Sometimes it's justified, sometimes it isn't. With Enron and Worldcom it was the accounting firms, and this time it's going to be the rating agencies.”
Ben Johnson