This summer's credit crunch brought the days of easy money to an end — and the commercial real estate industry is still suffering a hangover from that party — but things have begun to loosen up and finance pros are assuring owners that today's pain won't last too long into tomorrow.
A sign for optimism came in the form of Holliday Fenoglio Fowler L.P.'s (HFF) third quarter conference call on November 9. Executives from the commercial real estate financial intermediary pointed to strong fundamentals in the sector and an abundance of capital from pension funds, private funds and foreign players. So even though property investors that relied heavily on debt may be temporarily out of the picture, there is enough demand in the market from cash-flush players that cap rates may only rise a little in the coming months.
As proof of the industry's underlying strength, HFF executives pointed to the company's results for the third quarter. In spite of the current market conditions, the firm's revenue increased 23.8 percent, to $68 million, though operating income decreased 3.9 percent, to $13.6 million. Meanwhile, production volume rose 63.8 percent, to $11.9 billion in 300 transactions, from $7.3 billion in 309 transactions completed during the third quarter of 2006.
Those results came amid a scary two quarters for the industry, HFF leaders admitted, as troubles in the subprime mortgage sector roiled credit markets. In commercial real estate, the problems were most acutely felt in the commercial mortgage-backed securities (CMBS) sector. Going into this summer, CMBS issuance in the U.S. grew at an average annual rate of 18 percent. Last year, the industry recorded $299.2 billion of CMBS issuances and $35 billion of commercial real estate collateralized debt obligations.
But as demand for CMBS bonds became more voracious, CMBS lenders loosened underwriting standards in order to generate enough loans to meet the demand of bond investors. In many cases, CMBS issuers agreed to terms that were more aggressive than the conventional formula of 65 percent to 75 percent loan-to-value ratio, providing leverage of up to 90 percent, with no interest periods and similar perks, says Scott R. Lynn, director and principal with Metropolitan Capital Advisors, Ltd., a Dallas-based real estate investment banking firm. Many assets ended up grossly over-leveraged, with the average commercial loan worth 118 percent of a property's value in the third quarter of 2007, according to Moody's Investors Service.
In pursuing such aggressive terms, CMBS issuers bet on a continued rise in real estate values, but their bets did not always pay off. For the past four years, net occupancy income on CMBS-leveraged commercial properties came in below expectations, missing targeted returns by an average of 6 percent in 2006, according to data compiled by HFF. “There were some fairly substantial write-downs to get CMBS transactions to clear,” Lynn says. “They are backing away from making new loans or increasing their pricing. Risk has definitely been repriced.”