South Beach, Fla. -- The Commercial Mortgage Securities Association held its annual Investors Conference this week in South Beach, Fla., at a particularly precarious moment. Credit markets remain locked up, which has turned the previous deluge of CMBS issuance into a drizzle. As a result, there are deeply dampened expectations for CMBS issuance for 2008. Meanwhile, talk of which--if any--commercial real estate sector might go the way of the residential market clearly had some attendees worried.
The mood was in stark contrast to one year ago. The CMBS industry closed 2006 with $297.8 billion in CMBS issuance ($202.6 billion in the U.S.) and $39.8 billion in CDO issuance, according to Commercial Mortgage Alert. Expectations were that CMBS issuance in 2007 would approach $363 billion, including $245 billion in the U.S. (a figure calculated by averaging the predictions of 14 analysts and experts).
That pace held up for much of the year and, in fact, 2007 issuance did exceed 2006, but did not quite live up to the lofty expectations. In the end, CMBS originators finished 2007 with $314.7 billion in new CMBS issuance (with much of that coming in the first three quarters) and $39.3 billion in CDO issuance. Now, expectations are that the CMBS market will remain lackluster well into 2008. The same pool of experts and analysts surveyed by Commercial Mortgage Alert expects issuance to drop in half from 2007's levels down to $158 billion overall and $113 billion in the U.S.
And new issuance is not the only thing the industry has to worry about this year. There is also concern about the overall state of commercial real estate and whether a prolonged slump in housing will damage the prospects of other sectors. Furthermore, while most attendees expected the U.S. economy to avoid a recession with GDP growth slowing to between 1 percent and 2 percent this year, most have not ruled out the prospect of a downturn entirely. This is a key concern because any downturn in commercial real estate fundamentals could cause an increase in defaults and delinquencies in existing CMBS pools, which, for now, remain near record lows.
A panel of real estate economists debated the prospects of the major sectors and came away with some very disparate conclusions. The baseline for all three economists, Jon Southard, chief economist, CBRE/Torto Wheaton Research; Sam Chandan, chief economist, Reis Inc.; and Len Mills, director of debt research and risk management, Property and Portfolio Research (PPR), was that the U.S. would avoid a recession. Still, they foresaw that a slowdown would have a devastating effect on some sectors--primarily lodging. Interestingly, the economists also had widely divergent views on retail.
Southard expects commercial real estate to deliver annual average total returns of 7 percent. That's below the average 13 percent return seen over the past five years. The big change, he said, is that the returns over the past five years have been largely due to cap rate compression and rising property values and not a result of growing net occupancy income. Going forward, he expects that to reverse, with cap rates stabilizing or rising while net occupancy income increases. In the retail space specifically, Southard expects the industry to grow rents by an average of 2 percent per year for the next five years.
"With vacancies down and construction in check, we expect income growth and no cap rate compression. As a result, the returns will be less, but the important thing is that they will still be positive," Southard said.
Another point in retail's favor, he said, was the fact that the sector has long-term leases. That provides stability that some other sectors won't share and means it would take longer for a downturn in rents to negatively affect the sector.
Chandan agreed with that assessment, but still had concerns about the health of CMBS that could suffer even if commercial real estate fundamentals continue to grow. "There is a question in that the assumed growth in the underwriting of some CMBS is too aggressive and that will pressure the mortgages," he said. Some loans may be too aggressive in the loan-to-value ratios and have mortgages based on seriously escalating incomes, which may not materialize. And that could lead to defaults, even if growth doesn't turn negative.
Chandan also thought retail would remain stable, pointing out that huge increases in materials prices in recent years kept development in check. According to Reis's figures, the retail sector completions in 2007 were below 30 million square feet--less than half the pace of development in the 1980s when deliveries exceeded 50 million square feet a year.
Mills, however, had a much different view of the sector stemming from PPR's assessment that, in fact, retail construction had progressed at a much higher pace. PPR bases its figure on an aggregate accounting of construction in 54 markets it monitors, in addition to information from Reed Construction Data. PPR's figures show that 145 million square feet of new retail space was delivered in 2007--which is more than 30 percent higher than the historical average of 106 million square feet added each year since 1982. This year it expects another 122 million square feet to be added.
That led Mills to say there may be issues of overbuilding. Further, a lot of the new development activity has been in areas where new housing has come online, but in many cases, the new housing is vacant because of the downturn in the residential market. As a result, these newer centers are seeing higher vacancy rates than properties that opened in earlier years and are taking longer to lease up.
Still, all the economists agreed that a downturn in commercial real estate would not mirror the fall in the residential sector because of several important factors. For one, there are no low-documentation or no-documentation loans in the commercial sector as there are in residential. Such loans, in which borrowers can be approved with limited or no information provided on their financial health, have been one of the biggest reasons for the defaults and delinquencies on the residential side.
Further, commercial real estate loans are much more highly scrutinized. Lenders and rating agencies can peruse every loan in a CMBS pool, which they don't do on the residential side. Lastly, delinquencies on commercial real estate loans are nowhere near the levels in the residential space.
For all those reasons, while things may not exactly be pretty for CMBS investors, there is reason to believe that the subprime debacle won't be replayed in the commercial market.
| Categories | CMBS | ABS |
| Market Size | $650B | $600B |
| Delinquencies | 6.4% | 24.5% |
| LTV | 69% | 80% |
| Loan Size | $15.8M | $185,000 |
| Loan Term | 10 years | 30 years |
| Monitoring | Asset-by-asset | Statistical Modeling |
-- David Bodamer