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Read Previous Versions: March 2009 | June 2009
Government Programs to Restart Commercial Real Estate Credit Flows Beginning to
Show Promise
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The potential for significant commercial real estate-related losses tied to maturing
mortgage debt has emerged as a considerable risk due to constrained credit markets.
As a result, government initiatives to improve commercial real estate credit, particularly
the commercial mortgage-backed securities (CMBS) market, have been established.
At its peak in 2007, CMBS accounted for nearly 40 percent of the increase in new
commercial and multi-family mortgage debt outstanding nationwide. In mid-2008, CMBS
issuance came to a standstill, and the void in the marketplace has clearly taken
a toll on the commercial real estate sector.
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The securitization of commercial mortgage debt should spread the risk associated
with a pool of loans to many investors globally. Furthermore, because the debt is
sold, lenders are able to replenish capital, thereby enabling new loan originations.
During the liquidity boom, issuers of mortgage-backed securities (MBS) passed all
risk to investors, so underwriting standards of the underlying loans were not closely
monitored. When it became evident that the ratings agencies missed the mark in assessing
the risks associated with some CMBS, demand for the product fell sharply.The escalation
of the recession into a global financial crisis eliminated any hope for a quick
turnaround of the securitized debt market. Over the next year, modifications to
the securitization model will be necessary in order to restore investor confidence
in CMBS. It is possible that changes will be mandated as part of the new administration’s
proposed regulatory reform.
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Modifications to the securitization model are likely to include requirements for
originators to maintain some level of economic interest in CMBS. This, in turn,
should encourage lenders to uphold responsible underwriting standards. Freddie Mac
recently drew upon this new model for its first offering of K Certificates in June.
The $1 billion securitization of multi-family debt marked the first CMBS to clear
the pipeline in a year. Unlike traditional CMBS, however, Freddie Mac is guaranteeing
the senior bond classes. Based on the program’s initial success, Freddie Mac could
move forward with another securitization later this year.
Over the remainder of 2009, government programs should be instrumental in stimulating
demand for traditional existing and newly issued, highly rated CMBS. This should,
in effect, mark the starting point for clearing lenders’ balance sheets and eventually
lead to increased lending capacity for new commercial mortgage loans.
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Implementation of Government Programs Proves Complex
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Government programs to jumpstart commercial mortgage lending have been modified
in recent months, both in terms of size and scope, but they continue to move forward
and appear on track to be operational by this fall.
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Term Asset-Backed Securities Loan Facility (TALF). TALF was originally established
to provide financing for the purchase of newly issued, consumer-related, asset-backed
securities such as credit card debt and auto loans. In May, the government expanded
TALF to include highly rated new and legacy CMBS in an attempt to help clear up
lenders’ balance sheets and increase new commercial mortgage originations. At the
announcement of TALF’s expansion to include CMBS, spreads narrowed dramatically.
After peaking at more than 1,200 basis points over swaps in the first quarter of
2009, spreads on AAA-rated CMBS declined to approximately 600 basis points by late
May. Spreads ticked up in the weeks that followed, after Standard & Poor’s (S&P)
announced that changes to its risk-assessment methodology could result in mass downgrades
of once highly rated CMBS. More recently, S&P reversed its position and restated
the ratings on some of the loan pools. Spreads for AAA-rated CMBS have since declined
to 450 basis points over swaps, the lowest point since October of last year. Such
fluctuations are indicative of the complexity and uncertainty still impacting the
pending solutions for restarting the CMBS market.
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- Multiple deals adhering to TALF’s strict guidelines are under way. In order to qualify
for TALF, CMBS must have the highest credit rating available from at least two approved
ratings agencies. Furthermore, the mortgage pools must consist solely of fixed-rate
loans underwritten on current NOIs and valuations; construction loans are not eligible.
Major lower-leverage owners such as REITs stand to benefit directly from the program.
While developers and smaller private investors are unlikely to reap direct rewards
from TALF, they should ultimately benefit from greater availability of debt capital
as the credit markets begin to function normally.
- One of the first TALF offerings
of newly issued CMBS could involve Developers Diversified Realty (DDR), a retail
REIT. DDR is expected to borrow a combined $600 million against two pools of assets
in its portfolio. The properties in these pools should qualify, because they are
considered relatively low-risk, even in light of the current economic situation,
since they offer stable cash flows and are occupied mostly by discount retailers.
Furthermore, many of the properties in these pools are reported to be unencumbered
at present, and the resulting loan-to-value ratio will be around 40 percent. Vornado
Realty Trust is also reported to be assembling a TALF-eligible CMBS deal to raise
between $550 million and $600 million for the REIT.
- The legacy CMBS component
of the TALF program received requests for $670 million in loans at its first subscription
date in July. After reviewing the requests, the Fed approved all but one of the
36 bonds submitted as collateral for TALF loans.
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Of the many government programs, TALF appears to hold the most promise for freeing
up capital for commercial real estate lending in the near term. Since it can take
a few months to organize a TALF-eligible CMBS deal, the program is off to a slow
start, but the wheels are now in motion, and a growing number of large property
owners and lenders will take advantage of the program by year end. While TALF was
set to expire at the close of 2009, the program was recently extended to March 31,
2010, for existing CMBS and June 30, 2010, for newly issued CMBS.
Public-Private Investment Program (PPIP). Proposed government-private
partnerships aimed at moving toxic assets off of banks’ balance sheets were initially
well-received and promising, but implementation has proven difficult. To start,
banks have raised large amounts of equity capital without having to sell assets
at deep discounts, reducing their motivation to participate in the program. Furthermore,
some potential participants are reluctant to partner with the government, wary of
possible restrictions that could be imposed at a later date.
As of the end of July, PPIP was moving forward but at a scaled-down level. PPIP
had targeted the removal of up to $1 trillion of legacy loans and securities from
banks’ balance sheets; however, as financial markets improved, the government reduced
its target for the first round to $40 billion in legacy securities only. The impacts
of a scaled-back PPIP on commercial real estate investors are mixed. While it may
take more time for banks to clear their balance sheets of toxic mortgage-related
securities, their lack of enthusiasm for the program signals that mortgage term
extensions and workouts are likely to continue as a major focus, especially for
higher-quality assets.
- Legacy Securities Program. As part of the PPIP, the Legacy Securities Program allows
prequalified fund managers to receive an equity contribution and favorable financing
from the government to purchase legacy securities. These securities include existing
CMBS that were highly rated at the time of issuance. If successful, the program
could provide an important price discovery tool, one of the first steps in restarting
credit markets and freeing up capital for new lending.
- In early July, the Treasury formally announced its list of nine prequalified fund
managers to participate in the first round of the Legacy Securities PPIP. Fund managers
have 12 weeks to raise at least $500 million each in private capital, in addition
to investing a minimum of $20 million of their firm’s capital into the Public-Private
Investment Fund (PPIF).
- The government committed $30 billion to the program to match equity capital raised
from private sources and to provide up to 100 percent financing of the total equity
in the PPIF. The first round of the PPIP holds the potential to remove up to $40
billion of legacy securities from banks’ balance sheets.
- Legacy Loan Program. In conjunction with the PPIP, the Legacy Loan Program was intended
to help banks move whole loans off of their balance sheets. In June, the FDIC postponed
a pilot sale by open banks through its Legacy Loan Program, citing banks’ ability
to raise capital successfully without moving these assets off of their balance sheets.
At the same time, however, the FDIC announced plans to test a similar funding mechanism
to sell receivership assets of failed institutions this summer. While the platform
may draw from the model utilized by the Resolution Trust Corp. (RTC) in the early
1990s, the list of failed banks consists of mostly smaller institutions; therefore,
the quantity, size and quality of assets offered by the FDIC in the foreseeable
future will likely pale in comparison to the RTC days.
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Tight Financing Climate, Weakening Fundamentals Remain Key Challenges to Commercial
Real Estate Market; Economic Bottoming a Positive Sign
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Wave of Maturing Commercial Mortgage Debt Approaching.
The tight financing climate is not only hindering acquisitions but adding another
layer of complexity and challenge for commercial property owners with maturing debt.
In the next two years, an estimated $550 billion of commercial mortgage debt is
scheduled to mature. A significant share of this debt is unlikely to qualify for
refinancing without equity contributions by the owner. Issues could become more
severe as debt originated from 2005 to 2007 matures, since loan-to-values (LTVs)
during this period were at historically high levels, and many loans were underwritten
based on overly optimistic occupancy and rent growth assumptions. The impact on
the market is likely to be substantially minimized by lenders’ focus on workouts
and modifying loan terms, at least in the short term.
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Delinquency Rates Rising. During the first quarter of
2009, CMBS delinquency reached 1.85 percent, up from less than 0.5 percent early
last year and the highest level on record. The delinquency rate for loans issued
by banks and thrifts jumped to 2.28 percent in the first quarter, a 90 basis point
rise from six months earlier and on par with the rates reported in the mid-1990s.
Commercial mortgage delinquencies among life insurance companies Fannie Mae and
Freddie Mac also have increased in recent quarters but remain low at less than 0.35
percent, as these lenders maintained conservative underwriting standards throughout
the most recent real estate boom.
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Portfolio Lenders More Amenable to Commercial Mortgage Modifications.
Many portfolio lenders are actively working with borrowers to modify loan terms
and avoid foreclosures. The situation is more difficult for owners with CMBS loans,
as multiple parties hold an interest in the mortgage. Delinquent CMBS loans also
are transferred to special servicers that have strict limitations related to property
foreclosures and distressed sales, further delaying a large inventory of discount
sales coming to market.
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Distress Spreading. Since the start of 2008, the volume
of distressed commercial real estate has swelled to an estimated $115 billion. Distress
was initially concentrated among failed development and condo conversion deals,
but the office sector took the lead in the fall of 2008 as the financial crisis
intensified. The composition of distressed properties has since shifted again, with
retail properties now accounting for the greatest share, or 30 percent of the total,
up from less than 10 percent one year ago. Of the core commercial real estate sectors,
retail recorded the most significant speculative construction in recent years as
developers chased, and even built ahead of, rooftops into far-reaching suburbs.
The reversal of housing-related fortunes and shrinking stock portfolios have contributed
to the loss of $13 trillion from the overall net worth of U.S. households since
mid-2007, resulting in a drastic pullback in consumer spending and a growing propensity
to conserve cash.
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Commercial Lending at Bottom? Commercial mortgage originations
continued to decline during the first half of 2009, reflecting further reductions
in loan demand and broad-based constraints on debt capital. In the first quarter
alone, originations were down 26 percent from the fourth quarter of 2008 and were
nearly 90 percent below levels reported prior to the onset of the credit crunch
two years ago. Fannie Mae and Freddie Mac have recorded the lightest decrease in
originations over the past year, as their multi-family loan portfolios continue
to perform well.
With the exception of Freddie Mac’s recent securitization, CMBS issuance has been
at a complete standstill since last June, while life insurance companies generally
remain on the sidelines. Over the past several quarters, real estate investors have
relied largely on commercial banks for new loans, which have become wary of originating
large loans and increasing their risk exposure to individual assets. The limited
amount of debt available from traditional lenders has resulted in a drastic increase
in assumed or seller-backed financing in transactions, which now accounts for more
than half of the marketplace, compared with only 11 percent a few years ago.
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Investment Activity Remains in Lull; Price Differentiation Based on Quality, Location
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Tight Credit Hampering Commercial Real Estate Sales.
The escalation of the credit crunch to a full-blown financial crisis in the fall
of 2008 led to additional constraints on tight commercial real estate financing,
reducing sales activity further through the first part of 2009. Prior to the near
shutdown of credit markets last fall, commercial real estate sales volume was already
down 70 percent from peak levels. The trend gained momentum through the end of 2008
and first half of 2009, with sales volume 90 percent below its peak as of the second
quarter.
Buyer/Seller Disconnect Easing. In addition to the tighter
financing climate, the wide gap between buyers’ and sellers’ price expectations
is a major contributor to the drop-off in property sales. The disconnect became
more severe in recent quarters, as buyers anticipated far deeper discounts due to
rising distress and weaker fundamentals. There is some evidence emerging that sellers
are becoming more accepting of current market sentiment, with cap rates on newly
offered properties up approximately 50 basis points to 100 basis points from last
year. At the same time, buyers are recognizing the difference in pricing based on
market and property quality. Many investors remain on the sidelines, but interest
in commercial real estate has increased, as have available inventory and offer activity.
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Commercial Real Estate Investors Re-Evaluate Strategies as Downturn
Continues. Until earlier this year, many owners were operating under
the assumption that they were well-positioned to ride out the downturn. The deepening
of the financial crisis last fall, however, led to severe job cuts across industries,
as many companies were unable to secure short-term financing to fund basic operations.
As a result, space demand deteriorated rapidly, cutting into NOIs and property valuations.
With forecasts calling for continued economic weakness in the near term and rising
distress in the commercial real estate sector, more property owners will opt to
adjust prices rather than risk further equity erosion or a foreclosure.
Negative Investor Psychology vs. Long-Term Opportunity.
Government programs to jumpstart the credit markets are promising, but they are
only the first step in reversing the negative feedback loop currently in play throughout
the commercial real estate segment. One of the most challenging issues to overcome
for the investment market will be the negative psychology that has permeated the
commercial property sector. Many investors are awaiting the return of economic growth
to redeploy capital into commercial real estate. These investors run the risk of
missing acquisition opportunities, particularly for properties that rarely change
hands, as more of these assets are now available at reasonable prices.
Central Clearinghouse for Troubled Commercial Properties Unlikely.
While the FDIC will begin to accept bids on failed bank assets this summer, offerings
are unlikely to include a significant number of individual commercial properties.
In the early 1990s, the RTC helped to liquidate real estate- and mortgage-related
assets of failed Savings and Loan Associations (S&Ls). At that time, it was typical
for institutions to hold whole loans on their balance sheets. The situation today
is far more complex due to the securitization of mortgage debt, which grew out of
the S&L crisis. Furthermore, compared to the S&L crisis, the number of bank failures
during the current downturn has been relatively low. Even if a central clearinghouse
was established to liquidate bank assets, it would likely be on a much smaller scale
than the RTC. Disposition of troubled loans has largely been left up to individual
institutions and government agencies.
Opportunities Emerging. Unlike stocks and bonds, real
estate investors must wait for properties to be offered for sale, and some assets
rarely trade. As sellers become increasingly motivated due to maturing debt or capital
needs for other assets in their portfolios, a wide array of commercial properties
should emerge. This will mark a unique window to acquire assets that fit long-term
strategies at attractive returns, including core, stable properties in solid locations.
Investors with expectations of unrealistic discounts relative to quality will find
it difficult to participate.
Plenty of Capital Parked on Sidelines. There is already
a significant amount of private and REIT capital available for well-priced, quality
assets to be offered for sale. During the first six months of this year, REITs raised
approximately $19 billion, some of which will be used to pay down existing debt,
but it is likely a portion has been set aside for acquisitions. As lower-leverage
investors, REITs may face limited competition for large assets, since obtaining
financing for properties priced at more than $15 million has become particularly
challenging.
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Cause for Cautious Optimism. Despite the recent drop-off
in commercial real estate investment and expectations for further softening in vacancy
this year, several variables continue to support a positive long-term outlook for
the sector.
- Government stimulus and credit facilities need more time to trickle through the
system. The complexity of financial sector challenges has hampered the progress
of programs such as PPIP and the CMBS component of TALF, which are only now beginning
to gain momentum. Programs designed to encourage auto sales and first-time home
buying also are under way, and only a small share of the funding made available
through the $787 billion American Recovery and Reinvestment Act has been spent to
date.
- Payrolls were relatively lean heading into the current downturn. With approximately
6.7 million jobs lost since the recession began, many businesses will need to rehire
workers somewhat quickly when an economic recovery gains traction. As a result,
the commercial real estate market could experience a relatively swift increase in
space demand when compared to other recoveries.
- Productivity rates are rising, and companies have been able to reduce expenses significantly
in recent quarters. Consequently, companies are well-positioned to record strong
profit growth when the economy rebounds. Furthermore, with the unemployment rate
at 9.4 percent and likely to reach 10 percent by year end, there will be plenty
of slack in the economy. This will limit wage and pricing pressures as a recovery
takes shape, reducing inflation concerns in the near term. Overall, businesses should
be able to expand somewhat rapidly when demand for goods and services accelerates.
- During the most recent period of economic expansion, there was minimal overbuilding
in the commercial real estate sector, outside of retail. Through at least 2010,
weakened commercial real estate fundamentals and tight credit markets will lead
to the deferral or abandonment of many projects in the pipeline and hamper the pace
of new projects entering the planning phases. As a result, owners will have an opportunity
to lease existing vacant space ahead of the next construction cycle.
- The nation’s savings rate has skyrocketed in recent quarters, as consumers remain
cautious. Once economic uncertainty begins to ease and signs of growth re-emerge,
consumers will likely increase spending, albeit not to the degree recorded in the
years of easy lending and double-digit home price appreciation. Since consumer expenditures
account for roughly 70 percent of U.S. GDP, even moderate retail sales growth of
3 percent to 5 percent would support overall economic expansion.
- Demographic shifts such as the aging of baby boomers and the passage of echo boomers
into their prime renting years, along with solid population gains due to natural
growth and immigration, will support a positive outlook for apartment and commercial
space demand well into the future.
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Download the August 2009 Outlook Here
