Capital Markets Conundrum

Are there viable solutions to today's financing puzzle?

By Steve Bram

With daily reminders of gloom and doom regarding the economy’s current state, bank closures, and frozen credit, it is not a stretch to imagine that one day industry professionals will tell their young protégés about the struggle to find financing during the “Great Recession.”

The full extent of this downturn’s global implications on capital markets during the next six to 12 months is still unknown. Commercial real estate brokers and investors as a whole are waging an uphill battle, with those working in secondary and tertiary markets facing additional challenges. A recession oppression hovers over the capital markets and for those who seek financing for commercial real estate transactions, a break in the clouds is hard to find. Fewer lending sources are making fewer loans, multiplying the woes of buyers, sellers, and brokers.

The Lending Environment

Many issues are affecting the flow of commercial real estate capital today. Lenders have limited liquidity available because they are reserving capital for problem loans — of which there could be many. Banks have exposure to about $550 billion in construction loans, $1.1 trillion in commercial real estate loans, and about $150 billion in multifamily loans, according a Deutsche Bank report, which estimates that regional and local banks hold a much larger share than national banks. Thus, losses of up to $300 billion could be borne disproportionately by smaller banks. This threat is creating a significant fear among banks of lending too much and reducing their available remaining capital.

Lenders also are concerned about being required to fully mark their loans to market values, further eroding their capital. For small undercapitalized lenders, or even the larger, well-known lenders, this depletion could reduce their capital below the standard 8 percent threshold. Falling below this standard allows regulators to classify a financial institution as undercapitalized. Lenders that are extremely undercapitalized
can be ordered to halt all lending activities and face potentially worse outcomes, such as being closed down or forced to sell to another lender. This scenario has played itself out for numerous banks since the beginning of 2009, and industry watchers expect more to follow.

Conservative lending is not just a precaution to protect bank profitability in these troubled times. Profitability in many cases has taken a backseat behind job security. Lending professionals are wary of approving loans that are too aggressive and ultimately could cost them their jobs, putting them among the other 14.7 million unemployed Americans.

Securitized Lending

On the securitized lending side, loans are priced too high to make sense, if they are being priced at all. Concerns with new securitized lending include affordable ways to lay off the investment-grade piece, risks of movement in subordination levels, pricing of non-investment-grade pieces, and the requirement for the originators to hold some of the loans to term.

The Term Asset-Backed Securities Loan Facility or TALF program has offered a potential avenue for originators to lay off 85 percent of the investment-grade portions of the securitized loan. But so far TALF is only being considered for very large pooled transactions and has not yet started to be used for small, single-asset deals.

Subordination levels, the levels at which the investment-grade portion of a loan begins, are set by rating agencies. These levels play an important role in the pricing and risk management of structured finance products. Due to past issues such as overly aggressive underwriting, the rating agencies themselves are in a state of change. Lenders are afraid that the rating agencies may lower the subordination levels on recently issued deals as they discussed doing in mid-2009, as they develop new methods of analysis to calculate these levels.

Hedge funds represent a major source of potential buyers for the non-investment-grade portions of future securitized loans. Hedge fund investors compare the opportunity of investing in commercial mortgage-backed securities with the opportunity of purchasing discounted notes, foreclosed
properties, or even corporate securities. They want the highest return with the lowest risk. These investors currently are biding their time and not jumping into securitized lending, awaiting the best opportunities to use their cash.

These financing issues are having a major impact not only on commercial real estate professionals, but also on investors in small markets. Financing is the major transaction hurdle to overcome in any market today. Unless there is assumable financing, the job of obtaining new capital often derails deals.

Small-Market Lending

Secondary and tertiary markets are often extensions of primary suburban markets. These markets can be particularly hard hit during an economic downturn. However, in general, rents on commercial properties have not fallen as fast in secondary and tertiary markets because rents never rose as dramatically as they did in the primary markets.

Nevertheless, obtaining financing in secondary or tertiary markets can be a greater challenge than in large urban areas. Many small, local lenders and community banks have exited the market and regional and national lenders’ conservative underwriting standards prevent them from doing business in smaller markets. As a result, some sellers are offering seller financing, thereby providing buyers with either all or a portion of the capital needed to purchase their property. However, this type of financing reduces or eliminates the seller’s ability to cash out of their properties and possibly trade into other properties. As a result, secondary and tertiary markets across the country have experienced an even greater decline in sales prices than those in primary markets due to the loss of available financing.

Though many local banks are not lending, those that remain strong, liquid, and eager to lend make great partners for investors in secondary and tertiary markets. Borrowers seeking financing from these institutions need to be prepared for full-recourse, conservative underwriting; smaller loan amounts; and less flexible terms.

Investors who are already clients of regional or national banks will have the best chance to pursue loans from these institutions. Small insurance companies also may lend conservatively in secondary (but typically not tertiary) markets, but borrowers need to be prepared to obtain smaller loan amounts and face much higher interest rates than a bank normally might offer.

Occasionally the only options for investors in secondary and tertiary markets are private lenders that provide “hard money.” Here again, borrowers must face conservative underwriting and much higher interest rates.

The Future of Lending

Looking ahead, it is clear that the demand for lending cannot be satisfied by banks and insurance companies alone. Since the advent of CMBS, the lending capacity of insurance companies — and even some banks — dropped and will not increase in the near future. Many insurance companies greatly reduced or even eliminated their loan origination teams and began buying portions of CMBS loans (“paper”). With those investments locked up, it is unlikely that insurance companies will increase lending and those with no whole loan lending capacity probably will not re-establish their loan origination departments.

It will be difficult for the financial markets to return to normal without CMBS or some other form of securitized lending. The system works too well and provides too many positive attributes by offering investment tranches for a full range of investors at various levels of risk.

The industry is trying to figure out securitized lending through the TALF program for larger, multiple-asset/single-borrower portfolio loans. Of all government programs, TALF holds the most promise for freeing up capital for commercial real estate. However, despite the recent TALF extension, it has yet to be tested in the marketplace. Currently two real estate investment trusts are assembling TALF-eligible deals, both in the $500 million to $600 million range. These and other loans may be completed in the next 12 months through the program.

While full-spectrum CMBS lending may not return to the market for another two to three years, there are signs that the system is beginning to reinvent itself. The market will have to continue to crawl through the downturn until a perfected form of securitized lending is established.

In the next 12 months as banks begin to face their troubled assets, the focus will shift to dealing with the problem loans, making banks much less interested in formalizing new financing. While most banks have set aside large capital reserves for expected loan losses, it is not yet known if those reserves will be sufficient to account for the actual losses they will incur. Industry watchers expect that many banks will not survive the loan losses they will face during the next few years.

A reduced number of banks will mean less real estate financing available for owners. Fewer banks mean less competition among lenders, giving them little reason to be aggressive. In the next year, any loan will be a good loan. During these difficult times, investors need to adopt a new mantra about their financing: “If the shoe almost fits, wear it.”

Commercial/Multifamily Loan Originations

Investor Group, 2Q09, 2Q08, 2Q07, 2Q06, 2Q05

Conduits, 4, 9, 606, 343, 355

Commercial banks, 49, 298, 408, 457, 420

Life insurance cos., 59, 128, 175, 206, 174

Fannie Mae/Freddie Mac, 189, 186, 112, 99, 89

Source: Mortgage Bankers Association

Steve Bram is co-founder and principal/senior director of George Smith Partners, a real estate investment banking company based in Los Angeles. Contact him at (310) 557-8336 ext. 123 or sbram@gspartners.com.

Estimating Values in Today’s Market

While everyone understands the commercial real estate markets are in trouble, few comprehend the problem’s full magnitude. Values have dropped in most markets, but the amount of adjustment is difficult to ascertain due to the lack of transactions.

Earlier this year, Green Street Advisors, a real estate investment trust advisory firm, described the economy’s impact on commercial real estate as a one-two punch. Green Street predicts that capitalization rates will return to pre run-up levels due to more-expensive debt and increased return requirements. It's called the “969” phenomenon, which is a pattern of cap rates, not an area code. In other words, cap rates were close to 9 percent for many sectors early in the decade, dropped to 6 percent in the easy-credit environment, and will return to the 9 percent level when the market stabilizes.

A simple calculation explains the impact of this likelihood. A property with $100,000 in net income capped at 6 percent results in a value of $1.67 million. At a 9 percent cap rate, the same property would sell for $1.11 million, which represents a one-third value decline, assuming the income is stable. If rental rates decline or vacancy increases, the decline in value is even greater.

FMV Opinions has performed research on median cap rates for investment-grade office and industrial buildings nationally since the early 1990s. Generally, cap rates have ranged between 9 percent and 10 percent from 1993 to 2002. After that, cap rates for both asset classes dropped to the low 7 percent range from 2005 to 2008 for industrial investments and about 6 percent to 7 percent for office products during the same period. Through the first half of 2009, median cap rates have reached more than 9 percent for industrial and more than 8 percent for office. The commercial investment market has seen an increase of about 200 basis points, or 25 percent to 30 percent. This at least partially explains the downward adjustment in prices currently being registered in the commercial real estate market.

Green Street suggests these cap rate fluctuations will result in a value decline of 35 percent to 40 percent. While trades are few, Green Street says this is where the market is now and property owners should prepare for the impact on their financial statements, loan covenants, and other issues related to property ownership and operation.

Richard Parkus, head of commercial mortgage-backed securities research at Deutsche Bank, corroborates these findings in the company’s commercial real estate outlook. He predicts property prices will decline 35 percent to 45 percent or more overall during this recession.

FMV’s research shows that industrial prices peaked in 2005 and remained relatively level at near $47 per square foot. Since then, prices have dropped to about $40 psf, a 15 percent decline. Office investment prices peaked near $230 psf in 2008 and have dropped to about $200 psf in the first half of 2009, a decline of 13 percent. Based on our research, the annualized decline for 2009 could approach 25 percent to 30 percent. Taking into consideration cap rate movement and statements from major investment advisers, the probable minimum decline will be approximately 30 percent or more for 2009.

Clearly, the commercial real estate market is in a very serious correction. Actual sales data for the first half of 2009 show declines of 25 percent to 30 percent. With continued softness in employment, price declines will continue to occur in 2010, but at a slower rate.

The interesting wild card in the recovery is the capital markets. If Green Street Advisors is correct and cap rates adjust up to long-term averages approaching 9 percent, values will not adjust to levels reached at the peak in 2005 to 2008. Instead, capital return requirements coupled with more-stringent underwriting demands will result in higher cap rates and lower long-term values.

— by Robert E. Dietrich, CCIM, MAI, managing director of FMV Opinions in Irvine, Calif., and head of the firm’s real estate division. Contact him at rdietrich@fmv.com.