Since August 2007, arranging financing for commercial real estate has become an increasingly challenging task.
Liquidity is becoming scarcer by the day, as bond investors are shying away from buying mortgage-backed securities and some of the world's leading financial institutions have been forced to write off over $200 billion and seek significant cash infusions to survive.
Furthermore, in the absence of demand, commercial mortgage-backed securities (CMBS) issuance plunged 90% in the first quarter of 2008, the lowest quarterly issuance since 1990. With CMBS spreads blowing out during this period, bondholders were forced to take big write-downs on their CMBS portfolios. These events led to additional increases in spreads to the point where making new originations was virtually impossible.
At the same time, banks and life insurance companies are simply unable to pick up the slack. After all, by pooling the mortgages, securitizing them and selling them to bond investors, Wall Street has created a lending machine with a theoretically infinite capacity.
On the other hand, commercial banks and life insurance companies are balance-sheet lenders: They hold their loans until they are paid off and therefore have a limited lending capacity. With an originations volume of $44 billion in 2006 (and $31 billion in the first three quarters of 2007), it is simply impossible for life insurance companies to pick up a material portion of the reduction in conduit originations.
To fill in the void, commercial banks (which account for 41.9% of the total commercial mortgage debt outstanding) and life insurance companies (9.1%) would essentially have to increase their originations volume by 50% – a nearly impossible task.
Fed to the rescue?
Fortunately, there are signs that the market might be coming back, encouraged by the Federal Reserve's unprecedented and highly intrusive measures to save the financial markets from potentially collapsing.
The Fed's initial and most natural response to the credit crunch was lowering its benchmark rate and thus reducing overnight borrowing costs for banks. The board has cut the Fed Funds Rate seven times since September 2007, from 5.25% to 2.00%.
Pushing the six-month LIBOR to a record low – from an average rate of 5.36% in September 2007 to 2.68% this past March – the Fed's move, together with similar action by the European Central Bank, helped reduce borrowing costs for homeowners and corporate entities around the world, significantly mitigating the risk of defaults. Even this drastic measure, however, proved insufficient.
Following Bear Stearns' warning that the fifth largest securities firm might have to file bankruptcy, the Fed – supported by the Treasury Department – rushed to save the firm by lending $29 billion dollar to JPMorgan to finance its $30 billion acquisition of Bear on March 14.
According to a New York Fed statement, this controversial action was meant ‘to bolster market liquidity and promote orderly market functioning.’
To further advance this cause, the Fed, which had previously only been lending to banks, opened its discount window to investment banks, allowing them to borrow against a broad array of AAA-rated securities.
Finally, the effect of these actions has been noticed in the marketplace recently, with the CMBS market seeing its biggest boost in months: A $1 billion CMBS offering by Lehman Brothers and UBS found solid demand. The benchmark AAA class priced at 190 basis points (bps) over swaps, 35 bps tighter than the previous $1.8 billion offering by Citigroup and Goldman Sachs the previous week, according to Commercial Mortgage Alert (CMA).
For the first time in months, each of the investment-grade classes was oversubscribed. Recently, a $1.2 billion offering by JP Morgan found relatively strong demand as its triple-A tranche priced at 167 bps over swaps, marking the third week in a raw in which CMBS spreads have rallied (CMA, May 2). While significantly wider than the 85 bps level at year end, this pricing is significantly tighter than the 300 bps level seen in March.
Lingering concerns
This healthy trend is encouraging and well overdue. Although CMBS default rates have been moving around 0.30% this year, their spreads had implied a default rate of approximately 8% prior to a subsequent tightening. This assumption is well above the historical default rate of 0.79% and the most bearish projections that defaults will hit 2% this year.
It was just a matter of time, however, until the greed would overcome the fear and bond buyers will cautiously return to the market.
Additionally, much of the increase in CMBS spreads in the first quarter resulted from hedge funds shorting the CMBX index, betting defaults will rise. Many of these short positions must be covered in the next few months, further increasing the demand for CMBS paper and creating a downward pressure on spreads.
At the same time, while the trend is certainly positive, there is still much uncertainty in the market and economy in general. Large financial institutions are still licking their wounds and are announcing additional layoffs. Consumption growth remains anemic, and the labor market is quite weak.
The impact of this situation is starting to show on commercial real estate. For example, according to a recent National Real Estate Investor article, the national vacancy rate for neighborhood and community shopping centers increased by 20 basis points in the first quarter to 7.7%, the highest level since 1996.
Mall vacancy increased 10 basis points in the first quarter to 5.9%, and retail absorption of space was negative for the first time since real estate research company Reis began tracking the sector in 1980.
Additionally, a large and unexpected rise of 17 bps in LIBOR over one recent week is threatening to hurt borrowers around the world by adding billions of dollars to their interest bills. Hence, while the commercial real estate credit market is starting to show signs of recovery, there are still many risk factors that could easily reverse this recent positive trend.
Survival strategy
Accustomed to obtaining financing in a borrowers' market, borrowers now must adapt to operating in a lenders' market. All across the board, lenders have tightened their underwriting standards and are now digging into the specifics of each deal more carefully. Leverage is generally down by 20%, and lenders apply extensive diligence on each and every deal.
Pricing, however, is still cheap by historical terms: For example, fixed-rate permanent financing transactions are generally being priced at 5.75% to 6.50% (five-year term) and 6.00% to 6.75% (10-year term).
This trend occurs because much of the increase in spreads is offset by the reduction in interest rate indexes. The 10-year Treasury yield was down by as much as 1% this year and was trading at historical lows around 3.3% to 3.5%, LIBOR has been trading at below 3%, and the prime rate is down 3.25% this year to 5.00%.
During a recent period, we witnessed this trend reverse slightly, with some interest rate indexes going up and spreads tightening.
Hence, surviving in the current capital markets requires a good dose of liquidity, optimism and pragmatism. With leverage decreasing to historically normal levels, a borrower's ability to invest more cash in a deal is critical to its success in obtaining financing.
Optimism can help to sustain a positive morale and keep things in perspective. Finally, pragmatism will allow borrowers to acknowledge the challenges created by the constantly changing marketplace and adjust their decision-making processes accordingly.
While some liquidity could possibly come back to the marketplace in the next three to nine months, it is unlikely underwriting standards will loosen up in the foreseeable future. Even in an improved liquidity environment, much uncertainty would likely remain in the credit market. Leverage will remain low, scrutiny will stay high, and pricing will still be attractive by historic measures.
Predicting how long it will take for the market to recover is a difficult task. After all, much of the answer is psychological, with market participants looking at each other and waiting to see who will dare, jump and succeed. It is likely we have reached the bottom, but only time will tell.
Omer Ben-Zur is assistant vice president at George Smith Partners, a Los Angeles-headquartered real estate investment banking firm, where he is responsible for placing debt and equity transactions involving all asset types. Ben-Zur can be contacted at (310) 557-8336, ext. 111 or oben-zur@gspartners.com.
