current recession, which began in December 2007[/b], is one of the longest and deepest in recent memory. The commercial real estate market reflected the resilience of the economy during the first phase of the recession, with vacancies rising at a relatively steady pace through the third quarter of 2008. The primary exception was the retail sector, which had already entered a serious downturn due to weakness in the consumer segment and some overbuilding. The dramatic intensification of job losses since fall 2008, however, has taken its toll on commercial properties, causing vacancies to spike across core property types. The commercial mortgage financing climate, which tightened dramatically in summer 2007, became even more challenging as the credit crunch escalated to a global financial crisis in fall 2008. Commercial property sales volumes, down by 40% to 60% through the first three quarters of 2008, have come to a near halt recently, dropping as much as 80% to 90% from their peak. Smaller transactions make up the lion's share of deals in today's environment, compared to the large portfolio sales that became increasingly prevalent in 2006 and early 2007. The collapse of the commercial mortgage-backed securities (CMBS) market, which accounted for nearly half of new commercial mortgages at the market's peak, along with a shortage of capital from commercial banks, life insurers and private equity markets, define the current financing environment. In addition, a significant price-expectation gap between buyers and sellers has contributed to the sharp decrease in commercial property sales. Deteriorating property fundamentals and constraints on debt capital are resulting in price corrections and rising cap rates. The trend gained momentum in the first quarter of this year, as more sellers came to terms with market realities. It should be noted that the degree of price correction is highly varied depending on property quality and local market strength. [i][b]Maturing loans[/b][/i] The risks facing commercial real estate are deepening. An estimated $218 billion of commercial mortgages will mature this year, and an additional $270 billion is expected to come due between 2010 and 2011. Delinquency rates have been near historical lows throughout the downturn; however, as a lagging indicator, they are now beginning to reflect the impact of the recession on commercial real estate. The CMBS delinquency rate as of the fourth quarter of 2008 was nearly twice the rate reported during the previous quarter and, at 1.2%was only 50 basis points below the peak reached during the last cyclical downturn in the early 2000s. Delinquencies among banks are averaging 1.6%, the highest level on record since 1996. Life insurance companies and Fannie Mae/Freddie Mac are faring best, as their focus remained on lower-leverage loans and safer, quality assets during the most recent boom. Moreover, with property values down and loan-to-value requirements at significantly lower levels than a few years ago, many owners will be unable to refinance without contributing substantial amounts of equity. As a result, delinquency rates should rise, reaching 3% to 4% by year's end. Because underwriting standards loosened dramatically from late 2005 to early 2007, loans originated during this time are at the greatest risk. Furthermore, some of the largest commercial property loans originated during this period were subject to the least stringent underwriting, leading to significant vulnerability and potential losses for banks and investors. We are currently in the midst of unprecedented levels of governmental spending and market intervention. Recent and new measures are focused on stabilizing the banking industry and real estate markets by improving credit flows and, ultimately, sparking an economic recovery. After the onset of the credit crunch in the second half of 2007, the Fed began to aggressively cut interest rates and pump liquidity into the system. In early 2008, the Economic Stimulus Act was passed, which included $100 billion in stimulus checks for U.S. households. Regardless of the dollar amount of government stimulus or the depth of tax cuts, function first needs to return to the credit markets for the economy to stabilize. Businesses are struggling, as many forms of credit remain tight, ranging from lines of credit to acquisition loans, and even inventory financing. U.S. households have seen home equity lines of credit pulled and credit card limits cut. Even some seemingly creditworthy households have struggled to qualify for residential mortgages, as lenders are requiring stronger credit scores and higher down payments. Government intervention to stabilize the banking sector and stimulate credit markets has been vast and far-reaching. In addition to reducing the federal funds rate to essentially zero, the Federal Reserve has expanded access to credit through its discount window and created multiple new credit facilities that allow for a broader range of collateral. Furthermore, the Fed opened the door for securities dealers to borrow directly from the central bank. Specific facilities also have been created to pump liquidity into various segments of the financial sector. The Fed established the Term Auction Facility (TAF) in December 2007, offering depository institutions an opportunity to obtain credit through a bidding process. Additional programs were rolled out, including programs targeted at AIG, money market funds and the commercial paper market, which came to a near standstill last fall. The Fed also approved currency swap agreements with several foreign central banks to help quell concerns regarding dollar liquidity in global markets. [i][b]Program impact[/b][/i] Additional support for credit markets came in late 2008, when the Fed announced plans to purchase $600 billion in debt backed by housing-related government-sponsored entities. As a result of government intervention, residential mortgage rates have slipped to the lowest level in decades. In addition to Federal Reserve support, the government has enacted significant programs focused on unlocking credit markets. The first was the Troubled Asset Relief Program (TARP), which was passed in October 2008 and was initially intended to purchase toxic assets from troubled financial institutions. The government instead used much of the initial $350-billion installment to recapitalize banks through preferred equity investments. While the exact impact of these investments is difficult to quantify, they clearly helped to firm up the balance sheets of numerous institutions and likely kept several banks afloat. The next $100 billion of TARP funds has been earmarked for the Term Asset-Backed Securities Loan Facility (TALF) program. Under TALF, the Federal Reserve receives credit protection of $100 billion from TARP by the Treasury Department. The Fed will use this allocation to make loans of up to $1 trillion to the holders of newly originated AAA-rated asset-backed securities (ABS), which include car loans, credit card debt and other consumer debt. The debt underlying the ABS includes recently issued consumer and small-business loans, student loans, residential mortgages and newly added commercial mortgages. Under this program, the Federal Reserve lends to investors at low interest rates to encourage purchases of these collateralizations. This program has been in place since November 2008, and there is evidence that it is working; spreads on highly rated ABS have narrowed significantly from peak levels. With ready buyers for this type of paper, banks ultimately should have incentive to make new loans and earn the associated fees. One of the major problems with the original TALF and modified TARP programs is that they did not assist banks in ridding balance sheets of toxic securities and loans that no longer have marketable value. Therefore, with these legacy assets still on the books, it has remained difficult for banks to engage in any meaningful level of lending. The government has subsequently circled back to the issue of these assets and recently began releasing details on the Public Private Investment Program (PPIP). The program is intended to entice private investors to purchase toxic assets with the help of co-investment from the Treasury Department and nonrecourse loans backed by the FDIC. If successful, PPIP should serve as a price discovery tool for these assets, which is critical to restarting transaction volume. While the government is in the process of finalizing plans to make PPIP operational, market sentiment has been positive so far. Additionally, TALF will be expanded with a Legacy Securities Program to help fund PPIP purchases of previously AAA-rated ABS, including non-agency RMBS and CMBS. [i][b]CRE conditions[/b][/i] Once functioning credit markets are restored, a greater number of property owners will be able to refinance maturing debt, which is critical to the long-term health of the market. As a result of declining property fundamentals, delinquency rates will continue to rise in the near term, but a stabilizing economy should slow the pace of increases. Investors are hopeful that the TALF program can help restart the securitization market, ultimately providing additional financing options for real estate investors. It will require more than just this first push to get the CMBS market running again, but investor confidence in the product must be restored. This will likely require greater regulation and more stringent risk-assessment guidelines, all of which will require time. Other regulatory changes designed to assist the credit markets have been enacted recently or may be in store. These changes include relaxing mark-to-market accounting rules, announced in early April. Mark-to-market standards forced institutions to value assets based on the current market, which is largely illiquid for much of the assets-clogging balance sheets. The modification should reduce bank writedowns almost immediately, increasing lending capacity and equity market stability. In addition, the proposed restoration of the uptick rule, which forces short sellers of stocks to wait for an uptick in price before selling the stock short, could also help stabilize equity markets. This shift could, in turn, make it easier for banks to raise new equity and help restore normal function to credit markets. Distressed-property sales will increase over the next 24 months. The handling of these assets, however, is shaping up to be different than the way the management was done in the early 1990s. During that period, loans were held on balance sheets of commercial banks and savings and loans. The government stepped in by taking over failed institutions and creating a clearinghouse in the form of the Resolution Trust Corp. (RTC) to dispose of assets. In this cycle, securitization of commercial mortgages has complicated the issues. At the end of 2008, 21%, or $789 billion, of outstanding commercial mortgages had been pooled and sold to investors as CMBS. Unwinding these loans is far more complex than it was during the RTC days. Many owners that were planning to ride out the downturn are likely to re-evaluate their strategies in the near term due to maturing debt, deteriorating net operating incomes or the need to raise capital to support other properties. This will result in more realistic pricing and significant acquisition opportunities, including some high-quality assets that come to market as real estate investment trusts and institutions focus on improving liquidity. Although risks to the economy and financial system still exist, today's commercial real estate investment opportunities should be viewed with a long-term perspective. The U.S. economy is expected to bottom in 2009, setting the stage for an economic recovery cycle to begin in 2010, with commercial real estate following the trend. Even with modest job growth compared to past economic recovery periods, property fundamentals will stabilize, bringing a substantial volume of capital off the sidelines. [i]William Hughes is senior vice president and managing director of Marcus & Millichap Capital Corp. He can be contacted at (949) 419-3200 or william.hughes@marcusmillichap.com
