Consider a 27-story, Class A office building in midtown Manhattan and a three-bedroom single-family home in Las Vegas. Is this collateral the same? Unfortunately, today's market seems to think so.
There are, of course, vast differences between these properties and how they are underwritten, yet one of the central lessons of 2007 is that markets as seemingly disparate as commercial real estate and subprime single-family homes are becoming more entwined than previously recognized.
The similarities between commercial real estate and subprime single-family homes – which include a shared global capital markets investor base and vulnerability to the economy – have and will continue to create challenges for developers and owners of commercial real estate. Indeed, parallels between commercial real estate and residential housing will become even more apparent as the economy slows.
Similarities between subprime residential and commercial real estate may be driving today's market, but it is nonetheless valuable to recognize distinctions between them. These major distinctions include delinquency rates, underwriting practices and borrowers' sophistication and depth of resources.
Sky-high delinquency rates in residential subprime properties and historically low rates in commercial mortgage-backed securities (CMBS) – 17.31% for subprime loans and 0.40% for CMBS as of the fourth quarter of 2007, according to Mortgage Bankers Association data – reveal a significant difference in each market's fundamentals.
Such widely divergent rates also reveal the contrast in the rigor of the underwriting approaches used for residential and commercial loans.
Underwriting for residential mortgages – whether prime or subprime – focuses largely on the borrower's creditworthiness. A residential underwriter considers a home's location and the area's economy and demographic trends, but the prospective owner's credit history, employment, income and overall financial strength are critical in determining whether the borrower can obtain a mortgage.
Unfortunately, it appears underwriting for many subprime residential loans ignored these essential factors. In retrospect, it is painfully clear that underwriting for residential subprime loans was far too aggressive. One egregious example is a so-called NINJA loan, which stands for "no income, no job, no assets."
While these likely accounted for a fairly small portion of total subprime mortgages, lenient underwriting unquestionably led to granting mortgages to many borrowers of questionable financial stability.
In addition, most subprime residential mortgages were offered at very low teaser rates that reset two years later.
Even if a borrower had adequate income to service the mortgage at its initial interest rate, only the most optimistic underwriting assumptions would give that borrower enough income to cover the mortgage payment at a much higher rate just two years later. How could this have been a good idea?
Property considerations
Underwriting for commercial properties is more thorough in every way, which largely accounts for today's low delinquency rates. Underwriters conduct a corporate-level analysis on each property that includes evaluating its cashflow and net operating income.
The commercial real estate underwriting process also considers the property's ability to service the mortgage based on the financial strength of the tenants, upcoming rollovers, how cashflow might be affected if the property lost a major tenant, and its ability to attract new tenants in light of competition from nearby properties and similar metrics.
It is true that underwriting for commercial loans became more aggressive in late 2006 and early 2007, although it never approached the laxity of subprime residential underwriting.
Continuing such practices might have created problems for commercial real estate long-term. However, 2007's upheaval quickly brought commercial real estate underwriting back to basics.
Borrower sophistication and ability to adjust to changing conditions is another distinction between residential subprime and commercial real estate markets.
Countless articles have detailed subprime borrowers' assertions that they did not understand their mortgage documents or the potential risks associated with their loans. Many borrowers even said they were unaware they had obtained adjustable loans whose interest rates would rise in two years.
Clearly, it would have been prudent for subprime borrowers to read and insist on understanding the documents before signing them.
In contrast, there are few surprises among commercial mortgage borrowers. Commercial real estate borrowers tend to be experienced, knowledgeable professionals who understand the financing process, documents and their mortgages. Most are also assisted by mortgage bankers and attorneys who help negotiate financing and provide counsel.
Disturbing similarities
As legitimate as are the differences between commercial real estate and residential subprime markets, they fail to paint a complete picture of today's market.
The turmoil that began in 2007 and continues today demonstrates that the characteristics shared by commercial real estate and subprime markets – that is, capital markets investors and vulnerability to the economy – are presently more influential than their differences.
In fact, one of 2007's many unpleasant surprises was the extent to which the very same pool of investors was buying bonds based on commercial mortgages and bonds based on residential subprime mortgages.
When the value of bonds collateralized by subprime mortgages plummeted in 2007, many investors – especially leveraged investors such as those involved with collateralized debt obligations (CDOs) and special investment vehicles (SIVs) – suffered disastrous losses that forced them out of the market.
This departure had an immediate effect on CMBS. Commercial real estate's fundamentals remained sound, but the departure of so many investors eliminated buyers for certain tranches of CMBS bonds.
The conditions also made remaining investors extremely skittish, spurring substantially wider yields for CMBS bonds and unprecedented volatility that continues today.
Commercial real estate and residential real estate markets also share another fundamental characteristic: their viability and vitality depend on the economy. Although many people correctly believe the residential subprime meltdown triggered much of today's economic weakness, commercial real estate, single-family housing and every other sector are feeling the effects.
At the risk of oversimplification, we might say that the subprime crisis and ensuing credit crunch are driving down home values, which depresses the consumer spending that has been keeping the economy afloat.
Next, when consumers cut spending, demand for manufactured goods and warehousing falls, which translates into shrinking demand for facilities such as industrial warehouses and retail space.
Decreased consumer spending also means reduced demand for services and the space to office them. These conditions may increase layoffs, which will further depress consumer spending and reduce the operating income of commercial real estate.
Today's reality
Developers and owners of commercial real estate, as well as lenders, are today vividly experiencing the impact of similarities between commercial real estate and subprime residential markets.
First, a significantly smaller investor base means there is less appetite for CMBS bonds. Thus, many capital markets lenders are standing on the sidelines or have closed their doors. Fewer sources of commercial real estate financing also mean there is significantly less capital available to fund acquisitions, refinancing or growth.
Traditional lenders such as life insurance companies and community banks are filling some of the gap. However, their commercial real estate allocations are limited and will soon be filled. High interest-rate debt is available, albeit unattractive to most borrowers.
In addition, tighter liquidity is contributing to the slowdown of acquisitions, as is the ongoing disconnect between buyers and sellers. Sellers continue to demand prices that are unrealistic given the lack of liquidity, and higher financing costs make it impossible for buyers to purchase properties at these levels.
The reduced pool of lenders and capital also creates risks for the $44.2 billion of securitized mortgages scheduled to refinance this year.
A year ago, CMBS lenders would have aggressively competed for many of those refinancing opportunities. Today's property owners find no such wealth of choices. Instead, as a property's refinancing deadline approaches, lenders are examining its economic stability and a possible loan extension.
Owners of properties with high-leverage loans, potential tenant losses, weak sales or reduced net operating income may find it impossible to refinance. Some of these properties will go into default.
With capital for acquisition, refinancing and growth relatively scarce, property owners' strategies have changed. Owners are shifting their focus from expansion to management: monitoring tenant credit quality, anticipating rollovers and locking in new leases early in hopes of maintaining cashflow rather than building it through acquisitions.
Today, owners who hope to increase property values can no longer count on an aggressive cap rate movement. Rather, building value requires growing a property's net operating income, which is a difficult task in a slow economy or a recession.
Institutional investors
Although investors such as CDOs and SIVs have left the capital markets indefinitely, institutional and opportunistic investors are likely to replace them.
Commercial real estate capital markets offer investors a number of appealing opportunities, including the ability to deploy assets and extremely attractive spreads. In fact, CMBS securities are an excellent buy.
The growing presence of institutional investors may bring capital markets lenders back into the market, increasing liquidity and stability – but only if spreads begin to steady. Today, they remain volatile.
Even after lenders return to the market, underwriting standards are expected to remain conservative. In addition, commercial real estate property values are still relatively strong from a long-term perspective. Although various projections indicate declines of as much as 15% to 20%, commercial real estate prices are still up by 30% to 50% since 2000.
As it turns out, the distinctions between a Class A office tower in Manhattan and a single-family home in Las Vegas are plentiful and significant – and reveal fundamental differences in the strength of commercial real estate and residential markets.
But unfortunately, those differences may also be largely irrelevant in today's market because investor appetite and the economy are driving commercial real estate and single-family housing markets.
Dan Smith is managing director of RBC Capital Markets' Real Estate Mortgage Capital, which provides fixed- and floating-rate loans from $500,000 to over $100 million on all types of commercial properties. Smith can be reached at daniel.smith@rbccm.com.
