How did we get here? A total breakdown of the securitization market as we knew it rocked the world financial system to its core. Currently, there is a terrible breakdown of trust between counter-parties that has been caused by the combination of money chasing yield and the approximate tenfold increase in debt issuance over a very short time frame.
The rating agencies could not possibly staff up quickly enough with qualified personnel to handle the enormous volume thrown at them. This short-staffing led to their less-than-effective work product of the past – which the bond-buying community had come to trust.
However, the capital markets crisis is, of course, not entirely the rating agencies' fault. Some blame needs to rest with the B-piece-buying community members who continued to lower their yield requirements to win business from the investment banks.
Their doing so resulted in allowing the investment banks to fund more and more aggressively with the thought of offloading the paper in the very aggressive secondary market. Hence, the blame falls on all of the participants' shoulders.
Our system of rating debt instruments has to run on a basis of complete and total trust. Otherwise, the markets as we know them come to a grinding halt. Bond-buyers need to trust the rating agencies, which, in turn, need to trust the Wall Street issuers.
This implication is not intended to suggest you forgo the buyer-beware concept, as it is incumbent on any buyer to review the collateral. But trust in its contents must be a given.
Where trust breaks down is in the less factual aspect of the process and more in the selling part. The Wall Street firms seem to have used the power of persuasion in the subjective areas of the valuation process so as to convince rating agencies and B-piece buyers to gain these high values for the collateral in question.
Therefore, the trust did not break down due to malicious intent, but rather, more in the estimation and guessing portions of the process – e.g., one building deserves a better cap rate than another, or there are extenuating circumstances as to why this price is so low, the rent is way below market, etc.
Wall Street players, of course, instinctively fight to accentuate the positives in their deals to help them win business. As a result, it is up to the B-piece buyers and the rating agencies to keep these participants in check.
Steep interest rates
Bankers have the job of creating value for their firm, and some do so more aggressively than others. A few years ago, when I was leading a panel at a finance conference, one major Wall Street player in the audience said something to the effect of ‘Why should I care about the high loan to value as long as I can sell the paper?’
This particular comment is indicative of the attitude that helped us arrive at this market dislocation. His comment and business approach was not with malice or ill-intended. In fact, Wall Street's commercial mortgage-backed securities (CMBS) model depended on this approach.
Too many risks were taken on, however, and although assumptions were well-intentioned, they were faulty. These assumptions ultimately put us in this liquidity crisis.
What is the crisis' effect on commercial real estate values? Clearly, the lack of liquidity has caused our investment sales market to reevaluate itself, as the level of debt one can achieve is far less than it was at the beginning of 2007.
Many owners that purchased a trophy office building at a flat 6% cap rate and borrowed with an aggressive 80% loan coming due within the next 24 months will likely have to face the music upon loan maturity.
These owners will need to pay down that position by as much as 25% with equity or mezzanine financing. This new money requires an excessive interest rate north of 15%. As you can imagine, replacing 5% money with 15% money or worse dramatically erodes the overall value of that asset. This example is the obvious short-term effect on values during this liquidity crisis.
However, many successful real estate operators still seem to think that this liquidity crisis will not negatively impact operations at the property level as they tend to think it's a credit issue, not a practical operating issue.
They take comfort in the idea that their tenants will continue to pay the rent, whether or not there is credit in the market and regardless of changes in the cap-rate environment.
But because this credit crunch has affected all business lines worldwide, it will accordingly eventually impact owners at the property performance level. We see many operators who are completely unaware of how bad the credit crisis is on the general economy.
They seem to be only aware of the direct issues facing them, like a loan in their portfolio that is coming due in the near term and the very little liquidity in the market available to fund it. The general economy is potentially an even bigger threat to operations then debt replacement.
Contraction
For example, the owner of a building that has a $500 million apparel company as a tenant, as well as any other capital-intensive business that is heavily dependent on a $300 million line of credit maturing in 2008, could feel pain this year as well.
If the lease is near expiration, the current state of capital markets will no doubt affect lease decisions. One bet is for sure: The ability to continually access credit lines to sustain and/or grow business has been severely affected.
The owner is consequently likely having very difficult conversations with its lenders, because the cost of the lines are going up and loan amounts are going down. This is the essence of the de-levering process that we are experiencing throughout the world economy.
The effect on property operations – and lenders – is not immediate, but the process takes some time to work its way into the system. Ultimately, tenants will probably give back space instead of expanding.
The CEO of Linens 'n Things was recently quoted as saying something to the effect of ‘our capital structure was not designed to withstand this pummeling of the capital markets.’ Clearly, this is a systemic problem that is just now starting to affect properties at the operational level.
On the bright side, there are a few exceptions to the trend. Generally, the neighborhood grocer- or drug store-anchored center in stable markets should do okay. At the very high end, in the playgrounds of the ultra-wealthy, the cheap U.S. dollar is keeping property values strong with the foreign influence.
The overall de-levering process is likely to continue throughout the rest of 2008. We will probably see a reprieve in the first quarter of 2009, as portfolio lenders are given their new annual alottments of capital for the year.
Beware, however, that there will consequently be huge demand for that capital, which will likely run out early in 2009. Hence, late 2009 will likely be dry again.
In the early part of 2010, the CMBS and portfolio lenders may start to loosen the strings, but they will operate under a new set of rules. In order to earn the trust of the bond-buying community, CMBS issuers will need to have skin in the game and hold the first-loss positions of the loans they originate.
For the most part, these are all foreign concepts to Wall Street that are likely to be borne elsewhere and then copied by Wall Street thereafter. In any case, we will be dancing in the streets again in the middle of 2010.
Cliff Mendelson is senior managing director of the structured-finance group at Transwestern, which specializes in mezzanine lending, equity and other commercial real estate financing techniques, as well as first-mortgage originations. Mendelson can be contacted at (301) 896-9185 or cliff.mendelson@transwestern.net.
