Sound property fundamentals and extremely low – but upward-creeping – loan delinquency figures have served as the popular pillars of strength that commercial real estate finance executives continue to identify as good reasons to calm down, stay strong and refuse to believe the rumors of major distress.
Signs are emerging, however, that these reassurances may no longer be as readily defensible as they once were. The troubles in the credit markets, the U.S. economy and the residential mortgage market appear to have finally begun to noticeably threaten numerous commercial property types – as well as loan performance – and spark increasingly ominous data-backed predictions.
Of course, by no means will the damage be universal. Based on existing numbers and trends, can we pinpoint the exact trouble spots for both right now and the months – or years – to come? And more importantly for the industry at large, what might the various infamous economic downturns in recent decades teach us about the likely outcome of the current market?
The creators of at least one recent venture are betting that the incidence of commercial mortgage distress will soon be significant enough to warrant exclusive focus.
WLJ Partners, based in Coral Gables, Fla., announced in August that its fund is now fully supplied with $200 million of debt and equity. These funds will be used to acquire whole loans – typically with an outstanding principal balance between $2 million and $10 million – on what the company calls a ‘re-emerging secondary market for nonperforming commercial real estate debt.’
According to the fund's creators, its official launch accompanies the first widespread displays of trouble in the commercial mortgage space, as banks and other holders have begun liquidating nonperforming mortgages in their collections.
The indicators of future distress and conversations about forming such a venture, however, began long ago. ‘We've been seeing the writing on the wall for a while – since the credit collapse last summer,’ Paul Jones, a principal at WLJ Partners, tells CMI.
Jones, who is also founder and president of Pyramid Realty Group Inc., says that he and the other WLJ principals – Eileen Lyons, most recently a senior director at Hypo Real Estate Capital, and Rick Williamson, most recently a key executive at FBOP Corp. – first began hearing murmurs from colleagues about the idea over a year ago. The alarmingly active local development climate quickly increased industry interest.
‘In Miami, we're a little bit jaded because we have so much of an oversupply in the condo market,’ Jones admits.
But as market players nationwide have seen, supply issues are far from unique to the Miami area – or the condo market. He identifies retail, multifamily and office as the three specific commercial real estate sectors most vulnerable to the effects of the economy's downslide – and thus the focus areas of the fund.
Mounting difficulties
Jones calls retail the second tranche of major interest for WLJ Partners – behind multifamily, but ahead of office. Gas prices, commodity prices and unemployment represent the most dominant damaging forces for this sector, which he expects will feel the worst of the impact during its traditionally most profitable season.
‘I think we're going to see a very weak Christmas,’ Jones predicts. Subsequently, ‘All of the inline retailers will take their money from Christmas – which is usually around 70 percent of their gross for the year – and close up shop.
‘Once they do that, then by February, you're going to end up with a lot of community shopping centers and strip centers with vacancy issues,’ he continues, noting that small inline stores tend to carry a disproportionate amount of economic weight on these properties because anchors typically receive steeply discounted rents.
Compounding retail's woes is its close association with the single-family residential market – particularly the latter's stalled construction and clusters of unsold or vacated homes. A great deal of retail construction took place in anticipation of new rooftops that have failed to materialize, while entire deserted communities have emerged elsewhere and left shopping centers with only their anchor tenants – at most.
‘Most of the loans that were obtained for these projects are not designed to be paying debt service solely on the income of the anchor tenants,’ notes Jones.
In addition, luxury retailers – initially believed to be insulated from the issues gripping the rest of the sector – have begun feeling residential's pain through a different mechanism: According to Jones, because many upper-class consumers previously turned to second mortgages and home equity lines of credit to finance large purchases, the quick shutoff of the home-equity faucet has made such buys off-limits now.
Possible boosts from the single-family residential market's collapse notwithstanding, the multifamily market is currently in a position to generate nonperforming and subperforming loans as well.
Shadow supply – condominiums, single-family homes and townhomes rented by individuals – continues to rank as a top concern. Between the shadow market and the looming construction-fueled oversupply in many markets, what Jones calls the primary multifamily properties – traditional managed apartment communities – will begin struggling, he predicts.
The office sector's malaise is expected to appear in the form of pockets of distress that are likely to be closely linked to the beleaguered financial services industry. Jones says that New York; Charlotte, N.C.; and Newport Beach, Calif., are especially prone to office vacancy issues because of their high concentrations of Wall Street firms, major banks and subprime lenders, respectively.
Other areas of focus for potential office loan distress include foreclosure hot spots such as San Diego and Phoenix, as well as Dallas and Atlanta, ‘where there's unbridled building all the time,’ Jones remarks. ‘The more solid markets are the ones that are supply-constrained.’
Déjà vu?
During the 1974-1975 economic downturn, controversy and concern over fuel prices, high unemployment and a federal government saddled with debt due to an unpopular war dominated the U.S. scene, says Jones, noting that these conditions sound quite familiar today.
Similarly, following the 1981-1983 downturn, strong incentives for real estate building and high interest rates eventually sent residential real estate into a spiral that then affected the rest of the economy. A recession rooted in residential's tribulations is, of course, nothing new, either.
But despite some compelling parallels, the economic downturns of years past may not be entirely suitable models for predicting the direction of today's market.
Although negative economic indicators continue to appear and the effects from the residential mortgage crisis have yet to fade, the damage to commercial real estate is unlikely to be as severe as it is often portrayed, according to a recent report by Raymond G. Torto, PhD, global chief economist at CB Richard Ellis.
Job growth is strongly tied to demand for commercial real estate, Torto stresses in the article, which is titled ‘2008 Correction Unlikely to Match Depths of 1990 or 2001 Downturns.’
In an encouraging finding, the company found that current and projected job losses pale in comparison to those experienced in the early 1990s, when the U.S. experienced a financial-driven downturn. Even so, the data reveal six months of job losses (as of August) and projections for an additional three to six months of a similar pattern.
‘The U.S. economy is adjusting from an unsustainable over-allocation of resources into housing and mortgage production, and from auto and airline industry restructuring due to long-term implications of oil prices,’ Torto notes. ‘In light of this, it is surprising that the job losses to date have not been greater.’
Within the commercial real estate market itself, echoes of the early '90s are likely even more faint. During the 1989-1991 period, commercial real estate was overbuilt nationwide, Jones recalls.
‘You basically had a decade – especially the last three years – of capital-driven supply addition,’ he explains. ‘You had a lot of savings and loans that were self-dealing.’ These firms sent projects to subsidiaries and, seemingly protected by interest reserves, built projects that wound up with no tenants.
He does not foresee a similar situation in the near future and notes that those industry-wide proclamations of sound fundamentals remain more or less true – for right now. But he points out that at a major industry event in 2007, the lead speaker warned that construction is widely considered the notorious slow bullet in the industry.
‘Until you really know what the pipeline is for construction, you can't tell where your supply is going,’ Jones warns. In Miami, for example, the 4 million feet of office space currently under construction, coupled with recessionary conditions, is expected to deal a severe blow to the sector in 2010.
With the excess supply and tenant choice firmly in play, he believes that Class B buildings will face the most severe repercussions, and many loans on those properties may soon find themselves in trouble. Furthermore, with the rate of subleasing recently doubled, signs point to tenants that require much less space than they previously occupied.
The return of capital
According to Torto's report, the overall present and future for property fundamentals are slightly more encouraging than in Jones' assessment. Net operating income growth, increased cashflow as tenants roll from leases and some rental growth will likely ensure that most properties will not experience distress to the point of mortgage difficulty.
Even so, what he calls a shallow weakening – extending through 2009 – will claim a few victims along the way. ‘Properties that are on the cusp of trouble are those with marginal tenants or no tenants at all because of competitive disadvantages or speculative development risk,’ he says.
Given the present condition of the debt markets, another area of anticipated opportunity for distressed-debt players involves mortgages that may not be at all distressed in the conventional sense. Isolated situations where the property is performing exactly as expected – but the owner cannot refinance simply because of little to no availability of credit – will likely develop as short-term financings become due, says Jones.
These cases may even represent an ideal opportunity, he adds, but he finds that for right now, they remain relatively rare.
‘Generally, what I've seen in those situations is that the lenders are just doing extensions – one- or two-year Band-Aids,’ he remarks. As a result, ‘Those opportunities may come up again if the cycle doesn't improve with a couple of years.’
The likelihood of an ultimately successful refinance may depend on the level of the initial loan-to-value. Many loans signed in the past three years were written on cap rates that are no longer achievable, he notes – thus adding a value issue on top of an existing credit issue.
Similarly, Torto's research revealed that the potent combination of higher spreads and tighter underwriting has hampered property acquisitions in recent months. These delays have only been amplified by a pricing disconnect – as many sellers have held firm on pricing, while buyers have hesitated to significantly raise their bids.
‘Bridging the divide in expectations – and forging a 'meeting of the minds' on valuation – will be essential to returning the investment market to more normalized activity levels,’ he says in the report. ‘One thing is certain: There is plenty of capital looking to buy real estate at the 'right' price.’
Jones also cites the accumulation of capital on the sidelines as a promising indicator of recovery – and yet another noteworthy contrast to the bleak conditions of 1989-1991.
‘I would imagine we'll be through the depths of it within a couple of years,’ he states. ‘We may recover faster because we've got better mechanisms and more liquidity in the world than we've ever had, which could spark recovery faster than is traditional.’
