It is possible (subscription required). I am not happy about this but the tone of this piece will be more analytical than editorial.
Not to jump the gun here, but I think this is a situation that can possibly rear its head this year for two reasons. First, rising default rates on commercial mortgage-backed securities due to adverse conditions in the current market as well as very aggressive underwriting standards that were commonplace between 2004 and 2007. The second and more significant reason is that outstanding mortgage debt in commercial real estate is somewhere in the $3.4-$3.5 trillion range. It's not unreasonable to suggest that we can see anywhere between $250-$350 billion of loans come due in any given year. What will make matters worse in this current environment is refinancing any short-term debt that was originated in the past five years, especially as we move into 2010, 2011, and 2012, as 2005-2007, as I mentioned before, were years where loan underwriting was extremely aggressive.
There is plenty to be concerned about in today's real estate capital markets:
1. Property values have decreased substantially off their peaks in 2006-early 2007. Initially, the decreases were capital markets driven, as the debt markets weakened and the weighted average cost of capital rose as a result of a higher percentage of equity. As the conditions in the economy have deteriorated, real estate fundamentals (rents, occupancy rates, etc.) have started to worsen, and investors have become bearish in their expectations. Furthermore, volatility in a declining market where transaction volume is thin poses challenges to make reasonable estimates of value, posing difficulty for investors and lenders alike.
2. Wall Street lending via the originate-to-securitize model for commercial mortgage-backed securities is severely dislocated. Between 2005 and 2007, securitized lenders were responsible for approximately 40% of all commercial real estate originations. Loan originations from CMBS lenders were down 95% from 2007 levels (from $230 billion to $13 billion). I expect origination volume to be less than what it was in 2008. Between investors taking massive losses in these types of investments, absolutely zero comfort in the collateral and credit risk underlying many of these securities and a complete erosion of trust between originators and investors, investors believe that the risk is so high that the returns they demand make originating new loans extremely difficult.
3. This leaves, for better and for worse, commercial banks and life insurance companies as the only lenders in town that have any substantial capital to lend. I say for better because as these two sources are primarily balance sheet lenders and hold the loans on the balance sheet, borrowers facing refinancing risk in a difficult market can negotiate loan extensions, preventing, for the near term, the possibility of default. I say for worse because commercial banks and insurance companies, being both balance sheet lenders and risk averse, prefer neat, easy "middle of the fairway" transactions that exemplify the old institutional mindset of being very choosy about the types of properties they will lend on, conservative loan-to-value ratios, substantial borrower equity and credit and, at times, recourse.
The situation is not good. With all of these things in mind, take into consideration the following options:
- A borrower that financed through a CMBS lender is faced with the possiblity that there will be no lender at all, forcing an equity payment to pay the loan in full or an outright sale (although the sale option is a difficult proposition as I will explain in a bit). For properties in secondary or tertiary markets or properties that fall outside of the general categories of office, retail, industrial or multifamily, borrowers may face the risk of there being no capital at all.
- Owners who can refinance will be unable to obtain refinancing proceeds sufficient to pay down the existing loan, requiring substantial equity contributions. Owners may have face further stress on their balance sheets if lenders require recourse and they are forced to post collateral. This will (and has) put property owners and operators with highly leveraged balance sheets in considerable trouble.
- A borrower can avoid default and/or foreclosure via an outright sale of the property; however, the sales environment is as equally difficult. First, if a borrower can not refinance a property, there is a reasonable chance that a new investor may not as well. More potential deals than I can count have blown up due to potential buyers being unable to secure financing. Second, cash buyers are few and far between and given the dislocation in the debt markets, yields on debt exceed yields on existing real estate assets. As the question goes, why buy the existing asset when you can buy the underlying loan on the existing asset at a deep discount, take the property back in foreclosure, reposition the asset and sell it when the market improves? Whether or not this is a viable strategy is irrelevant to the issue that many equity investors are looking elsewhere. There will be a market for higher-quality assets that equity investors will pursue so I do not mean to make this sound like no one is looking for good real estate these days (they are); however, the markets are so dislocated that anything that isn't a "must-have" deal or is being sold by a very motivated seller will not get done.
The capital markets driving commercial real estate are in a state of severe dislocation. Property owners know this and, rightly, are worried. Refinancing risk, which two years ago seemed like nothing more than a bulletpoint in a Powerpoint presentation, is now a major concern over the next few years. The debt markets are severely supply-constrained and there is a lot of loans coming due that I think will not be refinanced in this current market. At this moment, there are no private sector sources of capital that will step in to fill the gap at interest rates or loan proceeds levels that will make sense to me.
Property owners here are acting as an interest group. They know these markets well. They know that the sale of assets in this market signals that sellers are in trouble. Buyers have no incentive to stretch their valuations to win deals (on the contrary, most investors get nervous if they win a deal). The situation for them is not good and they are attempting to use their political clout to do nothing more than protect the value of the portfolios and to ward off a fire sale.
Maybe it requires the use of TARP funds. Maybe it requires the Fed setting up a lending facility where it becomes the lender of last (more like first) resort for property owners. Maybe certain rules governing the mortgage-backed securities business will be rewritten to allow for loan workouts for defaulting loans in CMBS pools (which I think do not exist today). Unfortuneately, I do not have those kinds of details, but consider the possibility that we could hear about them soon.
Just saying...
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