MIAC Perspectives - Summer 2009
Commercial Real Estate – Markets in Turmoil
August, 2009.

Dean Hurley , SVP Capital Markets Group

     Many of our clients hold commercial real estate (“CRE”) related assets in the form of loans, commercial mortgage-backed securities (“CMBS”), servicing rights (“CMSRs”) and real estate owned (“REO”). MIAC sees this as a market that will be in decline over the next several years as cap rates rise, loan volumes remain low and loan assets run off or are written off. We survey the situation below, and indicate how MIAC may be able to assist our clients.

New Loan Originations

      What everyone knows is that lending volumes have been dramatically off primarily because of the complete halt in lending by the securitized shops starting in late 2007. Other CRE lending sources also have reduced their lending volumes. The data below comes from Commercial Mortgage Alert synopsizing a Mortgage Banker’s Association annual survey. It shows a 65% drop in volumes year-to-year, 2007 to 2008.

      Underwriting conditions are more stringent and costs are higher for those who do obtain loans. Typical first mortgage financing is now done at loan-to-value (“LTVs”) ratios of 55% to 65% and debt service coverage ratios (“DSCRs”) of 1.35x to 1.50x. Spreads of 425 to 600 basis points over Treasuries for fixed and 400 to 550 bps on floaters are now common, according to regular surveys by Cushman & Wakefield and CB Richard Ellis.   Pricing spreads on higher LTV debt can reach into 4-digits (1400 bps at 75 LTV and 2400 bps at 85 LTV). Floor rates over base rates are also back in favor. In contrast, during 2007, LTVs below 80% were the norm, and floors were definitely out.

Commercial Real Estate Fundamentals

      Vacancy rates are now near their past historical peaks according to the Torto Wheaton Research unit of CB Richard Ellis. These levels are expected to worsen over the next two years according to REIS. The following table aggregates the data.

      Delinquency and default levels have soared. Admittedly, the levels were very low ones to start with. But the consensus forecast is for increasing delinquency and defaults through 2011. Historical cumulative default rates on CMBS have been about 8%. Fitch is forecasting that this number could climb to 10% during 2009, driven by the latest origination vintages.

Source:   Fitch US CMBS Loan Defaults Study – May 2009.

Balloon Maturities:

      The biggest issue by far is balloon maturities. Deutsche Bank studies show that from 2009 through 2018 between 50% and 75% of existing deals could fail to qualify for a refinance at maturity based on LTV requirements of less than 70%.  Barclays Capital data shows that in June 2009, only 38% of maturing loans refinanced on time. The data so far show that many are able to refinance later. The January 2009 fail rate was 51%, rising to 77% refinancing fail rate by June.

      We agree with Deutsche Bank’s conclusion that maturity extensions will defer the problem. Eventual write downs on many of these assets are unavoidable even if the broader economy recovers starting in late 2009 because of changes in CRE loan underwriting fundamentals and because most special servicers will eventually be appraised out of their controlling class positions. But a postponement may be just what markets need this year, and CMBS special servicers have some latitude under most pooling and servicing agreements to modify and extend loans, particularly in the large fixed rate conduit and fusion deals.  We also believe that conservatively underwritten seasoned portfolios (lower LTVs and higher DSCRs more in line with the new paradigm) should perform better and hold their value better. Understanding where your portfolio stands is critical in today’s environment. MIAC can help you gauge your portfolio value so you can better understand your options in the current environment.

Positive Notes - Governmental Action and Re-Remics

      TALF is intended to buy “legacy” CMBS assets. It is also intended to finance new origination product at up to 85% loan-to-value for up to five years. We believe this program will acquire a significant portion of AAA rated CMBS legacy bonds, but that it will not restart the CMBS shops whose businesses ground to a halt because their business models were predicated on a complete clearing of their shelves with a realized gain on sale. The requirement for “skin in the game” will dictate that equity be retained on TALF financings. This is not a viable means of generating equity relief, and new loan originations would require new equity generation.  The large holders will move what they can to the TALF shelf as the financing terms are favorable, but will not re-enter the traditional business if this, or held to maturity, are the only exits.

      CMBS bond spreads took a drop (super senior AAAs moved to 715 from 815 bps over swaps) when news of the re-remics being done at Bank of America (priced 6/18) and Morgan Stanley (priced 6/24) was announced. Re-remics promise to provide capital relief for the institutions involved at higher financing spreads if they can “move” a portion of the deal. The super-senior AAA bonds are geared to provide protection to investors from ratings downgrades and losses (all of these deals have increased subordination levels to 50% from the 30% on the original deals to better market the bonds to institutional investors), and yields of 15% to 20% on the subordinate tranches (which are targeted at hedge fund buyers). All-in spreads on the Bank of America deal were calculated at about 675 basis points over swaps. Since then, Citicorp has priced a deal (6/30) as has Barclays (7/1). Right now, JP Morgan and Credit Suisse each have a re-remic in the market.

Outlook

      A look at AAA (super senior ten year) and BBB CMBS spreads as tracked by major players such as Morgan Stanley and as reported by Commercial Real Estate Direct are in the 725 and 8200 basis point range. CMBX spreads are similarly high. These spreads imply that future losses on the underlying bonds will be so high that the purchase price must be recouped in two years or less on the bottom investment-grade bonds. The fact that spreads have not declined significantly implies that no real exit exists for these “legacy” bonds other than holding them, and that losses will wipe out significant portions of the lower grade bonds.

      If stricter underwriting guidelines on new product do not result in much tighter spreads, and if TALF or some other program doesn’t provide a real exit, then the old business model is dead for the foreseeable future.  If CMBS spreads come in significantly for new conservatively underwritten product, then perhaps new CMBS can be executed for very sound loan originations at wider spreads when the current cycle ends and commercial real estate fundamentals return to more normal performance levels.  All this continues to bode ill for most secondary market loan sale pricing, which is worse than new loan spreads otherwise imply due to expected losses.

      We see the strong possibility that private equity will become active in the lending void that remains.  Pockets of capital are being formed to invest in new loans.  Private equity probably would not replace the amount of CMBS and life company money which has exited the commercial real estate mortgage space, but it could provide liquidity for a price in the current environment, and allow the generation of positive returns for viable properties with solid sponsorship.

      MIAC can help you price your CMBS, CRE loan or MSR products on a FAS 157 Level 3 basis. We understand how to forecast CRE collateral behavior in this market, our software models describe the component cash flows, and we know the secondary markets for loans, MSRs, and bonds.  Knowing the markets, what to expect, and how you stack up allows you to formulate plans to stay ahead.

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