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Dean Hurley , SVP
Capital Markets Group
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In Spite of Recovery Talk, We Aren’t Done With the Problems
Wednesday, July 07th, 2010.
While many commentators are saying that the commercial real estate markets will recover in 2011, according to the Korpacz survey, “Rental rates will continue to decline until strong, consistent job growth resumes. With $1.4 trillion of commercial real estate debt maturing by the end of 2012, some property owners will not be able to survive the downturn. Problems related to refinancing that debt could further delay a recovery in the sector.”
The chart below shows the prognosis according to major CRE property entity Jones Lang LaSalle.
MIAC believes that this forecast is more realistic than those anticipating a CRE recovery to begin earlier in 2011. MIAC sees a drawn out recovery where many segments of the market take much longer to show signs of improvement. Hotel and retail in good locations should improve with employment, while office and industrial should lag in the usual pattern. This is partly because of the nature of CRE and partly because of the nature of this recovery. The depth of this recession coupled with current regulatory and taxation uncertainties bode ill for a faster recovery timeline in our opinion.
The chart below from Jones Lang LaSalle shows the difference between debt outstanding at maturity and the level of debt sustainable based on normalized LTVs of about 68%. This highlights the fact that large amounts of maturing loans will not qualify for refinancing. Recent statistics have shown a drop in the percentage of loans successfully refinancing at maturity to 20.5% by balance last month according to Cushman and Wakefield. The lowest figure we recall was 18.7% in November, 2009. Three to six months after maturity, the refinanced or paid off percentages climb to 33% and 56% respectively.
CRE Lending
In spite of repeated announcements that conduit vehicles are returning to the CRE lending markets, we feel that there is little activity to be looked for there. The truth is that the very best deals are being financed by the life insurance companies, while small borrowers with established bank contacts are holding on to these funds sources for dear life. There currently isn’t enough funding from these lenders to meet expected demand.
An article written by Brian Halpern of CBRE Capital Markets, “Debt – The Haves or Have-Nots” states it quite clearly:
“Asset and sponsorship strength along with market concerns continues to trump the renewed lender demand to place mortgages. At this stage in the recovery, you either have what the lenders want or you’ll have to keep on looking . . . The ‘haves’ of available debt consist of those seeking acquisition finance for institutional quality assets with limited lease-up or rollover exposure. Deals fitting into that box can expect up to 70% leverage . . . The ‘have-nots’ consist of properties suffering from vacancy challenges, above market rents, and rollover exposure, among other problems. To date, the life companies have been unwilling to work outside their comfort box to meet their industry’s increased demand to place capital.”
So, who is holding the CRE debt, and who is extending the new debt? According to FRB data on the $3.4 trillion of CRE debt, this is the distribution:
We see a “funding gap” over the next two and a half years. Recent studies have suggested that traditional sources of CRE finance only offer about $200 billion of funds annually for CRE lending (based upon a recent three year average of loan originations by this group). However, just to refinance CRE maturing debt a total of $500 billion will be needed over the rest of 2010, 2011 & 2012. This “funding gap” doesn't take into account funding for defaulted CRE loans (by way of financing purchases of notes and REO from lenders and servicers).
Who will fill this gap?
- The touted “CMBS 2.0” will not fill this funding gap any time soon. True, banks and life companies are forming CMBS 2.0 programs. However, at the CMSA January conference, in an informal poll of investors cited by Keith Mullen of the Winstead law firm, 58% of the investors believed that “CMBS 1.0” style multi-borrower, fixed rate pools will return no sooner than 2012 (or even later); and 69% of the investors believed that new, annual CMBS issuances would not exceed $100 billion until 2013. This partially explains why the new “CMBS 2.0” programs will be underwriting loans as if they were going to hold them on their books – and not sell them in a securitization. While, more recently, the just completed (Jume 11th) sale of the bonds on the J.P. Morgan Chase Commercial Mortgage Securities Trust 2010-C1 CMBS transaction is a very positive sign, and we note the re-constitution of CMBS asset groups at Wells and several other financial institutions per June 17 Reuters article, we continue to believe that it will be a long time before we see CMBS anywhere near what it once was.
- Bank CRE lending will not fill the gap. Bank credit allocations for CRE will probably decrease for the near term (up to five years), for several reasons.
- Recently, the US Controller of the Currency spoke at the annual convention of the Independent Community Bankers of America, and called on policymakers to devote special attention to the CRE lending concentrations at banks. He then suggested a lengthy list of options, all of which would reduce lending risks AND result in less capital available for CRE lending. Other regulators and legislators are similarly pushing to require banks to hold increased levels of capital. The Congressional Oversight Panel report from February and Sheila Bair of the FDIC cite similar concerns. Regional and community banks have high CRE loan concentrations. MIAC looks at bank asset portfolios regularly, and commercial loans of various types (CRE, ADC, C&I and Land) approximate the majority of the balance sheet assets at many small and mid-sized institutions.
- The Financial Accounting Standards Board is proposing that banks expand their use of market values (called “mark-to-market”) for financial assets such as loans. If these accounting rules are implemented, then this will be another pressure on banks to make less capital available for all but the most secure deployment of funds, and to reduce price volatility by shortening portfolio durations. This bodes ill for CRE lending.
- Insurance company CRE lending will not fill the gap. Recently, the Capital Adequacy Working Group of the National Association of Insurance Commissioners (“NAIC") voted to release for comment a proposal that might result in a large increase to the risk-based capital (“RBC”) charges for life company holdings of CRE mortgages. If passed, this could significantly restrict the ability of some life companies to make capital available for CRE lending.
While this situation presents opportunities for non-traditional lenders such as mortgage REITs, the situation on the ground according to the market buzz is that CRE deals qualifying for this type of financing are few and far between today. These lenders are usually looking for institutional grade assets and sponsors, and want to underwrite closer to life company standards than non-life lenders have historically done. With CRE performance still “in the tank” (the traditional lag in the recovery of CRE assets after a recession) and because CMBS asset resolutions are being attenuated by extensions, MIAC believes it will be several years before enough assets emerge to qualify for these kinds of lending programs.
Extend and Pretend
It has been said here before. We see extensive extending happening. Recent changes in US Treasury regulations have made it easier for CMBS servicers to “modify” these loans, and they are beginning to pick up the pace. We also continue to believe that attenuating the problem will prove ultimately better than the alternatives, particularly where any fresh equity can be obtained. Lags in the performance of CRE notwithstanding, an economic recovery offers the possibility (or hope) that property owners can soften or improve declining cash flow situations sooner rather than later.
We agree with Real Capital Analytics, Inc.’s statement that government and regulatory policy will have greater impact on pricing than occupancy levels or rents. “Policymakers control what happens to commercial mortgages in default,” Robert White, the president of Real Capital Analytics, wrote a few months back. They “have encouraged loan modifications and extensions even in cases where loans are above a property’s current value. Tax policy, meanwhile, has made it easier for special servicers to negotiate with borrowers, a move meant to prevent a wave of maturity defaults and property fire sales. Keep rates low and easing restrictions on foreign capital will also influence industry prospects.” Real Capital Analytics notes that commercial mortgage-backed securities (CMBS) hold 42 percent of distressed loans; American banks 31 percent; and foreign banks 13 percent.
Deutsche Bank did an extended analysis in April of the new reality of CMBS loan modifications in their report “CMBS Research, Loan Modifications in CMBS Step into the Spotlight”. According to Deutsche, between 2000 and 2008, a total of $1.1 billion of CMBS loans had been modified and in the last 15 months another $12.6 billion of loans have been modified.
Conclusion
MIAC is continually monitoring the factors that influence market values for seasoned loan assets. We consider the demand for and supply of new loan product to be a particularly important set of variables to monitor. The collapse and very slow re-emergence of CRE lending in the capital markets space, and regulatory factors impacting banks’ abilities to make such loans in the future, is a critical area for all interested parties to follow closely. MIAC has the expertise to help today’s banks understand the markets and their impact on the value of bank assets.
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