Commercial Real Estate is next!

The past eighteen months have seen some of the most difficult times in the credit markets history; it has had a bad dose of constipation to clear by writing off an unprecedented amount of residential mortgages. Just when we think we have cleared the system we are dealt the blow of a major recession which will bring on major credit card losses and eventually commercial mortgage losses due to the contraction of the tenant base.

To compound commercial real estates' problems, the underwriting standards being used between 2005 & 2007 were very poor and resulted in highly leveraged loans being closed. Theses same loans will not get refinanced on the same terms on maturity and will require a massive infusion of equity or necessitate owners having to sell assets. Large amounts of equity being pumped into property to allow for a refinance will divert funds that could otherwise be used to buy real estate and hence dampen demand. Additionally large amounts of property being put on the block due to an inability to refinance will increase supply sharply. Both these factors are going to weigh on property prices for a number of years.

The recent commercial real estate bubble peaked in 2007 and came about due to easy credit. The ability to acquire a property with high leverage and light covenants, such as adequate debt service coverage, meant that buyers had much greater purchasing power and could bid higher for their targeted real estate acquisitions. Other underwriting standards were also relaxed such as the assessment of the creditworthiness of tenants leasing the underlying property.

Due to low interest rates and the ease of obtaining credit, buyers were also prepared to acquire property at historically low Cap Rates. The Cap Rate is the property's Net Operating Income (NOI) divided by its Purchase Price. Cap Rates will fluctuate based on the investor's risk appetite, the perceived risk in the asset or its location, and the prevailing interest rates. Cap Rates have now moved out at least 200 basis points from their lows (a low Cap Rate results in a higher value). As Cap Rates have moved up, Net Operating Income of properties has been declining due to the effects of the recession resulting in tenants giving up space, not renewing leases, or going out of business.

We are in a perfect storm of Rising Cap Rates, declining NOI, and a lack of available credit. The full effects of this will be spread out over the next few years as term loans come to maturity and property owners are unable to obtain the same favorable loans due to tightening underwriting. Even if the NOI of properties improve back to the levels of 2007, the same leverage will not be available and will result in massive equity calls on property owners in order to refinance.

The years between 2005 & 2007 saw the highest deterioration of underwriting standards, particularly in the Commercial Mortgage Backed Security (CMBS) arena. CMBS loans were packaged up and sold on the capital markets as bonds to a diversified and fragmented group of investors. Unlike banks or insurance companies that maintain a close relationship with their borrowers and therefore continually monitor the health of their borrowers' financial situation and the properties that they have leant against, CMBS loans are managed by servicing agents whose main concern is monthly collections and reporting. Servicing agents are not in a position to see a problem coming down the tracks, they simply report on problems after they have arisen. As the underwriting standards of the CMBS loans worsened the standards of traditional lenders such as banks and insurance companies followed suit in order to stay competitive.

Research has shown that in the period 2009-2012 up to 70% of the CMBS loans maturing, and up to 50% of traditional bank and insurance company loans maturing, will not qualify for refinancing under traditional underwriting standards. Worse still, up to 80% of CMBS loans originated in 2007 would not qualify for refinancing.

In the period 2010 to 2013 there will be approximately $300 billion of CMBS loans maturing and another approximately $1 trillion of traditional bank and insurance company loans maturing. Based on the percentage of loans not qualifying for refinance and assuming a shortfall of 20% in equity to obtain financing, this would equate to approximately $150 billion of additional required equity from owners.

Current CMBS default rates are at 3.29%, up from 2.71% in 2007, which seems low compared to residential mortgage defaults; however this is projected to increase to an average of 6.5% over the coming years and peak at 12.5% for CMBS loans originated in 2007. Foresight Analytics has estimated that commercial real estate loan losses in the US banking sector could top $250 billion.

This all sounds very gloomy but there is an upside in the tremendous opportunities that will be presented to us in the next couple of years. At the moment the best opportunities are being presented by banks selling their notes or selling their REO (Real Estate Owned) property that they have already foreclosed on. There is still a huge disconnect between buyers and sellers of property, with a very wide spread between both parties respective valuations of property.

In the coming months as sellers expectations of value are not realized the gap will be bridged and we can expect to see some deals getting done again. This of course is subject normal liquidity returning to the credit markets; otherwise it will not only be a buyers market, but a cash buyers market where cash will truly be king!