Six Months into 2008, the CMBS Market Has Failed to Recover

from Retail Traffic website

Jul 2, 2008 11:06 AM

When the credit crunch first broke in earnest last fall and froze the U.S. commercial mortgage-backed securities (CMBS) market in its tracks, the most bullish prognosticators predicted a mere blip. Many expected issuance in the U.S. to be down from $237 billion in 2007, but thought it could reach $150 billion. The conservative estimates put the expected 2008 volume at $100 billion.

Today, those worst-case scenarios are looking wildly optimistic.

Through the end of June, U.S. CMBS issuance had reached just $12.1 billion according to Commercial Mortgage Alert, an industry newsletter. Overall, that's a 91 percent drop compared with the first six months of 2007. In June itself, $1.3 billion of CMBS bonds were sold. That was up slightly from the $900 million in May, but down more than 96 percent from the record $37.4 billion in June 2007.

In all, analysts are no longer calling for any kind of rebound this year. Analysts from J.P. Morgan Chase & Co., in fact, expect the second half of 2008 to be even quieter than the first, with full-year CMBS issuance volume totaling $20 billion.

What's the upshot of all this? Since CMBS loans accounted for about 70 percent of all commercial real estate financing in 2007, it means prospective borrowers still have no place to turn and the slowdown in investment sales that has plagued the sector won't be resolved any time soon, according to Sam Chandan, chief economist with REIS, Inc., a New York City-based provider of commercial real estate information.

The fundamental problem is the wild uncertainty within credit markets. CMBS spreads to 10-year Treasuries have not only widened considerably from a year ago, but continue to fluctuate from month to month. As a result, it’s more difficult for borrowers to decide whether or not to take conduit loans. Further, alternative sources of funding, such as banks and life insurance companies, aren't offering the same generous terms CMBS lenders did in the past, nor are they greatly increasing their allocations to commercial real estate. Lending on commercial real estate is down across the board from 2007.

Within the CMBS sector, spreads have begun to widen once again. As of June 25, spreads over Treasuries on five-year, fixed-rate AAA conduit loans stood at 165 basis points, above the 52-week average of 147 basis points, reports Commercial Mortgage Alert. Spreads on 10-year, AA loans were at 475 basis points, above the 52-week average of 370 basis points, and spreads on 10-year BBB loans were at 1,250 basis points, compared to a 52-week average of 931 basis points. For borrowers, those rates are simply too high. Moreover, loans from other sources offer competitive pricing--an area where previously CMBS loans had an edge.

"With spreads as wide as they are, loans that are destined for securitized pools are not as competitive,” Chandan notes. “Investors are demanding extraordinary premiums as opposed to the types of spreads we’ve observed in recent memory.”

With CMBS out of the picture, the retail real estate sector saw a 53 percent drop in overall lending activity in the first quarter of 2008, according to data released last month by the Mortgage Bankers Association (MBA), an industry organization. Commercial bank originations in the commercial/multifamily sector fell 28 percent in the first quarter of the year, according to the MBA, to $228 billion. Originations by life insurance companies decreased 25 percent, to $119 billion.

All of that means that it continues to be difficult to complete investment sales deals on properties that don’t include in-place financing, says Philip D. Voorhees, senior vice president of retail investments with the Newport Beach, Calif.-based office of global brokerage firm CB Richard Ellis. Life insurance companies and regional banks tend to be much more selective in the kinds of properties they will finance, Voorhees notes. The life insurance firms, for example, require that a property feature a location in a major metro market, a vacancy rate lower than 5 percent and credit tenants before agreeing to issue a loan. They also insist on loan-to-value ratios of 60 percent to 65 percent, lower than most investors feel comfortable with.

“They’ve only got so much to lend out and that is drying up. Similarly, the local banks are reportedly approaching capacity,” Voorhees adds. “We lost one of our biggest sources of debt in the conduit market and nobody is there to replace that.”

As a result, the volume of sales transactions closed by Voorhees’ team year-to-date has been about 30 percent off compared to the same period in 2007. Voorhees has some hope the situation will improve by the fourth quarter. But with more than $11 billion worth of securitized loans becoming eligible for refinancing in the next six months, Chandan says it’s not likely.

“There are concerns about limited liquidity in the market,” he says. “We don’t expect to see significant gains in transaction volumes in the summer or early fall.”

--Elaine Misonzhnik

Fashon Valley Mall v. NLRB

One of the more interesting articles that I found this weekend is the ongoing legal struggle between property owners (more specifically large shopping mall owners) and the advocates for ‘free speech’. There is a current case in front of the California Supreme Court that attempts to limit the private property rights of owners that their ability to control business practices on their properties. The tenants (and we’re talking about tenants like Target, Macy’s, etc.) have a right to conduct business on the properties that they lease from large shopping center owners. When someone attempts to pass out a flyer on private property or protest an "unfair" trade practice, the landlords argue that they (and their tenants) have a right to conduct business on private property.

This latest case, Fashion Valley Mall v. NLRB, stems from a 1998 incident in which a Teamsters Union affiliate involved in a dispute with the San Diego Union-Tribune newspaper was distributing leaflets outside a Robinsons-May store, urging shoppers to telephone the paper's owner. But the store was a Union-Tribune advertiser. The mall ejected the union representatives, saying that they had failed to complete a permit application agreeing to abide by mall rules — one of which forbids advocating boycotts. The case is now before California's Supreme Court, which last week heard amicus curiae testimony on behalf of ICSC and the California Business Properties Association delivered by Thomas Leanse, of the Chicago-based Katten Muchin Rosenman law firm. Leanse argued that shopping centers are private property and shopping center owners should be allowed to protect their business interests.

“This isn't Speaker's Corner in Hyde Park, it's not Pershing Square in Los Angeles,” said Leanse. “These are privately owned shopping centers and the protestors directly interfere with business.” The court is scheduled to deliver its verdict within 90 days. What makes the case important, Leanse says, is a 1979 ruling in California, Robins v. PruneYard Shopping Center, in which the court extended the right of free expression to large shopping centers, likening them to town squares. Leanse says there is a chance that this ruling will be overturned, though it is a small one. “It is unlikely the 1979 precedent will be overturned,” he said. “But we argue that the shopping center has rules, and they are rules we can enforce, like the no-boycott rule.”

Commercial CAP Rates on the Rise

For all of the talk that Commercial Brokers spoke about bifurcated markets (residential on the decline and commercial strong and steady), there is evidence that commercial pricing among all assets classes is starting to drop. Institutional investors aren't staying away because of the "credit crunch", they are staying away because they fear prices will drop another 10-15% by year end (echoing what Sam Zell was discussing in the last post about a "confidence crunch" vs. a "credit crunch").

A recent article from RetailTraffic reiterates these sentiments from the 4Q of 2007 with rising CAP rates on all commercial asset classes due to the tightened credit and underwriting guidelines for commercial deals. This translates to lower pricing models and higher CAP rates moving forward:

In July, investors closed the smallest number of commercial real estate deals since August 2006, at 930 transactions valued at more than $5 million, Real Capital Analytics researchers told Bloomberg.com.

Stephannie Mower, executive vice president with PM Realty Group, a Houston-based real estate services firm, reports that this July the firm experienced a 14 percent drop in sales activity across all asset classes, the worst performance in five years.

She says many of her institutional clients are purposefully staying away from acquisitions right now, not because they don't have the cash, but because they figure that prices will soon begin to drop on even the best quality assets. Across the board, they expect to see a discount of 15 percent before year's end.

Troubles in the debt markets are crippling leveraged buyers. Conduit lenders especially have stumbled, unable to sell loans they originated at terms they used six months ago into a secondary market suddenly squeamish about risk. From 2006 to August 2007, spreads to 10-year Treasuries on AA-rated fixed-rate CMBS loans, for example, more than doubled, jumping 122 basis points in all to 211 basis points from 89 basis points in 2006, according to RBS Greenwich Capital. Meanwhile, spreads on A-rated loans rose 162 basis points, to 261 basis points, and spreads on BBB-rated loans rose 262 basis points, to 396 basis points.

Bernard J. Haddigan, senior vice president and managing director of the national retail group with brokerage firm Marcus & Millichap Real Estate Investment Services says CMBS lenders also no longer play fast and loose with their underwriting. They won't grant investors interest only mortgages, nor are they willing to hike up the loan amount to cover for small property defects, such as a vacant space, in a core asset. In the past year, the acceptable loan to value ratio dropped to 60 percent, whereas in 2006, investors still closed deals at 95 percent loan to value.

"Now the lenders are really looking at their coverage," Haddigan says.

With all the troubles in the debt market, however, investors are demanding higher returns, Farahnik says. So if last year an acceptable ROI for a given deal was in the mid-teens, this year, that number moved to the high teens.

That kind of attitude drives the market right now, according to French. Though buyers are putting out lower bids on class A assets--this summer, some offered bids of 8 percent and higher--and though the period between the listing and the closing nearly doubled to 150 days compared to 2006, people still think that retail properties are a good investment.

Going forward, however, that equilibrium might not last. In the past few years, the private investors and 1031 exchange buyers drove cap rates down by taking on a lot of leverage, according to Mower. Now that the credit crunch has limited their ability to borrow, institutional funds will once again rule the day.

For additional information on swap spreads go to this article from Kenny Pratt @ SimpleRE for some great insight.