COVER STORY, AUGUST 2008

STATE OF LENDING
One year after the crunch, the road to recovery is still long but better paved.
Ed Bailey

Rates fell to record lows driving a frenzy of acquisitions and record per-square-foot prices for commercial real estate in the Southeast and throughout the U.S during the white hot past few years. Then the good times rolled right over the edge of a cliff, yanked into a chasm created by a residential lending market burdened by a deluge of bad loans and declining home prices. As CB Richard Ellis’ Raymond Torto and Nick Axford put it in a recent research piece, “What was originally a serious deterioration in lending standards concomitant with increased speculation in the U.S. housing market has evolved into a global credit shortage and economic slowdown.”

So here we are a year after this whole mess began, wondering what’s next after the implosion of commercial mortgage backed securities markets, the demise of financial institutions such as IndyMac and Bear Stearns and uncertainty revolving around Freddie Mac and Fannie Mae.

“No one expected it to completely stop like this,” says Chuck Ernst, Southeast director for Arbor Commercial Mortgage. “A lot of people who got into real estate in the past 10 years had not seen a real down cycle. I had people look at me in shock when I told them real estate could depreciate. I don’t think anyone really understood the depth of it.”

The housing market’s woes leaked into commercial finance, hitting CMBS hard. In 2007, the CMBS market contributed approximately $250 million to commercial debt markets. This year, lenders and mortgage brokers anticipate $25 to $30 million in CMBS issuance total.

There are glimmers of hope, though. Charlotte, N.C.-based Grandbridge Real Estate Capital research reported increasing signs of life in the CMBS market as the summer began, especially for AAA-rated bonds, which account for approximately 85 percent of most securitization’s bonds. These bonds peaked at 315 basis points over swap spreads in March but were closer to 135 basis points at mid-year. Commercial Mortgage Alert recently reported that conduit lenders will return to underwriting new loans once bond spreads get closer to 100 basis points.

Though CMBS lenders are still leery of originating new loans for securitization, they have sold a number of the loans sitting on their balance sheets for the past year, according to Grandbridge, which notes that “CMBS programs are unlikely to begin originating new loans until they can unwind all their existing positions.”

“Velocity-wise, our entire industry is down tremendously due to the propensity of CMBS,” says Tom Gracey, executive vice president in Grandbridge’s Naples, Fla., office. “CMBS is probably not going to be a real influence on long-term finance until about 2010.”

Grandbridge had about 290 CMBS transactions in 2007 and had about a dozen through mid 2008, Gracey says. Still, the mortgage banking firm has held firm with a little help from a few old friends — life insurance companies and local and regional banks.

For their part, banks currently are more comfortable with 5-year terms. Bill Tyler, senior vice president of CBRE Melody, compares the situation to a hurricane, where we were in the eye of the hurricane over the spring and now must work through to the other side. CBRE Melody, too, has leaned on long-term relationships with life insurance companies and banks, Tyler says, though he knows it won’t ameliorate the conduits’ woes.

“A lot of this year we’ve been looking at 5-year money rather than 10-year money just to get through this,” says Tyler, who’s based in his firm’s Atlanta office. “The difference has been made up by the banks. It’ll take a while to repair this.”

Still, mortgage bankers expect a CMBS resurgence to take a while. Each week, Gracey hears about an investment bank or clearing house that’s laying off employees or going out of business. When the market does return to equilibrium, those cogs in the system, those firms, will have to re-hire and re-train before production can fully ramp up.

“It will look nothing like it did in 2005 and 2006,” Gracey says. “It got so white hot from 2004 to 2006 and borrowers’ expectations got so unreasonable.”

Many recent deals didn’t make much sense, but that didn’t prevent them, says Ted Hermes, senior vice president at Bethesda, Md.-based Walker & Dunlop. Mortgage bankers also expect more conservative underwriting — similar to what they’re getting from life companies and banks now — as institutions clear their books and move forward.

“When the CMBS market does come back, it’ll be much different from past years,” Hermes says. “Underwriting will be vastly different, and we’ll be back to basics, which will be helpful for the market.”

True Name of the Game: Equity

Interest rates have increased modestly, but the level of equity required to close deals has increased drastically. Borrowers are looking at 50 percent to 70 percent loan-to-value ratios where they were getting 80 percent to 90 percent loan-to-value from conduits about a year ago. Debt-service ratios, too, are climbing, reaching 1.2 to 1.25 percent at mid-year, says Steve Hoerth, vice president-Southeast at RBC Capital Markets.

“Overall, the lending climate is much more conservative,” Hoerth says. “You’re going to have to come to the table with more equity.”

So far in 2008, multifamily has been a bit of an exception, fueled by Fannie Mae and Freddie Mac. At mid-year, Fannie Mae was providing multifamily lenders with interest rates below 6 percent on 30-year loans. Though equity requirements are up a bit for multifamily, too, strong borrowers are still able to get 80 percent loan-to-value on no-interest, 10-year deals with 1.2 debt service ratio, according to RBC’s Hoerth.

Added Arbor’s Ernst, “Multifamily is doing the best right now because of more liquidity with the agencies. It’s really the only game in town right now.”

For its part, Grandbridge, which, like a number of its peers, is a Delegated Underwriting and Servicing lender, had closed 74 agency loans valued at more than $845 million with an additional $746 million in loan commitments or applications at mid-year.

Still, as we went to press, Freddie and Fannie faced crises of their own. Both firms’ share prices tumbled in July as questions lingered over their financial health and ability to raise fresh capital to offset the decreasing values of loans on their books. The crisis forced the U.S. Treasury to issue a statement in support of the two mortgage giants in mid-July.

“Between Fannie Mae and Freddie, they’re both continuing to provide aggressive financing, though they need to be stabilized,” Hermes says.

Silver Linings

There are always exceptions, but most Southeast property markets and submarkets continue to perform relatively well and don’t face the specter of over-building, as with past downturns in the 1980s and early 1990s.

First, the potential trouble spots and exceptions. Atlanta’s Buckhead office market as well as pockets of office development in the Washington, D.C., suburbs raise red flags with the prospect of over-building, with approximately 2.5 million square feet of new development without any preleasing in Buckhead alone. Across the board, lenders aren’t too keen on hotel deals after rapid industry expansion earlier this decade. After closing 112 lodging-related transactions in 2006, Grandbridge’s Gracey said his firm may not do 10 this year. With retail, grocery-anchored centers remain stalwart and other formats offer increasing risk as consumer confidence and consumers’ disposable incomes decline.

Still, the Southeast’s job creation and population-growth engines are expected to progress as they have for nearly 3 decades, which generally bodes well for the multifamily sector, especially with the single-family residential sector in such a funk.

“The Southeast as a whole continues to perform well,” Hoerth says.

Gracey noted that some lenders are hesitant to make deals in certain submarkets, but he has not heard a clear-cut “no” on any property type.

“We really haven’t had a market in the Southeast where we’ve had serious over-heating,” Gracey says.

That relative stability also plays a role in another problem area: the gap between asking price and bids on acquisitions. Potential buyers seeking opportunities may paint a much gloomier picture than sellers are willing to accept, especially if they paid a record price only a few years ago. Prices are falling, too, as Moody’s reported a 2.3 percent decline in its Commercial Property Price Index in March, the largest decline since the index’s inception. So far, commercial loan default and foreclosure have not emerged as major issues, and potential sellers have so far been perfectly willing to sit on their hands, waiting for a better deal or waiting for the credit crisis to pass.

Slowly, though, that gap is closing.

“The disconnect is fading,” Hoerth says. “People are understanding that the deals they were getting a year ago aren’t there anymore. Things are starting to look better.”

The overall U.S. economy is a bit of a wildcard for commercial lending markets, and elections may drag things out a bit, too, but a “back-to-basics” — or back to realistic expectations — mentality will play a major role in the industry’s resurgence.

“We’re back to better underwriting where cash flow matters and property debt service matters,” Hermes says.

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