Financial Fallout: A tale of two markets 

While Wall Street reels from the credit crisis and big-name developers are forced to sell assts they can’t refinance, many Main Street lenders remain ready and willing to make loans on commercial property. The reason behind this dichotomy can be summarized in three words – commercial mortgage-backed securities (CMBS). For the 28 percent of commercial real estate mortgages that are securitized (according to Goldman Sachs), the credit freeze that began with failing subprime home mortgages brought lending to a near standstill in the second half of 2007. But for the second- and third-tier market lenders who seldom securitize their commercial real estate loans, the impact of CMBS declines--at least thus far—has been minor. That’s good news for commercial property owners and commercial practitioners who focus on smaller properties. In the world of trophy buildings and megadeals, it’s a grimmer story.

Wall Street Woes

 “The financing world has turned upside down from a year ago,” says Kevin Phelen, CRE, president of Colliers Meredith & Grew in Boston and director of CMG’s Capital Markets Group. In the first half of 2007, conduit loans—which are designed to be syndicated — were up 70 percent over 2006 levels, according to Jamie Woodwell, senior director of commercial/multi-family research for the Mortgage Bankers Association. In the second half of the year, conduit loans were down 30 percent over ’06 levels.

Since conduits accounted for approximately two-thirds of all real estate loans, when they become “a nonfactor,” you’re bound to see problems, says John Doan, managing director for Babson Capital Management Ltd., a member of the MassMutual financial Group. Although a few conduit deals are still being done, Doan expects total loans in this category to reach only about $100 billion in 2008, compared to $230 billion in 2007. And with spreads as high as 400 basis points over 10-year Treasuries, conduits have become the lender of last resort, says Eric Tupler, vice chairman of CBRE Capital Markets.

Another part of the financing problem is that, despite demand, other traditional commercial real estate lenders aren’t stepping up to fill the void. According to MBA data, only government-sponsored enterprises Fannie Mae and Freddie Mac increased their commercial loan originations in the second half of 2007. Life insurance companies allocated approximately $60 billion to commercial loans in 2007 and will probably allocate about the same amount for 2008, says Doan. Although commercial real estate lending has become more profitable thanks to the rise in CMBS spreads, insurance companies can still earn more from investments such as AAA CMBS paper than from permanent mortgages, he explains.

Even where funds are available from life insurance companies, borrowers with maturing conduit loans may find that life insurance companies’ demand for higher institutional-grade properties cuts off that avenue to refinancing. These conservative real estate lenders are now requiring loan-to-value ratios of 70 percent or even 60 percent, with spreads in the range of 240 to 260 basis points over 10-year Treasuries (in late February), says Jerry Monash, executive director of investment services for NAI Global.

Main Street money

But if mega borrowers are struggling, local and community banks in second- and third-tier markets still seem ready and willing to finance sound commercial properties priced below $10 million. Unlike larger lenders, community banks seldom securitize commercial real estate loans and thus have dodged most of the fallout from CMBS.

“Credit is available and affordable. With low interest rates, it’s a great time to borrow,” says commercial practitioner and mortgage broker Manny Jemente of Champion Lending Group in El Paso. Lenders in El Paso, he notes, are lending with as little as 10 percent down to borrowers with good credit, providing that the building will produce sufficient cash flow to cover the debt.

Buyers who intend to use property for a business and need to borrow under $1 million can still get very favorable rates with loans guaranteed by the Small Business Administration, advises Bill Davies, a former commercial real estate broker who now works as a commercial mortgage specialist for Acceptance Capital Mortgage Corp.

Greg Schenk, SIOR, of the Schenk Co. in Columbus, Ohio, is also finding lenders willing to write permanent mortgages for commercial borrowers with experience and viable pro formas. Schenk is seeing some loans quoted at 5.7 percent for a five-year fixed loan. Fierce competition for business among the growing number of local banks has helped make these lenders more willing to provide financing and kept rates and terms attractive, he notes. He has seen more emphasis on personal guarantees of loans, but “there’s no lack of capital if you have good relationships with lenders,” he says. And despite a January 2008 Federal Reserve survey of senior loan officers at U.S. banks, which found that 80 percent had increases their underwriting requirements on commercial loans in the last three months, Schenk says “we haven’t found that local banks in our area have significantly increased underwriting requirements, although they are looking a little harder at appraisals since commercial real estate price appreciations have slowed.”

Funding Going Forward

It’s this concern about the extent to which the financial crisis will affect commercial prices and demand that remains the greater worry for many commercial practitioners. Most of those we interviewed expect liquidity to return to the financial system by the second half of 2008, even if loan underwriting remains fairly conservative. “In 12 to 24 months, when the write-downs have been taken, a functioning conduit market will emerge,” says Dan Wald, managing director, NaI BT Commercial, San Francisco.

Whether that recovery will be enough to prevent serious deterioration in commercial property prices and demand fundamentals is a harder question. Commercial property prices have already retreated from summer highs, and most experts anticipate that prices will decline 10 percent to 15 percent before the market hits bottom. Some, like Goldman Sachs, predict price falls in the 25 percent range. But commercial markets aren’t faced with serious oversupply of product, which should prevent the “meltdown of the early 1990s when buildings were worth less than their debt,” says Wald.

Others aren’t quite as certain. “Loans that were made between 2003 and 2006 will be resetting beginning in 2008, and there’s a risk that the cash flows to cover the debt service won’t necessarily be there, especially if the economy slows further,” says Monash.

The risk may be even greater in 2010 or 2011, says Tupler. “Borrowers with interest-only loans should be able to cover debt service today even if fundamentals shift. It’s when these loans mature and need to be refinanced that you face the real risk if there’s not liquidity,” he says.

For now, leveraged buyers without equity capital and sound pro formas are being pushed to the sidelines, but the many owners “sitting on good capitalization will ride out the storm,” says Tupler. For those who must sell, he notes, there’s till a lot of capital out there among REITs, pension funds, and foreign investors, and they’re looking for opportunities.