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COVER STORY, JANUARY 2008
A BALANCING ACT
The challenges in the financial sector may lead to volatile, though relatively healthy, conditions in 2008.
Sean O’Malley
Much of 2007 was marked by turmoil in the global capital markets and commercial real estate. People with limited commercial real estate experience might think the year was disastrous. Those that have a longer commercial real estate history have seen much worse, particularly markets in which commercial real estate collateral suffered significant defaults and delinquencies.
Hype aside, the primary result of 2007’s volatility and ensuing correction is largely a return to the underwriting fundamentals of a stable commercial real estate market — one characterized by a variety of lenders, more realistic standards, stable, albeit wider spreads, and the ability to finance sound deals in every property sector across the Midwest and the United States.
Even with these fundamentals in place, the outlook for commercial real estate in 2008 is still somewhat uncertain.
A Rollercoaster
2007 was a wild ride even for those accustomed to Wall Street’s ups and downs. Rampant volatility appeared almost overnight. Many lenders stopped lending. Capital markets and traditional lenders abandoned loose underwriting practices. Aggressive structuring such as full-term, interest-only loans disappeared. Cash equity became a requirement. Spreads widened to levels not seen in years.
The collapse of the residential subprime mortgage market is largely to blame. Concerned about potential losses, investors that were buying bonds collateralized by subprime mortgages, as well as bonds collateralized by commercial real estate loans, reacted quickly. Some investors stopped buying bonds entirely; others bought only commercial real estate bonds that reflected cautious lending practices and offered higher returns.
The agencies that rate CMBS bonds responded to investors’ concerns by criticizing aggressive underwriting standards. Rating agencies also raised subordination levels on CMBS securitizations, which immediately reduced every capital markets lender’s returns.
In the face of volatility, skittish investors, higher subordination levels and lower returns, many lenders temporarily withdrew from the market. Others continued lending with wider spreads and more conservative underwriting standards to accommodate investor and rating agency concerns. Many lenders have laid off numerous staff in response to the downturn.
Looking Ahead
Some of 2007’s extremes have already leveled off and many CMBS lenders have returned to the market. However, the underwriting shift that took place last year will remain constant, which will contribute to short-term uncertainty until the market responds to securitizations of loans reflecting the new standards.
In addition to conservative underwriting standards and deal structures, equity requirements and wider spreads, the commercial real estate landscape in 2008 will likely be faced with a number of other issues:
• Reduced CMBS Originations
CMBS originations this year are projected to be approximately 50 percent of those in 2007. Sellers are not willing to accept reduced prices; buyers are not willing to pay 2007 prices. As a result, many buyers and sellers will sit out the first half of the year.
• Potential Retail Challenges
It is not yet clear whether the subprime meltdown and reductions in residential property values led consumers to rein in holiday and general spending. If so, tenant credit quality and retail property prices could suffer.
• Limited Development
Financing new development will be more challenging, largely because lenders will require more equity and less speculative deals. Construction financing will most likely come from traditional lenders such as local banks, although parameters will be conservative.
• A Mixed Picture in the Midwest
Midwestern growth in 2008 will likely be concentrated in larger cities, such as Chicago and Minneapolis, that have proven their ability to attract and retain big business and a highly educated workforce. Commercial office buildings in these cities should experience higher occupancy levels and rental rates than similar properties in other midwestern markets. Although the residential housing industry in the Midwest has and will continue to be affected by the recent market downturn, it is also somewhat more insulated than other regions that experience faster growth. In contrast, states such as Michigan and Ohio, which are facing more challenging economic conditions, may have greater difficulty riding out the current commercial and residential market volatility.
• Increased Demand for Multifamily and Self-Storage Properties
The multifamily and self-storage sectors stand to gain noticeably this year, as people that lose their houses move into apartments and seek storage for overflow belongings. Many markets are already experiencing reduced vacancy rates and increased rents.
Although last year’s volatility was largely triggered by the collapse of the residential subprime mortgage market, the primary impact on commercial real estate was a market stabilization that some would say was long overdue. Underwriting standards had become too aggressive. The risk of overbuilding was looming, along with the potential for a more serious credit crunch caused by significantly reduced occupancy rates and falling rents.
The more conservative financing landscape that is likely to emerge this year should ultimately benefit the entire commercial real estate market. Buyers accustomed to zero equity and aggressive pricing and deal structures may disagree, yet investors with cash equity are starting to shop and initiating transactions that should be complete mid-year.
Once the short and long-term effects of the subprime meltdown are fully known, the more stable environment that will result from 2007’s corrections should foster a stronger, more stable commercial real estate market through this year and beyond.
Chicago-based Sean O’Malley is regional director for the Midwest and Eastern regions of RBC Capital Markets’ Real Estate Mortgage Capital. RBC Capital Markets’ Real Estate Mortgage Capital sources and securitizes commercial real estate loans on a variety of income-producing properties across the United States.
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