On September 9, 2007, Gary E. Mozer, GSP Principal/Managing Director, lead a panel discussion on “Market Fluctuations – Understanding the Uncertainty in Today’s Real Estate Capital Markets” for real estate investors. About 120 presidents of commercial real estate companies tuned in to hear the panel’s discussion and ask questions. The panel included:
· Mark Finerman, RBS Greenwich Capital, Managing Director, Head of Real Estate Group – who provided the Wall Street perspective.
· Tim Sloan, Wells Fargo Bank, Executive Vice President, Group Head of Specialty Finance, Capital Markets Group – who provided the banking perspective.
· John Menne – MetLife, Director of the Los Angeles Regional Office, does debt and equity – who provided a Life Insurance Company perspective.
Mr. Mozer began the event by discussing the circumstances leading up to the current liquidity crisis. (See 8/16/07 and 8/30/07 FINfacts.) In brief, after the “tech-wreck” “cheap” capital flooded the market, foreign investors began buying real estate and securities, and Wall Street found creative ways to bring liquidity to market, including the maturity of the CMBS market and the creation of the CDO market. Rates came down, spreads tightened and pension funds allocated more money to real estate. Investors enjoyed positive leverage and a strong economy.
As competition among lenders increased, underwriting standards loosened. Borrowers could get 10 year interest only loans at 1.10 DCR, with nominal reserves or recourse.
But suddenly the market changed. In February, investment grade bonds backed by subprime mortgages began experiencing losses as the housing slump carried over from 2006. Interest rates started rising. Then Moody’s changed subordination levels. Liquidity started drying up in real estate and other capital markets.
According to Mark Finerman, Wall Street took notice when an article from Moodys stated that underwriting standards had deteriorated with too much IO, low DCRs, and weaker structure characterized by the lack of warm bodies to guarantee loans. Moody’s announcement spooked investors. About the same time, subprime loans saw default rates rise. As bonds backed by subprime mortgages suffered increased losses, mortgages” became a dirty word. This led to a liquidity crisis unlike any we have seen since 1998. Demand for bonds has dried up with some bonds receiving no bids.
How has the huge supply on Wall Street of old paradigm paper and the new underwriting standards affected portfolio lenders?
John Menne says that life companies, MetLife in particular, have always underwritten loans more conservatively. For instance, Met rarely chased loans at less than breakeven coverage. It has always underwritten loans with amortization and debt coverage going in.
On the other hand, since the credit crunch, Met has seen a lot of investment opportunities in all asset classes. It invests in a couple dozen different asset classes for the general account book, one of which is real estate. It tries to be strategic about which real estate transactions it invests in, looking at loans with repeat customers at leverage of 50%-65% LTV.
How has the cost of capital been affected for banks?
Tim Sloan asserts that one needs to look at banks in different categories because of all the recent changes in capital markets. The larger banks with real estate capital markets orientation, many having their own conduit, can’t sell their loans in the capital markets today. These banks have moved to the sidelines until they can clean up their balance sheets.
On the other hand, banks and other financial institutions without a large concentration of CMBS loans are very active today. While spreads have gone up, they haven’t gone up too much. Advance rates and LTV’s have come down because of how underwriting standards in capital markets have changed. One used to see 75-80% LTC on recourse and non-recourse loans just a few months ago, but now it’s rare to see loans over 60-65% LTC.
Still some institutions/banks have credit issues in their real estate portfolios that have nothing to do with what has gone on with capital markets, but more to do with aggressive lending they did in perhaps overly aggressive markets (i.e. condo markets, land).
Has the cost of capital on Wall Street really changed?
Mark Finerman says that Wall Street conduits cannot calculate their cost of capital because of the disruption in the capital markets. AAAs now trade up to 65 bps over swaps or 150 bps over treasuries. BBB- paper is priced at 500 bps over swaps with few trades actually occurring. As a consequence, originators, desperate to move loans off their balance sheets, will sell the AAA bonds and the first loss B pieces, but are forced to hold all classes in between for lack of buyers.
Floating rate loans have suffered even more than fixed rate. Investment banks have therefore stopped quoting floating rate loans. Most floating rate bridge loans are now being originated by commercial banks who can still find syndication partners.
With the increased cost of capital, what is happening in the equity market?
Cap rates are up and values are down. According to Tim Sloan, a number of transactions that have fully underwritten debt commitments and hard equity will not close today. Prices for commercial real estate have already fallen between 5-10% because of more conservative underwriting standards from debt providers. In the end we will see 10-15% change in values, with the possible exception of multifamily
Finerman notes that Greenwich Capital wrote $9-10 billion mortgage loans in the first six months of 2007. They will probably write only $1.5 billion in the second six months as the uncertainty in the markets makes it difficult for Wall Street firms to originate new debt. Furthermore, transaction volume is down across the real estate industry as sellers and buyers see a wider bid/ask spread.
John Menne sees investor yield requirements rising by 10-15%, although Class A properties may hold their values as many trophy buyers pay all cash and do not have to rely upon the debt markets.
There is good news in the midst of this crisis: There is still a lot of money out there. Unemployment is low. Real estate fundamentals are good.
The panel concluded with the following advice for investors:
John Menne continues to be optimistic about real estate as an asset class. He believes it will continue to perform well. MetLife will continue to invest in real estate. He warns buyers to be cautious about over-negotiating terms of their loans – if it makes sense, go ahead and book it.
Mark Finerman believes that spreads will eventually tighten but Treasuries are artificially low because of flight capital. Investors will return to fixed rate capital, albeit at more conservative terms and pricing. The real estate capital markets won’t be the same as they have been, but they will be ok. He echoes Menne: If the property is ready to be financed now, do it.
Tim Sloan adds that real estate is an important asset class for investors. It is important to have your own view where the economy is going. Forget about the crazy rates, spreads, loan structures we saw over the last six months. Think about where they were a year ago. If you like a property, assume spreads will come back to where they were a year ago.
