Since the start of the financial crisis, the deterioration in the credit markets has dried up traditional sources of financing for commercial real estate development. George Smith Partners is presenting a new short series of articles focusing on the CMBS (commercial mortgage-backed securities) market to provide insight into a key part of the capital markets and track developments in government policy. This series of articles will attempt to provide professionals with insider industry knowledge so they better understand the underlying forces that drive and shape the commercial real estate market. (Please click here to view article with graph and citations).
The breakdown of the CMBS market has left the commercial real estate financing industry crippled. As losses mounted investors became totally averse to securities backed by real estate debt. The sudden lack of a mechanism to unload warehoused loans led to the CMBS origination market grinding to a sudden halt. After the signs of trouble in 2007 there has not been a single U.S. CMBS issuance since June of 2008.
The question on everyone’s mind is how will the market move forward and when will we see CMBS, or some variation, come back? Trying to answer the question produces a lot of gut reactions from every corner of the industry, some providing key insight while others are less rational. There are many participants in the CMBS market with varying views, but the market was designed and structured with one key stakeholder in mind: the bond investor. Understanding the current problems and the potential outcomes requires looking at the situation from the perspective of the CMBS investor.
One reason for investors’ hesitancy is steadily increasing CMBS loan delinquencies as the delinquency rate (+60 days late) has reached 1.66%, surpassing the high from the last CMBS downturn in 2003. The future continues to look bleak as the percentage of CMBS loans transferred to special servicing or 30 days delinquent is now at 3.28% and has been increasing for thirteen consecutive months. The delinquency rates for multifamily, office, and retail property loans are at all time highs dating back to December of 2000
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Fundamental deterioration in the economy has increased vacancies and decreased cash flows leaving a general sentiment among CMBS investors that commercial real estate has lagged behind the housing market and CMBS losses have trailed other asset classes. While late mortgage payments are worrying investors, another risk that was given little consideration during the CMBS boom years is starting to overshadow delinquencies.
The increasing prospect that CMBS borrowers will be unable to find lending sources to refinance their loans causing a maturity default is the issue of focus for the CMBS industry. In the first quarter of 2009 the percentage of CMBS fixed-rate loans (93% of outstanding CMBS debt) paid off at maturity decreased from 83% in the previous quarter to 55%. Of the $2.44 billion worth of CMBS debt that matured in the first quarter, 32% was transferred to special servicing totaling $790 million. This balloon risk is especially worrisome considering the outstanding balance of CMBS loans maturing between 2010 and 2012 is more than ten times greater than the balance maturing in 2009.
The rising maturity defaults and near term balloon risk can be attributed to two primary factors. First, the lending market has witnessed a major shift to more conservative underwriting guidelines including lower loan-to-value limits, higher debt coverage ratios, reduced maximum loan sizes, and higher interest rates. This change combined with the significant drop in property values is squeezing the proceeds out of properties in need of refinancing. Industry projections are grim with one report predicting anywhere from 50-65% of properties backed by CMBS loans maturing between 2009 and 2012 will not generate the proceeds necessary to refinance their existing debt
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The second problem is the current financing capacity for commercial real estate is insufficient to satisfy the volume of CMBS loans that are maturing over the next several years. The vast majority of lenders have dismantled their CMBS origination teams and asset managers are virtually the only personnel remaining. Multifamily is the only property type with a source of capital using a conduit platform, via the agencies (Fannie Mae & Freddie Mac), while owners of retail, hospitality, and office properties must go to portfolio lenders. This is hardly a solution as portfolio lenders are saddled with non-performing loans weighing down their balance sheets and do not have the liquid vehicle of securitization to handle the volume of loans coming due. Even for properties that are able to find a lending source the problem for CMBS investors is not solved.
The drop in property values and shift to more conservative underwriting guidelines has brought about higher losses for CMBS loans finding a resolution. Whether the outcome is refinancing or liquidation through foreclosure, the loss severity, the ratio of the loss from liquidation over the outstanding principal, has increased significantly. The loss severity rate for CMBS loans repaid in the first quarter of 2009 was 48%, up 17% from 2008 and the highest it’s been in the past seven years. Given the current conditions in the financing markets the high loss severity rate is projected to continue.
CMBS investors are faced with a lose-lose situation when evaluating CMBS loans backing the bonds. Not only do they risk late repayment of capital due to the inability of borrowers to find a source of financing, they face severe losses due to inadequate refinancing proceeds and distressed selling prices. Investors’ concern over seasoned CMBS presents a major roadblock for originators trying to restart the CMBS engine. Borrowers and mortgage industry professionals need to closely watch the market in hopes that fundamentals improve and investors rediscover their appetite for CMBS.
Creating strong investor interest in existing bonds is a first step on the road to recovery for the CMBS market and the commercial real estate capital markets as a whole. In the upcoming articles we will look at Federal Reserve and Treasury programs attempting to alleviate the stress in the market and generate interest in CMBS. In addition, we will take a more in depth look at the issues facing CMBS participants as well as initiatives in the private sector aiming to remedy and reshape the CMBS market.
