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Developing residential land vs. suburban sprawl: Developers talk about expansion in central PA

A CMBS Jump Start…or another economic dead battery?
By Sheila J. Scherrer

Sheila Scherrer is a Managing Director at M&T Realty Capital Corporation and is responsible for the placement of commercial mortgage debt with a network of life insurance companies and other institutional investors. Ms. Scherrer has over 24 years experience in the secondary market for commercial mortgage debt. Prior to joining M&T in March 1998, she spent seven years at Key Bank as their Northeastern Regional Manager for Real Estate Capital Markets, and also led their nationwide whole loan purchase and sale group. Ms. Scherrer is a licensed Real Estate Broker and received her B.S. degree from Cornell University in Business Management and Marketing.

In the last 60 days, three new Commercial Mortgage Backed Securities (CMBS) issues successfully cleared the market at better than expected levels, with only minimal use of government financing (Term Asset-backed Loan Facility). This has created significant market optimism that this vehicle for financing commercial real estate is finally back on the road after almost two years in the ditch.

This may be true for borrowers with high quality properties that only need low leverage (less than 65 percent of value), typically those held by REITs (Real Estate Investment Trusts) or other conservative investors. Unfortunately,
this is just a small percentage of the market. As more CMBS issues come to market, and if buyers return for the lowest rated bonds, the maximum Loan-To-Value (LTV) should increase to 75 percent.
The CMBS market, dead for most of the past two years, recently showed signs of life, first with Goldman Sachs’ $400 million Developers Diversified Realty issue in November, followed by Bank of America’s $460 million Flagler/Fortress deal in early December, backed by 44 Florida office and industrial properties. JP Morgan followed with a $625 million loan to Inland, an Illinois based REIT, $500 million of which was financed through CMBS issuance.

This aggregate of $1.365 billion in CMBS issuance is encouraging, but underlying LTVs were in the 50–60 percent range, using current, higher cap rates on current property economics. Only a very small percentage of the property universe has the flexibility to refinance at this low leverage, and it is no coincidence that all three borrowers are REITs, which typically have low-to-no leverage on properties in their portfolios.

In its current form, however, this car will not start for the vast majority of borrowers, who typically financed 80 percent (often up to 90 percent if mezzanine financing was also utilized) of their property’s value. Keep in mind that these values were calculated when cap rates were at their historical lows, during a period of cap rate compression never before seen in the commercial property markets. Cap rates that reached a low of 5.17 percent at the peak of the cycle in 2008 are now on average 8.96 percent, which represents a 42 percent loss in value, before incorporating lower rents and higher vacancies that accompanied this trend. If you assume a 10 percent lower NOI as a result of weakening fundamentals, the value loss increases to 48 percent.

For markets like Harrisburg, PA, the news is not as bleak, mainly because values did not skyrocket and cap rates rarely went below 7 percent, making the value drop only 22 percent if NOI remained intact, or 30 percent if NOI declined by 10 percent. This is a significantly better result, but there is still a sizable equity gap to be dealt with when refinancing.

For example, if you financed a $10 million central PA shopping center with $8 million in CMBS bonds at the peak of the market in 2007, your property may now only be valued at $7–7.8 million (22–30 percent lower) in December 2009. Your new loan would be $5.25–$5.85 million under CMBS redux underwriting (assuming a best-case 75 percent LTV), thereby necessitating a $2.15–$2.75 million equity injection. Where will this equity come from?

There is a lot of opportunistic cash waiting in the wings to assist in these distressed situations, however, it comes at the price of significant equity dilution, if not a complete wipeout. Government programs like PPIP (public-private investment partnership) may soften the impact, but only for the best capitalized borrowers who have excess cash to deleverage. That leaves most borrowers still stranded, with no ability to refinance. If they do get a jump start in the form of new investor equity, they will have to share the keys with their new partner(s).

For leverage to increase on new CMBS loans, the market for non-investment grade bonds (rated below BBB-) must improve, both on an absolute demand basis and at a yield that allows reasonable interest rates on the underlying loans. There were no bonds rated below BBB- in any of the three issues that recently came to market, and none rated below “A” in two of the three. JPM was able to privately place $125 million in subordinate debt as part of the Inland transaction, which reportedly brought the total LTV up to 73.6 percent, but at an assumed high cost, given the 9 percent yield required to place the BBB- bonds.

Typical buyers for below investment grade bonds are investors willing to take risk for outsized returns, and many of these investors still fear further declines in Commercial Real Estate values. A reasonable position when you consider the past year’s dramatic increase in delinquency and special servicing in the loans collateralizing the $670 billion CMBS universe.

In addition to $33.23 billion in delinquent loans, another $32 billion need “special attention” for a total of $65.2 billion of loans in Special Servicing, or 8.95 percent of the total CMBS universe. The percentage of loans in Special Servicing has increased for 19 consecutive months and is now 22 times higher than the record low of .40 percent in August, 2007. This increase in distressed assets occurred during a period when relatively few CMBS loans were maturing ($20.6 billion in 2009). Looking ahead through 2010 and beyond, maturing loans increase significantly, and distressed assets likely will, also.

Although in the next two years there are less than $60 billion annually in CMBS maturities, overall commercial real estate loan maturities (all lenders) loom large at $200 to $300 billion annually between 2010 and 2013. There are some mitigating factors, and “seasoning” is a critical one. Most fixed rate CMBS are 10 year loans, so the 2010 maturities represent loans originated in 2000, before the boom years in value appreciation, meaning these loans should not be as over-leveraged. However, many floating rate loans were originated in 2005 or later, and often represented transitional properties where occupancies and NOI were expected to increase significantly; these rosy
projections likely did not materialize, so the floaters will be more problematic. Fortunately, the floaters are a much smaller problem since they represent only 5.3 percent of CMBS issuance.

It is encouraging to see signs of life in the moribund CMBS market, and we will see more CMBS issuance in 2010, hopefully in the range of at least $20–30 billion. Work has already begun on multi-borrower deals versus the single borrower issues done so far post-crash.

Much has also been learned on the legal documentation side, which will improve the quality of the asset class down the road, and thereby increase investor interest.

To determine whether the new model CMBS will run for individual borrowers depends on their property’s characteristics, market location, leverage, and the strength of the sponsor’s balance sheet. Those borrowers lucky enough to have kept the leverage load low should be able to pull out of the ditch and motor down the road, but it is likely there will be many left behind waiting for assistance.

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