How commercial real estate is dealing with the credit crunch

Current commercial real estate market conditions have been labeled many different ways—some experts say it’s a necessary slowdown, while others quibble over whether it should be cast as a pothole, sinkhole or even a multi-car pileup. But regardless of how one chooses to define it, just about everyone agrees on its origin: a severe “credit crunch”— shorthand for a tightening squeeze on the availability of capital—which resulted from the virtual collapse of the sub-prime home mortgage market last year. Also stemming from that collapse are record numbers of home foreclosures, a weakened economy, the recent governmental takeover of finance giants Fannie Mae, Freddie Mac and AIG, and the bankruptcy or buyout of one colossal financial institution after another.

What Happened?

The first domino leading to today’s reality may have been set when residential home loans were first pooled together and sold as funds back in the 1960s, said Glenn Mueller, real estate investment strategist for the Dividend Capital Group and professor in the FL Burns School of Real Estate and Construction Management at the University of Denver.

“The idea of pooling loans, and reducing the risk to investors through quasi-government agency guarantees via Freddie Mac and Fannie Mae, made loans significantly easier to get and more affordable,” Mueller said, “and helped push the United States into the number-two position for home ownership worldwide (Sweden is first). But it wasn’t without risk.”

In the late1980s, the commercial real estate industry decided to jump on the bandwagon, pooling loans and transferring them to trusts, which then issued a series of bonds with different ratings; a pool of $1 billion in commercial loans could, for example, be made up of 80 percent AAA, AA or A rated bonds; 15 percent rated BBB, BB or B; and the remainder non-rated. (In such a situation, the AAA bonds get paid first from the interest and principal received from all of the pooled loans, then the AA, and so on down the line, leaving the non-rated bonds the ones that don’t get paid if someone defaults.)

The varying levels of risk between investment options opened up the commercial real estate market to a much wider range of investors than ever before, with commercial mortgage backed securities (CMBS) on the debt side and real estate investment trusts (REITs) on the equity side the most popular vehicles. But other, more risky options developed a following as time went on, including “collateral mortgage obligations” (CMOs), which were oftentimes low-rated pieces, or “traunches,” of CMBS deals. In other cases, the high-risk CMOs were made up entirely of non-rated loans that investors figured would at least bring in some money when at least some of the loans were paid.

The trouble with them, Mueller pointed out, is their synthetic security—investments are backed by a piece of paper rather than a bricks and mortar asset.

The first reality check of investing during troubled economic times came during the real estate crash of 1990, when a lot of financial institutions started shedding unpaid loans, and a Resolution Trust Corporations (RTC) was created to pick up the debris. But soon enough, some investors started looking at higher-risk rated bonds in new ways; one publicly traded mortgage REIT in Washington, D.C., for example, would tour all of the properties bundled in a CMBS pool and tell the CMBS mortgage originator which of the properties they wanted taken out of the CMBS pool, while the properties that were left out ended up being held by the bank. Mortgage REITs ultimately helped to facilitate the growth of the CMBS market by purchasing the high-risk, non-rated traunches, but when the REIT market crashed in 1998 and stock prices declined, the mortgage REITs couldn’t buy those traunches anymore, and the banks were stuck with them, as well.

“Banks are in the business of doing transactions—not investing in securities or managing real estate—and it wasn’t good for banks to hold these non-rated securities or higher risk properties,” Mueller said.

Similar things were happening in the residential markets, as the CMO model expanded to collateralized debt obligations (CDOs) and started taking on other high-risk deals, such as for credit card debt and, eventually, to sub-prime mortgages for people who wouldn’t normally qualify for home mortgages. It wasn’t long before financial verifications, home appraisals and required down payments went out the window leading to one of the greatest expansion of home ownership, the catch being many homebuyers were investing beyond their means. Then, the originally low-interest-rate loans started to adjust up, and many borrowers found they could no longer pay. In short order, the sub-prime mortgage market crumbled, and a very fragile house of cards in residential lending began to collapse.

Today’s Reality

Today, commercial banks are sitting on billions of dollars of CMBS loans that they originated, but CMBS buyers are scarce. And without being able to sell current loan securities, they’re in no position to make loans. That squeeze, of course, applies to all; if 20 percent of all bank lending goes to real estate, there’s no defining line between how much goes to residential and how much goes to commercial, so the entire industry suffers.

Ray Torto, principal & chief strategist for CBRE Torto Wheaton Research, who views yesterday’s market as “froth” and today’s market as a necessary correction, points out that the Riverton apartment complex in Harlem is a classic example of froth going bad: “In 2005, a group bought Riverton for $131 million. In 2006, they refinanced it with a $225 million, 10-year, interest-only mortgage, presuming that they could convert some rent-controlled apartments to market-rate and significantly boost income. That level of conversion didn’t happen, and they’re now in a position of not being able to pay off their $225 million loan. If they ultimately have to default on the loan, the bank will get stuck and will have to re-sell the original $130 million loan back into the marketplace. They’ll then have to make up the discrepancy of almost $100 million, and until they do that, they won’t have the ability to lend to others. It’s a vicious circle.”

“What makes the situation even more interesting,” Torto added, “is that the income on the Riverton apartment building probably didn’t change much. Rents may have even gone up. The only thing that did change was the value of the property, and the owners got stuck with a short-term liability—the result of their refinance based on faulty assumptions—that they then couldn’t pay off. It’s all a matter of people reducing their due diligence and borrowing money assuming that asset prices would only rise and never fall.”

The end result is significant: According to Thomson Financial, investment in commercial office space fell dramatically to $48.2 billion in the first four months of 2008, down 69.5 percent from the $157.8 billion during the same period in 2007 when credit was easily available. Many believe the volume of deals will not increase until a downward repricing of real estate takes place.

Not surprisingly, some asset types are more affected than others. Retail is perhaps the hardest hit, with consumers cutting back and high gas prices keeping people at home. Industrial is perhaps second up from retail, with hotels third as fewer people travel due to fuel costs and airfare increases. Office is also feeling the heat but holding its own, while at the top end are apartments, with more people turning to rentals following foreclosures on their homes. Along those same lines, self-storage emerged as the strongest REIT in the first half of this year, with returns up more than 12 percent according to the National Association of Real Estate Investment Trusts (NAREIT) for the simple reason that those same people who have turned to rentals need a place to store their extra belongings.

Also performing well are medical office buildings (MOBs) and healthcare facilities. As Brent Tharp, senior vice president and sales manager of medical properties for GE Healthcare Finance, pointed out, people get sick and age in good economies and in bad.

“The government pays for half of all medical care in this country, which of course could change in the future,” Tharp added. “But in general, as long as the government is trying to save money, healthcare will push out to areas where it costs less to deliver it. The most expensive place to receive care is in the hospital; the least expensive is in the doctor’s office. And that’s the fundamental reason that medical space should do well.”

Danny Prosky, executive vice president of healthcare real estate for Grubb & Ellis Realty Investors, also noted that healthcare real estate has been historically dependable, with rental rates growing around three percent per year, regardless of which direction the economy is headed. And while he has noticed perhaps a slight drop in deal volume this year, it is nothing like the 70 percent drop seen on the office side.

“We’re low leverage buyers, which positions us well in this market, and we’re still seeing access to money. It may take longer to borrow—weeks versus days—but it’s still there,” Prosky said. “And although the overall returns with MOBs are never extremely high, they are consistent, and we expect them to continue to be. Healthcare is the fastest growing segment of the gross domestic product (GDP), and demand for space will continue. After all, we don’t need an increase in the population to increase medical need—we just need an aging population that demands more access to medical care—and all the Class A office space in the world isn’t going to help a doctor they need medical space.”

Still, Tharp points out the flip side to the argument that any one asset is truly recession proof: “The credit crunch is a global problem and not asset specific. So if a bank is going to lend to an MOB, they’ll lend to other projects too they’re either in the market or they’re completely out of it—no one is dabbling. I’ve been in finance for 20 years, and I’ve never seen this level of broken deals, or deals coming back with different buyers, sellers, and lenders. I don’t see that aspect of it changing until the credit crunch is over.”

So when exactly will the credit crunch be a thing of the past? Absent a crystal ball, no one can say for sure, but most experts have revised their initial predictions that things would start heading north by the end of this year, largely because no one foresaw the spike in oil prices that mitigated the effect of Congress’ fiscal stimulus package. Instead, most are now leaning toward the middle of 2009 before economic recovery may begin, which would mean that it could be late 2009 or early 2010 before commercial real estate markets catch up with the rest of the economy and begin to recover.

About the Author: Stephanie J. Oppenheimer, APR, formerly the assistant vice president of communications for BOMA International, is principal of Skylite Communications, a freelance writing and editing company based in Falls Church, Va.