For Borrowers, Half-Full Glass Could Pour Empty

MBA (5/27/2008 ) Murray, Michael
Few commercial mortgage players believe the halcyon days of 2006-2007 will return anytime soon—if at all—but some industry participants still view the glass as half-full. And with low interest rates, some say the best future for commercial real estate borrowers is now.
"We see a need to look at the glass as half full, not half empty, and to realize that today's rates are attractive even though they don't resemble the types of leverage that we saw in 2007," said John Levy, principal at John B. Levy & Co. Inc., Richmond, Va. "We do think, however, that today's rates will be cheaper than they will be in the near to intermediate term."

Levy said that volume was historically well above average in late 2005-2007, and this year’s first four months appear more like the same time in 2004.

"It's important to remember that 2004 turned out to be a very solid year," Levy said. "With that in mind, I think it depends on how we want to look at the market. Do we want to look at it as having a glass that's half full or a glass that's half empty? When does the 2007 market return? In our opinion—no time soon."

“[ Commercial mortgage-backed securities] will come back but not anywhere near the driver it was,” said Michael Lipson, CMB, executive vice president at Capmark Finance Inc., Horsham, Pa., who foresees major industry changes in the next five years. “The days of the 1990s and early 2000s are gone. Five years from now, I believe it will be a very different industry.”

Levy said the 2007 market would likely go down as an "aberration" rather than a normal CMBS market, and that aspects of the commercial real estate debt market are working today—including moderate interest rates.

"Interest rates are what you pay. Even though spreads are high, interest rates are very, very moderate. Today, money costs somewhere in the 6-6.5 percent range and by historical standards, that's just cheap," Levy said.

Spreads in the CMBS market increased as the synthetic CMBX indices widened when macro-hedge funds shorted the market. Synthetic CMBX was formed as derivative to act as a form of insurance or leverage against pricing in the CMBS market, but negative headlines produced the appearance of a CMBS market headed for delinquencies and defaults, lumping highly leveraged commercial real estate CMBS loans with the residential subprime market. The result of market volatility and wider spreads kept CMBS investors out of the market.

Some analysts said market volatility and panic stopped and consistency returned to the capital markets once the Federal Reserve provided J.P. Morgan partial funding to purchase Bear, Stearns & Co. Inc. The Dow Jones showed its most significant drop last week compared to recent weeks based on rising oil prices and inflation concerns by the Fed.

RBS Greenwich Capital, Greenwich, Conn., however, reported last week that cash fixed-rate CMBS spreads tightened by 25 to75 basis points . RBS said 125 CMBS were upgraded and 52 downgraded, for a 2.4 to 1 ratio, a "steep falloff" from the 2006/2007 ratios of 16 to 1 and 9 to 1, respectively. Earlier this month, Standard & Poor's reported that the CMBS market has been resilient; the Mortgage Bankers Association's Commercial Delinquency Survey in March showed CMBS delinquencies remain at historical lows—.4 percent. CMBS delinquency rates at the end 2007, for example, were lower than those at year-end of nine of the previous 10 years.

Despite low delinquencies, the growing number of recent-vintage investment-grade downgrades in CMBS concerns RBS Greenwich. The firm reported that in April, three 2006-vintage CMBS saw downgrades, with one 2006 experiencing downgrades to [investment grade] classes. The absolute number of CRE CDO ratings actions remains low, but they are growing.

"A well delineated trend is emerging," said Lisa Pendergast, head of CMBS strategy at RBS Greenwich. "Deals collateralized by high levels of [investment] bonds are seeing upgrades, and those backed by low [non-investment grade] bonds are seeing downgrades to 2007 deals."

Levy said, historically, spreads will decline over time but treasuries increase faster than spread declines.

"As a result, as a borrower or an owner, you actually pay higher rates. If you are waiting for average rates to decline over the near or intermediate term, you are going to be gravely disappointed. And if treasuries decline, then we are in a real serious recession where it [would] be difficult to get any real estate capital, much less at attractive rates and attractive leverage levels," Levy said.

Borrowers could lock in a three-to-five year loan rather than a long-term loan to avoid the current credit market turmoil while absorbing a “modest” prepayment, Levy said. He recommended mezzanine debt, preferred equity and joint ventures as resources to add leverage for borrowers.

"That type of extra leverage may be necessary to get the total leverage that [borrowers] need," Levy said. "But keep in mind that today's underwriting is based on actual cash flows. The proforma cash flows or the 'make-believe' cash flows that were in 2007 and even 2006, they're gone. Looking ahead, in predicting rates, we would not encourage [borrowers] to wait."