10/16/2009

Lenders Gloomy as Credit Crunch Drags On

More than two years into the credit crunch, commercial real estate lenders still see no easy way out.

Property prices have yet to hit bottom, leaving both owners and lenders in disarray. The fresh capital pouring into the sector is dwarfed by the amount of debt scheduled to mature over the next few years. And several factors are combining to slow the massive wave of deleveraging necessary for the re-emergence of a sustainable lending market.

The upshot: Despite the emergence of a few "green shoots," the commercial mortgage market still has at least a couple of years of deep pain ahead.

That's the consensus of a dozen debt-market pros interviewed by Commercial Mortgage Alert. While there was some disagreement on just how rough the road would be, most saw significant obstacles to a return of active originations. All agreed that the coming challenges would unfold slowly over several years, rather than result in a sudden meltdown. Likewise, they felt that originations would re-emerge slowly, as market-clearing prices are established across asset types and as worked-out properties qualify for loans in the new world of strict underwriting.

The main concern for the next few years is the overhang of maturing debt that won't qualify for refinancing. "I think this is a much bigger problem than people realize," said Jack Taylor, a managing director of Prudential Real Estate Investors. "The magnitude is unprecedented. It's much larger than we experienced either in volume or systemically in the RTC days."

"It will be a long, slow slog out of this," agreed David Rodgers, a principal at advisory firm Park Bridge Financial of New York and a former executive in Merrill Lynch's commercial mortgage group. "The shoes will drop for years to come."

Added Steven Ball, who ran Merrill's commercial real estate finance operation for eight years and now heads FundCore Finance of New York: "The next 24 months will be slow and painful."

While there is money available for loans, that won't help owners who are underwater. Plunging property values have wiped out the equity of many investors who used high leverage to buy real estate since 2006. Especially distressed are those who qualified for larger loans on the basis of projected increases in rents and occupancy rates that haven't materialized. What's more, stricter underwriting standards have reduced the size of loans, further widening the gap between existing mortgages and takeout financing.

Because of cyclical patterns, the volume of maturing debt over the past two years was relatively low. But refinancing demands pick up dramatically over the next several years. Deutsche Bank calculates that maturing portfolio and commercial MBS loans will rise from $204 billion this year to $247 billion next year, $296 billion in 2011 and $338 billion in 2012.

To be sure, new capital is flowing into the market. For example, about 350 property and debt funds have raised some $135 billion of equity since 2008, according to sister publication Real Estate Alert. Also, REITs have sold $15.6 billion of stock this year and have floated another $9.2 billion of unsecured debt, according to Wells Fargo. And four mortgage REITs have lined up $1.5 billion via IPOs since August.

But those numbers pale in comparison to the amount of capital needed by property owners. A Pru Real Estate research report estimates that if the $2.8 trillion of mortgages originated between 2005 and 2008 had to be refinanced today, the underlying properties would qualify for as little as $2 trillion of debt, creating a "funding gap" of up to $825 billion that would have to be filled by writedowns or fresh equity.

"People say, 'Wow, look at all the capital that has formed,' " said one veteran lender. "But it is minuscule compared to what is needed."

Because of a combination of factors, problems so far have unfolded in slow motion, at least when compared to the housing sector. Unlike some other investors, many property owners don't have to mark their holdings to market value. So as long as they can make their loan payments, the crunch does not come until loans mature. Long-term leases have delayed the day of reckoning for many office landlords. And extraordinarily low Libor rates have helped borrowers with short-term loans skate by.

Also, lenders and owners have a mutual interest in kicking problems down the road. Lenders are willing to extend loans rather than recognize losses that could cripple their capital bases. "They don't want to panic sell and go out of business, nor sell like they did in 1991 and give the house away," said one veteran lender.

Owners often are also motivated to hang on. "A lot of them make money from the management of the property," said Mark Zussman, a portfolio manager at HypoVereinsbank. "That's cashflow for these guys. They aren't going to give up easily if it's a good, solid property with upside potential. Some developers have resources that will let them hang on as long as they can."

"Time is what everyone is hoping for," said Bill Green, a former real estate chief of Wachovia who now is a principal at Tannery Brook Partners, a Charlotte advisory firm. "Enough time to make something happen at the asset, time to let inflation occur, time to allow for the further rallies in public equity markets and time for new forms of debt capital to emerge."

For that reason, market pros said, problems will surface gradually. "Everything will not come to a screeching halt," said Jon Strain, managing director of J.P. Morgan. "Some loans will be extended, some will pay off, and some will face foreclosure. There will be calamities each month for the next three years, and maybe longer."

So far, 75% of CMBS loans scheduled to mature this year, by balance, have been refinanced, according to Citigroup. "Borrowers may complain about the lack of financing, but when push comes to shove there is money out there, and they don't want to lose their property," said analyst Darrell Wheeler.

But as large CMBS loans originated near the frothy peak of the market come due, far fewer will qualify for full refinancing, according to an analysis by FundCore. "For loans of more than $50 million, the percentage, by loan count, shrinks to 34% in 2010 and to just 12% in 2011," said managing partner John Mulligan.

Those figures suggest that defaults will soar. "The reality is, 80%-leveraged loans, with property values down 35%, may mean that borrowers effectively sold their properties to the triple-A bondholders," said Strain.

Overdue loans, especially on construction projects and hotels, will face foreclosure first. Also, maturing CMBS loans will tend to come under pressure sooner than portfolio loans. "CMBS is a closed system," said one lender. "It does not have outside revenues to re-equitize with. So special servicers will be forced to sell assets. Banks, on the other hand, can make money. So they will move more slowly, working out loans with existing borrowers and taking equity kickers. They will take the property only if the borrower is a bad guy or if cashflow is so low that it's futile to restructure."

A few positive signs have emerged lately. Insurance companies are actively pursuing low-leverage loans on high-quality properties. CMBS spreads have tightened significantly, to the point that Citi's Wheeler thinks some securitization programs might be willing to resume amassing small loans for CMBS transactions. And last month, the U.S. Treasury Department released tax-rule guidance that may make it easier to restructure troubled loans, prompting Alan Todd, a CMBS analyst at J.P. Morgan, to reduce his projected loss rate on CMBS transactions issued in 2007 by 50 bp, to 9%.

But the slow ongoing pace of resolution for overleveraged loans is delaying the market from hitting bottom, which in turn is preventing a widespread resumption of lending. Debt pros said the negative-equity hole of property owners can't be filled by new loans, but only by lender writedowns and the establishment of lower, market-clearing prices, which will drive up property capitalization rates.

"We live in a world where cap rates have to be higher than the cost of debt," said Strain. "Right now, the opposite is true. Cap rates have got to widen or mortgage rates have got to come down. But it is not at an equilibrium yet, it is not sustainable. All the investors I speak to think the world will settle at an 8-10% cap rate, with 9% the average. If that's true, mortgage capital has to settle at less than that, at 6-8%."

Added Rodgers of Park Bridge: "If you wrote a loan today with a 75% loan-to-value ratio and a reasonable coupon that a borrower would pay, you couldn't sell it at par value. So why would you make such a loan? There is much more fear than greed now among commercial real estate debt investors."

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