Will Liquidity Return to the Market Soon?

Insights into the future of commercial real estate lending

by Josh Slaybaugh, President, Trade Up 1031

As those involved in the commercial real estate market know, deal volume is way down this year. The latest numbers, according to a report by Jones Lang LaSalle, indicate commercial real estate transaction volume plummeted in the first three months of the year to $39.2 billion, a 69% decrease from levels a year ago. It seems that there are two primary forces at play causing this slow-down. One is simply overall economic uncertainty and the other is the lack of available debt for refinances and new purchases of commercial assets.

The general uncertainty and low consumer confidence stems from a number of factors, including record high crude oil prices (translating to record high prices at the pump), the rising cost of food and other staple items, and of course, increasing residential foreclosure rates and a growing inventory of unsold homes across the country. Add these together and throw in a presidential election year and you’ve got a recipe for the predominant “wait and see” mentality permeating and in turn, stagnating the market.

Like always, in times like these, most people gravitate towards either of into two camps of thought: the “wait and see” party and the more opportunistic “sell into greed, buy into fear” vultures. In many areas, CAP rates for most asset classes have been on the rise as seller’s expectations slowly are aligning with buyer’s requirements and the reality of what they can finance. Sellers in today’s market seem to be both cautious of finding qualified buyers, but also eager to close quickly once under agreement.

Of course, this leads to the other current sticking point in the commercial real estate market, the ability for buyer’s to get their required terms and loan-to-value from lenders. Nearly every owner and broker I know has been involved with or close to a deal that fell apart in the past 6-8 months due to problems with securing adequate financing. An all-cash buyer has the deck stacked in their favor. Since there’s no need to wait for a mortgage commitment or possible contention with a negative leverage situation, these buyers are poised to take advantage of the current up-tick in cap rates and seller attitudes. However, the rest of the market that needs, wants, and counts on borrowed funds to make their acquisitions are still having a tough go of things.

When will spreads tighten?

When will the national and regional lenders get back in the game of lending to commercial real estate investors?

Good news may be on the way. Conduit loans, loans that are subsequently rated, packaged and sold off in securitized tranches as commercial mortgage backed securities (CMBS) were especially hard hit by the wave of panic experienced by lending institutions in the fall-out of the sub-prime meltdown. Loans of this type were a driving force behind a great number of large commercial real estate transactions over the past few years, but recently had all but disappeared from the marketplace. A new study released June 2008, commissioned by the Commercial Mortgage Securities Association (CMSA), presents new data on the mispricing of commercial mortgage-backed securities (CMBS) compared to their fair value and returns relative to risk profile. It concludes that “current spreads for most CMBS vintages are still far wider than their fair value, an irrational market reaction that presents significant arbitrage opportunities for investors.” The study analyzed approximately 39% of all outstanding fixed rate conduit CMBS and the consensus is that investors have every reason to be optimistic. Fixed rate, investmentgrade CMBS performed exceptionally well in the stress-test analysis and the vast majority are at little to no risk of downgrade in a recession, but are current spreads “unreasonably imply a ‘doomsday scenario.’”

What does all this mean? Hopefully, as real estate capital markets sift through these recent findings and investors settle in with a new Commander-in-Chief, some semblance of normalcy and transaction volume will return. Most industry experts don’t believe we’ll see year 2007 levels of CMBS issuance and investment property sales anytime soon, but perhaps a “back to the future” of the year 2004 is in order. As one of my peers recently said to me, “I don’t know about you, but I remember 2004 as a pretty good year for me.”

References: Commercial Mortgage-Backed Securities Prices Reflect Irrational Fears, Study Predicts CMBS to Perform Well in Recession- “In Search of Fair Value for CMBS” Forecasts Minimal Downgrades, Defaults and Losses, Presents New Data on Market’s Mis-pricing of CMBS. New York, June 9, 2008

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