Capital Markets, CMBS Not Likely to Return Until Mid-2009

MBA (3/24/2008 ) Murray, Michael
The capital markets will not likely return to full function for the next 18- 24 months, meaning commercial mortgage-backed securities will take a back seat in financing for the near term.

“It takes awhile to do these things to get them going,” said Arthur Margon, partner at Rosen Consulting, Berkely, Calif., speaking at an Urban Land Institute webinar.“You are not going to see very much in the first half of the year—if anything more—and it’s going to remain weak in the second half of the year."

As of March 19, the global CMBS market stood at $6.1 billion after U.S. CMBS hit more than $60 billion at this time last year, based on statistics from Commercial Mortgage Alert.

Margon said the result of no CMBS market is an all-cash or high-level equity buyer financed by loan-to-hold institutions. Despite more expensive loans compared to CMBS loan in 2006.

“At least for the next—in my view—18 to 24 months, that’s going to be the reality,” Margon said. “The interest rates [portfolio lenders] are charging for the loans are not horrendous interest rates. They are the kind of interest rates that in 2000 people would have said, ‘Oh, that’s not too bad. I can live with a falling cost of debt in the seven’s.’ But you’re not going to see the CMBS market come roaring back—in our view—anytime soon. You’re going to see more traditional kinds of lenders doing the financing as things loosen up.”

Peter Linneman, principal of Linneman Associates, Philadelphia, Pa., and Albert Sussman Professor of Real Estate and Finance at the University of Pennsylvania Wharton School of Business, also estimated 18 to 24 months for the market to return to normal but said the market is already eight months into the capital market crisis. He added that the fault of the capital markets crisis lies not in securitization but in bad monetary policy and ourselves.

“No condo loans were securitized but we got a bit excess in condo loans, I’d say,” Linneman said. “Japan never securitized a single real estate loan in the [1980s], and I think they had a bit excess; and in the [1980s] in the United States, we didn't securitize anything in the real estate markets—debt markets—and you got an excess. The issue is bad monetary policy—not purposely bad—but bad monetary policy and human hubris. It’ll take awhile.”

Linneman said CMBS has been driven by purchasers of the unrated tranche. “That buyer is gone because they refused to do it with short term financing, there is not enough equity out there to do it on an all-equity basis and there’s no CDO market to give an asset liability match,” he added.

“This has always been the conundrum of CMBS—who buys that long-dated, illiquid residual piece,” Linneman said. “That is going to take confidence. My guess is you’re going to see vehicles that have more equity and less debt than they used to which means they are going to require higher returns. But it’ll take time.”

Linneman added cashflows have only eroded on subprime underwriting while "the rest is all spread eroded." He said the Federal Reserve's increase of the prime rate from 1 percent to 5.25 percent 18 months later moved investor sentiment from "long and risky" to "short and safe."

"The margin that switched the demand from long and risky to short and safe—that caused margin calls, that caused the cascading effect on the downside," Linneman said. "It's not the first time this has happened, it's not the last time this will happen. Whenever you see something as big as this, you know it was caused by government policy. Nothing else is big enough."

Despite greater transparency in CMBS and equity securitization for real estate investment trusts (REITs) compared to 15-20 years ago, Margon said intermediaries expected to screen loans—ratings agencies and investment houses—did not provide enough transparency causing misplaced confidence by investors and putting significant amounts of leveraged capital at risk. He added that the transparency issue needs to be addressed for the CMBS market to come back in a significant way.

“There is going to have to be a more transparent look-through because in a lot of these cases, it’s not easy to figure out exactly what is in these securities and exactly what the situation is of the individual properties for loans that underlie the security itself,” Margon said. “Yes, there are government policy issues and, yes, there were human frailties and greed, but I think that there is also a structural issue. It’s much more transparent than it used to be, but it’s not there yet.”

Linneman said the capital markets crisis will simply take time to work itself out, but sources of capital remain. “I do think there is a lot of money out there,” he added. “It just has to be so attractively priced that people do it, and then you start a new cycle again.”

Margon said the investment banking community has been wounded by the capital markets crisis, and because they had an important role in bringing the capital together and dispensing it back out, it will take awhile until they are as active as they were before the crisis.

“I don’t expect them to disappear…the way the S&Ls did, but I think they may be on the disabled list…for the next year or so, before they can really come roaring back and playing that kind of role,” Margon said.

He added that sovereign wealth funds will be a source of capital in addition to high net worth individuals. Pension schemes from Australia and balance sheet lenders—large insurance companies here and outside of the U.S.—will also become available as capital pools.

Statistically, Margon noted that commercial real estate supply has been contained, and it moves into this downturn in “much better shape on the supply side than we have been for any cycle in my memory.”

“That means that the supply side is not going to cause the problem that we are going to have—whatever extent it may be—in commercial real estate and that the issue is going to be getting the economy back on its feet so that demand for the various real estate products stays strong, doesn’t fall out of bid,” Margon said.