2011 Real Estate Symposium: Restoring Functioning Debt Markets Panel
By Jared Nutt ’13
Jeffrey Barclay ’83, managing director and chief investment offiver of Goldman Sachs Asset Management’s Real Estate Investment Group, adjunct professor at Columbia Business School, and chairman of the 2011 Real Estate Symposium Steering Committee moderated the panel discussion on the state of the commercial real estate debt markets. Panelists included Robert Lieber, executive managing director, Island Capital Group; Anthony Orso ’90, executive managing director and CEO, Cantor Commercial Real Estate; and Daniel Ottensoser, Law ’96, managing director, Goldman Sachs & Co.
The panel discussion began by describing current issues facing the commercial mortgage backed securities (CMBS) market. One of the most significant issues highlighted was the approximately $55 billion of loans maturing in 2012, $19 billion or one-third of which were originated in 2007. Since October 2007, U.S. commercial property values have fallen 41, according to Moody’s/REAL Commercial Property Price Indices. Refinancing maturing CMBS loans in 2012 will be challenging not only as a result of depressed commercial property values but also because of slow economic growth and limited availability of borrower equity. At the time of the panel discussion, CMBS delinquencies stood at 9.13, up from 8.89 at the beginning of 2011.
A linked issue is curtailed CMBS issuance, which totaled $30 billion in 2011 through the third quarter. While this figure is up significantly compared to the same periods from 2008 through 2010, it falls well below the level necessary to absorb impending maturities. The panelists cited several root causes of the lack of CMBS issuance. The first of which is the high cost of capital associated with CMBS lending, which was estimated between 500 and 600 basis points. The cost of capital coupled with the high volatility of CMBS spreads makes CMBS lending a risky endeavor. Additionally, B-piece buyers have gained more negotiating power over the past several months, as only four to six buyers remain in the market. These buyers have increased yield requirements and have instituted higher loan kick-out rates. Thus, the profitability of CMBS issuance has been impacted by wider pricing at the bottom of the capital stack. Finally, the long-term effects of financial regulatory reform and new capital requirements facing financial institutions, such as Basel III, cast considerable uncertainty regarding the viability of CMBS lending.
The panel later turned to resolutions of troubled CMBS loans. Special servicers are faced with significant volume of workout activity and have a desire to offload loans from trusts, as the cost of holding the troubled loans in the trusts is substantial. This trend follows closely to how domestic commercial banks are exploring selling portions of their commercial real estate loan portfolios. The economics on performing whole loan sales have averaged between 70 and 80 cents on the dollar of the outstanding balance. Investors have sought 15 total returns. These investors have mostly been of the ‘buy-and-hold’ variety.
As it relates the regulatory environment, the panel focused on the issue of mandating ‘skin in the game’ for CMBS issuers pertaining to the performance of a CMBS deal. The consensus opinion was that such a mandate is unnecessary. Essentially, it is not the objective or in the best interests of a CMBS issuer to structure a loan that will fail. The systematic risks that led to the downturn were unforeseeable. In addition, B-piece buyers can’t be absolved from CMBS credit issues. B-piece buyers hired third parties to underwrite for them. Also, collateralized debt obligations (CDOs) backed by B-piece tranches turned out to be very problematic, leading to overly cheap debt in market and adding leverage on top of leverage. Notwithstanding these issues, positive developments have occurred that mitigate these concerns. First, smaller CMBS deals lead to more manageable due diligence processes on the part of CMBS investors. Second, debt yields are stronger, typically 11 or higher. The panel stressed that certainty in the regulatory environment is integral to functioning debt markets.
As another component of uncertainty, the European sovereign debt crises have caused havoc for many financial institutions and the macro economy. Commercial real estate lenders with European exposure have continued to hedge risks, trading in and out of positions. According to the panelists, others have found an opportunity to lend given less competition from European financial institutions, which may be required to raise $150 billion in new capital. Of course, special servicers are looking to build operations in the European Union should the crises cause further deterioration in credit.
In summary, commercial real estate debt markets continue to slowly, but surely, work through issues relating to the downturn since late 2007, but are hampered by uncertainty as it relates to regulatory reform and the macro economy. These issues must be resolved before full restoration and functionality. On a positive note, the panelists concluded that the commercial real estate debt market may be better off given what has happened, specifically pointing to higher CMBS subordination levels, more conservative underwriting, and lower leveraged transactions.