COVER STORY, FEBRUARY 2009

REBUILDING THE ENGINE
After the paradigm shift turned out to be shifty, it's time for a new outlook on commercial real estate finance.
Mark Zytko

Not including the relatively modest downturn in 2001, it’s been nearly 20 years since the last dramatic real estate slump. History will likely show that the real estate boom of the past 2 decades will be defined by the years between 2001 and 2007 when the industry was running on the redline. There was a new paradigm in real estate. Earnings and cap rates didn’t matter anymore. Sounds kind of like Internet stocks. But any time people tell you there is a new paradigm, it’s time to be afraid, very afraid.

During that period, the risk premium between senior lending, mezzanine and equity became blurred. Values skyrocketed, not driven by strong underlying fundamentals but by hyper liquidity and the continued and dramatic decrease in the cost of capital throughout the capital stack. To make money in real estate, one simply had to get in the way of the train. Trophy assets were trading at 3 to 5 percent cap rates, values that were simply unsustainable. We were at redline for too long and we blew the engine.

Before we can move forward, we must first rebuild the engine. The industry needs to move away from the financial engineering of the past to a market based on real estate fundamentals, with strong underwriting and discipline. The industry as a whole needs to return to a point where values are based on performance. Owners must demonstrate good fundamentals, property operations and asset management. Those that can out-operate their competition will succeed.

Outlook for 2009

For the near term, lending should remain extremely muted, and it will take a year, maybe longer, for capital markets to stabilize, after which markets and values will begin to grow. Contributing to the malaise is the fact that values aren’t done falling, simply because there is an unwillingness to transact. Many people don’t have the money to transact, and for those that do values are not attractive nor are returns high enough to induce them to take the first step. Hyper liquidity contributed to driving up real estate to hyper values. Prices need to drop 30 to 40 percent or more from their peak. That may mean another 10 or 20 percent depending upon the market or property type. Values in core property types in core infill locations should fall less. The weaker real estate and weaker markets will fall a lot more, but overall should stay in that range.

Debt capital will be limited. For strong borrowers and core property types, it will be available but very moderately leveraged in the 50 to 60 percent loan-to-value range. The price of first mortgage loans will be high — 7 to 9 percent. Rates and spreads will be high compared to recent times, but reasonable historically and on an absolute-cost basis. Mezzanine capital will be more available than first mortgage debt and will fill the space between the first mortgage and 70 to 80 percent loan-to-value range. This capital is and will continue to be priced in the low to high teens depending upon the transaction.

Equity is available, but it doesn’t want to play because prices haven’t dropped far enough. While some would say it is irrational that equity isn’t taking advantage of reduced values, it is being patient and waiting for values to come down to a more attractive level. Two things need to occur to attract equity to the market: first, a confidence that prices have become attractive and, secondly, the returns available have to be attractive when compared to other opportunities such as distressed debt.

One of the biggest questions facing the industry: what will happen to the large volume of CMBS deals that are maturing in 2009 and beyond? While bigger than the market can absorb due to the acute lack of capital, the amount of CMBS deals maturing in 2009 will be relatively small ($20 billion). The stabilization of the market and flow of capital will really be tested in 2010 through 2012 when much larger volumes of deals mature (see cover graph). Ironically, it is those deals that are coming due in 2009 that should contribute to the real estate recovery. If it does nothing else, the recapitalization of those deals will stimulate deal flow and help define the new level of stabilization.

Transaction volume is good for the market, and CMBS maturities will provide this volume. This will take place in multiple ways: borrowers will have to refinance (which may require a recapitalization with mezzanine financing or new equity in addition to a new first mortgage), sell the property or be foreclosed on.  Since interest rates on most recent vintage debt are quite low, defaults during the term of the loan will be less of a factor than defaults at maturity. Because of low interest rates and interest-only payments, the option payment to stay in the game is relatively low even for sub-performing properties and overleveraged loans. The hope for owners is that the capital that is available now will bridge them through 2009 to 2011 and 2012 when real estate markets and the economy should be recovering.

If the industry begins to stabilize in 2009, we won’t take as big a hit as many predict. The much larger pool of loans coming due in 2010 and 2011 will really test any stabilization and recovery we begin to feel. This 2- to 3-year period provides a good runway for the economy to get back on track.

While the securitization markets are standstill, portfolio-oriented lenders, such as private lenders, commercial banks and life insurance companies, will have to step in to replace CMBS. These capital sources will be the bridge until CMBS comes back in a more conservative form by 2010 or later. After a 20-year long run of successes driven by a strong economy, and later in the cycle-continuing drops in capital costs, capital providers became undisciplined. In the early 1990s, there was the savings and loan crisis, and the RTC; today there are the credit freeze and the TARP. Just as commercial real estate made it through the early 1990s, markets will stabilize and make it through this cycle. Capital that has fled the markets will return when values are reset and prices become attractive again. That said, the amount of CMBS capital that was deployed in 2005 to 2007 may never have to be replaced, because values have come down 30 percent, capital stacks will be lower leveraged and the velocity of trading that generated those extreme volumes won’t be seen again anytime soon.

For example, let’s say in 2007 a property worth $100 was financed at 85 percent loan to value (LTV) for $85 of loan volume. Today, that same property may be worth about $70. A new loan at 60 percent LTV would require $42 of debt capital in the near to medium term. That difference between $42 and $85, which doesn’t need to be replaced in the new world, represents a 50 percent decrease in required debt capital and the size of the CMBS market. Another factor to consider was the velocity that drove the CMBS market. Properties were trading so fast that the same loan could show up in the same market two or three times in the same year. For example, the office buildings from the Equity Office Properties portfolio showed up in CMBS financings as many as four or five times in 2007. Since properties won’t be trading at such a rapid-fire pace, there is no need to replace that capital, nor those volumes.

While not all borrowers and recent vintage deals will survive the downturn, those that can outperform and have the ability to recapitalize will make it through and be rewarded. In this market any access to capital should be utilized. Even if a loan isn’t attractive, if it helps a sponsor get through the cycle they should seize that. In the old cycle, borrowers bid the cost of capital to the bone. In this cycle the key factor is availability. If someone offers you capital, take it.

Mark Zytko is a principal at Los Angeles-based Mesa West Capital.

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