Financing commercial real estate isn't easy these days. Uncertainty about the economic outlook, capital concerns among lenders and a general lack of consensus about which way things are headed has lead to conservatism among lenders. But despair isn't the only option. Instead, the numbers seem to be pointing — once again — to the importance of knowing the market and one's place in it over the long haul.
In 2008, mortgage origination levels were only 40 percent of 2007 levels. Commercial real estate owners slowed their borrowing and lenders slowed their lending. And things got slower as the year progressed. During the fourth quarter, loan volumes were only 20 percent of 2007 levels.
But interestingly, while borrowing has dropped precipitously, the amount of commercial and multifamily mortgage debt outstanding continues to rise. The Federal Reserve Board reported $3.5 trillion in outstanding mortgages on commercial and multifamily properties at the end of December 2008. This represents an increase of $166 billion, or 5 percent, over the year.
This seeming paradox is driven by the fact that fewer mortgages are paying off. During the go-go days of 2006 and 2007, heavy transaction volumes meant that lenders needed to originate significant volumes of new mortgages just to replace the mortgages they saw pay off when properties sold. Counter to what we keep hearing, the amount of capital is actually increasing. The challenge is that less new money is being lent and the environment has changed dramatically.
During 2006 and 2007, when rents were rapidly rising and vacancy rates dropped, lenders were under competitive pressure to underwrite loans based on pro-forma rents — sometimes basing their underwriting decisions on forecasts of future incomes. With the current downturn, some properties are again facing pro forma underwriting — but today that often means lenders are marking down incomes based on expectations of where the recession might take rents and occupancy levels.
The same is true for values. Since their peak in 2007, commercial real estate prices have declined by between 16 percent and 22 percent. Given that lenders look to the property as security for their loan, a drop in property value can mean a drop in the size of the loan. For some properties that were highly leveraged at the market's peak, value declines may have eaten into equity to a large enough degree that financing is negatively affected.
Another key variable in the market is the mortgage rate. Base interest rates on which commercial mortgages are priced are generally at or near historic lows. The 10-year Treasury has been under 3 percent in recent months and the three-month LIBOR — while above short-term Treasury rates that are hovering around zero — remains very low.
What's different is the investor spread. Lenders and investors in commercial mortgages have a wide range of high-yield investment alternatives. To compete, commercial mortgages need to provide similar risk-adjusted returns, meaning the mortgage spread charged above those very low base rates has become relatively high. The result is all-in rates that remain low by historical standards but can sometimes bring surprise to borrowers used to a lower mortgage rate relative to Treasuries or other base rates.
For those who do have loans coming due or conditions or terms that are changing, the best advice is to start early. Deals today will likely take longer than they did in the past. Purchases, refinancings, loan modifications, assumptions and most every other type of transaction may all take longer.
The commercial real estate markets are going through their most significant recalibration in 20 years. That's providing challenges — and long-run opportunities — for buyers, sellers, lenders and almost everyone in between. Rather than ignore the situation and hope it goes away, now is the perfect time to make plans for the long haul.