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Liquidity May Be Drying Up

For the past six months, analysts and market observers have been contrasting the performance of single-family housing and commercial real estate. Conventional wisdom is that even though the residential market continues to self-destruct — particularly the subprime category — commercial real estate remains strong. That trend is noted in the latest commercial loan origination numbers from the Mortgage Bankers Association (MBA).

While the MBA's commercial and multifamily loan originations index in the first quarter shows volume declining 15% over the fourth quarter of 2006 — a normal occurrence due to seasonality — volume rose 37% over the first quarter of 2006, and is generally on a high-growth trajectory.

This surely explains why the outlook among investment advisors is for continued growth in commercial real estate. However, an emerging trend in the corporate debt markets, combined with continued fallout in the residential space, is taking aim at the safety of sacred senior classes of bond issues.

High-risk investors are demanding higher returns for the increased risk they now perceive in the marketplace, and these developments can no longer be ignored. In fact, they should temper investors' near-term optimism.

LBO troubles

When bond traders reported weak demand for a slew of prominent, high-yield corporate bonds during the week of June 25, market analysts expressed concern about many large leveraged buyouts (LBOs) still in the offing.

The disappearance of buyers for high-yield bonds — including the corporate offerings paying coupon interest rates in the low teens — could be a sign that liquidity is drying up in other sectors as well.

Traders noted that the investment-banking firms stepped in for the first time in many years to shoulder most of the burden in absorbing these offerings. The developments caused some planned LBO financing to be postponed because they are extremely dependent on demand from high-yield buyers. Commercial real estate-backed bonds have always followed the lead of the corporate sector, beginning with the advent of the high-yield market in the late 1980s.

And since the real estate sector has been growing, due in large part to the willingness of hedge funds and private equity investors to finance high-risk transactions, the developments in the corporate debt markets could be a harbinger of what's to come in commercial real estate.

The residential market has reached a point where portfolios with subprime loans, for instance, are trading at steep discounts, and bond traders are worried about a further meltdown. Angst in the loan trading market was recently accentuated in a subprime portfolio acquisition by Newport Beach, Calif.-based Composite Solutions Inc. in July. The acquisition was priced at 40% of the notes' aggregate value.

So what does this mean to commercial real estate investors? It points to an uneasy high-yield investment market, where high-leverage transactions are either made or broken.

Many of these deals depend on mezzanine, bridge and other transitioning loan products, as well as a generous stream of equity financing. The first potential sign of a breakdown in demand for real estate related bonds will likely occur when capital dries up for the high-yield portions.

CMBS & CDOs next?

One reason that collateralized debt obligations (CDOs) have become so popular among real estate investors is that the portion of loans that could not make the grade for inclusion in commercial mortgage-backed securities often get packaged into CDOs. As a result, the rocket scientists on Wall Street joined forces with real estate asset managers and special loan servicers to manage these high-risk loans by holding first-loss CDO pieces.

These asset managers play the crucial role of overseeing the performance of the loans, and often wait in the wings to step in and take control of any troubled asset in the CDO, should it become necessary. Because of this safety net, there has been healthy demand for the higher-rated classes of CDOs.

And when products such as condo conversion, construction, bridge and mezzanine loans dominate CDO issues, as they have in the recent past, then cash-rich, high-yield investors were drawn to them. Should these investments sustain any drying up of liquidity, this would surely mark the end of an era of pushing the leverage envelope, a practice that's fueled commercial real estate growth.

W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.

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