Stay in the game until 2010 and protect your assets. That's the message Tom Wratten, the retired founder and CEO of Principal Commercial Acceptance, is delivering to the commercial real estate investment community. “We're talking about 24 months during which we're going to be squeezing out the excessiveness of the last 24 months,” says Wratten, a 40-year industry veteran and early champion of real estate securitization.
The painful lesson? When the price of commercial real estate exceeds its reproduction cost plus the rate of inflation, a correction is inevitable, says Wratten. “We need to back up and look at 2004 numbers and start all over again. In my 40 years in the investment business we always have had periods when things go so well — and the tracks get so straight and smooth — that the train gets going too fast and runs right off the end.”
The train ran off the tracks beginning in 2005, most noticeably on the residential side. Many buyers bought into the idea that they could obtain 105% financing on their home because in two years they would have 15% equity due to price appreciation. Ultimately, the pricing was unsustainable.
The excesses cited by Wratten stem from cheap debt that flooded the real estate industry in recent years. The easy money triggered a subprime mortgage meltdown in 2007 that has since snowballed into a full-blown credit crunch and a deep crisis of confidence among bond investors. The commercial mortgage-backed securities (CMBS) market is virtually at a standstill. Consider that there was zero CMBS issuance in January, a development no one thought possible a year ago. To put that goose egg of a figure into perspective, dealers sold a record $233.7 billion of domestic CMBS in 2007, or an average of $19.5 billion monthly.
It isn't helping matters that the validity of the securitization model is threatened by some unscrupulous mortgage practices in the residential sector. What's more, news that foreclosure filings on U.S. homes increased 57% in January over the same period a year ago gives the entire mortgage industry a black eye. Not surprisingly, employment in the mortgage industry has declined significantly over the past few years (see chart).
Fully aware that the securitized lending market has nearly ground to a halt and that some of its younger members have never managed through a sharp downturn before, the Mortgage Bankers Association is supporting networking and education opportunities in select markets and at national conferences.
MBA recently hosted a joint after-work program with the Commercial Mortgage Securities Association (CMSA) in New York and hopes to boost investor confidence via forums in which lenders, originators, investors, servicers and the rating agencies talk to one another. “Part of what people want to do in times like these is communicate. You've got to give people the opportunity and the platform to do that,” says Jan Sternin, senior vice president of MBA's commercial/multifamily division.
The maturing, but still relatively young, CMBS industry finds itself in uncharted waters, so there is no consensus among MBA members about how this crisis is going to play out, says Sternin. “If you take six top professionals in this business and put them on a panel and ask them what's the timing of when the market will come back, how big that market will be, and what the product mix is going to look like, you'll get nine opinions.”
Until the fog in the capital markets clears, it is imperative that commercial real estate owners keep their properties in tip-top shape and well managed to ensure that they retain the highest value possible, urges Wratten, who was instrumental in launching CMSA. “When the capital markets adjust and settle down, liquidity will price the business risk associated with owning commercial real estate at its appropriate level.”
The long-range outlook for the commercial real estate is bright, Wratten says, due to built-in demand. The U.S. population is growing by 1.1% annually, more than 3 million per year. “Every time that we think we have forever altered our business model, we forget that next year we're going to need new houses and new jobs” to accommodate that growth, he points out.
Ultimately, Wratten encourages a spirited debate about how to improve the CMBS marketplace. “When this cycle is over, we then come out with a better business model with even better consumer confidence in the professionals who run it.”
Matt Valley can be reached at [email protected].