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Where do we go from here? That was the question on many people's minds during the tumultuous two-week period in mid-September that took the credit crisis to a harrowing new level. In quick succession, the federal takeovers of Freddie Mac and Fannie Mae, investment banking giant Lehman Brothers's Chapter 11 bankruptcy, Merrill Lynch & Co.'s sale to Bank of America for $50 billion and the $85 billion nationalization of insurance provider AIG made it abundantly clear that the credit crisis is here for the long haul. As of press time, Treasury Secretary Henry Paulsen had concocted a $700 billion bailout plan enabling the government to buy toxic assets from troubled banks and hopefully finally stabilize the system. Congress was preparing to vote on the package.

Moreover, the last two investment banks — Morgan Stanley and Goldman Sachs — abandoned their independent status and became bank holding companies, giving the banks access to a wider variety of lending facilities, but also opening themselves up to greater regulatory scrutiny.

The extent of the crisis has resulted in a complete overhaul of the structure of Wall Street. The potential implications for the retail real estate sector are profound. Most of the troubled assets on bank balance sheets remain tied to residential real estate. But increasingly, commercial real estate is coming to the fore in the ongoing crisis. One of Lehman Brothers's troubles is a $32.6 billion portfolio of commercial real estate whole loans and commercial mortgage-backed securities (CMBS) bonds. Lehman's commercial real estate portfolio in the United States was valued at $17 billion and its exposure to CMBS loans amounted to $600 million. As of May 31, retail made up 11 percent of its commercial mortgage whole loan portfolio.

In spite of its months-long efforts to sell the portfolio, Lehman could find no takers because potential buyers are terrified of risk. In other words, that $32.6 billion portfolio may not be really worth $32.6 billion. Perhaps that's why, despite low default rates, industry backers were lobbying hard to make sure CMBS are eligible for any bailout plan that gets passed. “Any action must include commercial real estate mortgages and [CMBS] in the targeted class of illiquid assets,” Real Estate Roundtable President and CEO Jeffery DeBoer said in a statement. “Including commercial real estate mortgages in the assets eligible to be purchased by the proposed new federal entity is critical to addressing current overall credit market illiquidity.”

CMBS investors, who typically don't participate in real estate management and rely on the credit rating agencies to show them which loans to invest in, are too spooked by the growing perception of risk attached to commercial real estate to buy those bonds right now, according to Sam Chandan, chief economist with Reis, Inc., a New York City-based commercial real estate information provider. Inland Mortgage Capital Corp., an Oak Brook, Ill.-based REIT, took a look at some of the loans Lehman was offering for sale, but found they did not fit in with Inland's conservative acquisition criteria, according to Art Rendak, vice president. Inland has set aside $300 million to acquire and originate new loans, but it wants well-performing assets, with an occupancy rate of at least 80 percent and a loan-to-value ratio of less than 85 percent. The firm wants returns ranging from 9 percent to 13 percent, and it wants to make sure that if it ends up having to take over the property, it will get its investment back.

“Some of the Lehman assets, at least what we've seen, are just so risky,” Rendak says. “If it's over-levered and has got significant leasing problems, it's not for the faint of heart, that's for sure.”

The problem, then, is that if Lehman were forced to sell, it might have to take deep discounts because of the risk aversion in the market. Besides Lehman, Merrill Lynch has a $20 billion exposure in CMBS and commercial real estate whole loans. Meanwhile, AIG provides insurance for commercial real estate in addition to being neck-deep in the $62 trillion credit default swaps market where the company got involved in insuring bonds. Overall, commercial real estate may be getting sucked further into the crisis.

Lehman, which on Sept. 16, agreed to sell its broker-dealer division to the British bank Barclays, floated plans to spin off its commercial real estate assets into a separate, publicly traded company, Real Estate Investments Global. That would have parked its real estate assets for the time being and enabled Lehman to sell them later, presumably when liquidity had returned to the market. Its bankruptcy, however, has thrown doubt on whether that plan will come to fruition raising again the prospect of a fire sale. Such sales would have a cascading effect as banks marked to market. Banking rules dictate that hard-to-value assets on balance sheets get marked to values of similar assets sold in the market.

What the market wants to avoid is a scenario such as what happened with some of the residential bonds that Merrill sold earlier this year. The package was sold for 22 cents on the dollar. But it's even worse than that. Merrill provided financing for the deal. It also includes a put option, ensuring that if the bonds fall further, Merrill would have to take back the assets. In the end, the deal looks to be worth between 5 and 7 cents on the dollar of the assets. No one wants to see deals like that emerge on CMBS bonds.

Furthermore, continued instability on the investment side would keep the origination side mired in a complete lockdown. After crawling to $12.1 billion in originations in the first half of the year, CMBS issuance in each of the three months since July has amounted to $0, reports Commercial Mortgage Alert, an industry newsletter. As of Sept. 10, spreads on the highest-rated, triple-A, five-year, fixed-rate conduit loans stood at 285 basis points, up from a 52-week average of 161 basis points. On really bad days, spreads rise to more than 300 basis points, says David Akeman, director in the capital markets group of Stan Johnson Company, a Tulsa, Okla.-based commercial real estate investment firm.

Commercial real estate stands at the edge of another precipice. Up until now, defaults and delinquencies have remained low on commercial real estate debt — both on CMBS and with traditional banks. In the second quarter, the total delinquency rate for commercial mortgages stood at a conservative 2.1 percent, estimates Foresight Analytics, an Oakland, Calif.-based real estate consulting firm. The delinquency rate for CMBS loans was at 0.53 percent, according to the Mortgage Bankers Association (MBA). Rating agency Fitch put the number at 0.44 percent, but said that delinquencies on retail real estate were higher than any other sector. In contrast, delinquencies in August jumped to 24.48 percent on subprime residential loans, to 14.38 percent on option adjustable-rate mortgages and 10.73 percent on Alt-A mortgages, according to Applied Analytics.

Experts expect the picture to get worse shortly, especially as the number of loans that become eligible for refinancing rises. As of July, only 5 percent of all outstanding CMBS loans, which total $780 billion, were eligible for refinancing, according to Reis numbers. Most of those loans were originated 5 to 10 years ago, when underwriting standards were still tight, and have benefited from several years of increases in property values, so they shouldn't present much of a problem, according to Jon Southard, principal and director of forecasting with CBRE | Torto Wheaton Research, a Boston-based research firm.

Things will get a lot more complicated, however, over the next three years, as more of the loans originated in the carefree days of 2006 and 2007 come due, including some mega-billion-dollar deals on giant projects, says Chandan. Most of those loans were CMBS loans, often completed at 85 percent to 95 percent loan to value. Many have interest-only terms and very optimistic projections on future cash flows. Already in June, more than 15 percent of 2006 and 2007 CMBS vintages were put on watch lists, according to JPMorgan. Vintages from 2006 look particularly troublesome, according to JPMorgan analyst Alan L. Todd, with 40 percent of the loans originated that year showing cash flow drops of more than 10 percent. About 35 percent of the loans originated in 2007 appear to be under similar strain.

What's more, owners of retail real estate, who have certainly had a rough year thus far, haven't seen the worst of it yet, according to Gerard V. Mason, executive managing director in the New York City office of Savills, a global real estate services provider. Since 2007, the retail industry has announced more than 4,200 store closings, including some by major anchors, but come January of next year, the number will rise astronomically, he predicts. “If we are going to have any major distress, that's when it's going to occur,” Mason says. “That's when the lenders and the special servicers will have to stand up and say, ‘We are either getting these properties back or we'll have to do something about it.’”

CMBS comeback

The most favorable scenario for the commercial real estate industry would involve the speedy comeback of CMBS loans, which would fill the current debt gap. “CMBS is an efficient and terrific source of capital for real estate and, theoretically, it's unlimited capital,” says Rendak. But although most industry insiders say they are certain CMBS will eventually come back into the market, that's not likely to happen for at least 12 to 18 months, according to Chandan and others.

As it stands, the debt vehicle that served as the preferred source of real estate financing for the past five years and last year covered 70 percent of all transactions is no longer available. Meanwhile, the more traditional lenders, which include insurance companies, pension funds and national banks, haven't been stepping up their game. In the second quarter of 2008, commercial/multifamily mortgage originations by commercial banks fell 29 percent compared to the same period in 2007, to 289, according to the MBA. Originations by life insurance companies fell 27 percent, to 119. And the total number of originations for retail properties fell 63 percent, to 169. What's more, when they do lend, these conservative players demand much more restrictive loan terms than Wall Street lenders, including 60 percent to 65 percent loan-to-value ratios, a minimum of 1.3 in debt service coverage ratios, 25-year amortization terms, recourse and no interest-only deals, says Akeman.

In addition to the fact that CMBS investors have lost all confidence in the credit rating agencies — and rightfully so, since the agencies proved too eager in assigning triple-A ratings to bonds that eventually ended up in the junk basket — they worry about the state of the U.S. economy and its effect on demand for commercial real estate. Until they see a significant improvement in U.S. consumer confidence, they will stay away from buying paper backed by retail assets, says Adam B. Weissburg, partner with Cox Castle Nicholson LLP, a Los Angeles-based real estate law firm.

Even when CMBS debt comes back into the picture, it will feature more conservative underwriting, in line with traditional lenders' terms, and won't reach the levels achieved at the peak of 2007, which saw $237 billion in CMBS issuance. Going forward, experts say CMBS issuance will average approximately $50 billion a year. CMBS debt was designed to work for stable, income-producing assets with no need for major improvements, according to Weissburg. Add a level of risk to the equation and the system goes haywire.

“CMBS lenders will have to crawl before they walk, before the industry can prove to the investors the value of underlying properties,” says David B. St. Pierre, cofounder and president of Legacy Capital Partners, a Lyndhurst, Ohio-based private equity firm.

Holding out for a hero

With scant hope for a CMBS comeback, some industry insiders pray for the emergence of another major source of capital. In the first half of the year, regional banks picked up some of the slack from Wall Street and other real estate funders, but their lending capacity is limited. By mid-year, they accounted for just 5 percent of all acquisition financing in the commercial real estate market, down from 7 percent in 2007, according to New York City-based Real Capital Analytics. Meanwhile, national banks accounted for 8 percent of all financing, down from 26 percent last year, and finance/management firms for 5 percent, down from 9 percent in 2007.

Insurance firms increased their lending business slightly, to 7 percent from 6 percent, but that's still a fairly conservative figure. “Right now, there are only two or three types of lenders out there, and everything is very conservative,” says Mason.

One alternative Mason still has some hopes for are covered bonds — securities that function in a way similar to CMBS bonds, but remain on the issuer's balance sheet. They're more conservative structure guarantees that even if the issuer goes bankrupt, the way Lehman did, the bond investors still get their money back. The lower level of risk associated with covered bonds might lure those investors back into the market, which is why the Federal Reserve and four of the country's biggest banks, including JPMorgan, Wells Fargo, Bank of America and Citi, are already considering issuing such bonds in the residential market.

But developing a viable debt vehicle takes time, notes Weissburg, and it will take some work to convince those investors who have been burned by CMBS that the new bonds are much safer. “People have been creative in the past, and certainly times like these almost breed creativity,” he says. “But the market will have to calm down and the Fed will have to stabilize things,” before Wall Street will get a chance to prove that its new debt instruments work.

Apocalypse now

In the worst-case scenario, the financial markets will continue to deteriorate. If that happens and no new source of capital emerges, the consequences will differ for holders of traditional and CMBS loans. In the case of a default on a traditional loan, the issuer still has the power to help the borrower, by granting extensions, redesigning loan terms and simply waiting out the credit freeze, according to Mason. That's already been happening in secondary and tertiary markets, where owners of retail properties are having a harder time collecting their rents, says Gary E. Mozer, principal and managing director with George Smith Partners, a Los Angeles-based real estate investment banking firm. They will also have the option to do a “deed in lieu of bankruptcy,” where they will technically assume ownership of the property, but will have an extra 24 months to decide how to proceed further. In the meantime, the borrower can continue managing the asset.

In general, lenders will try to avoid foreclosure as long as possible because they don't want to be forced to sell their assets at a discount. “There is an old saying that a rolling loan gathers no loss,” Mozer says.

CMBS lenders, however, will face a much more daunting task in dealing with defaulting borrowers. There are significant tax penalties to changing the terms of a CMBS loan, says Weissburg, and instead of having just one party — the issuer — make the determination on whether to reengineer the terms, every agency with a stake in the conduit will have to grant its agreement. What's more, a traditional lender can afford to lower the monthly mortgage payment, the best the CMBS lender can usually do is grant an extension. “In a classic workout, the lender owns the loan and says, ‘I need to do a, b and c,’” Mozer notes. “The special servicer in a CMBS loan doesn't have money to advance, so that's an impediment.”

If the servicer doesn't manage to extend the loan, the issuer might find itself in a tough position. Since CMBS loans cover a host of properties and are owned by a number of bond investors, foreclosing on an asset that's defaulted might prove as difficult as reworking the loan. Even if the issuer takes back the property, the investors are not qualified to manage it. The most viable option in such a case is to sell the loan.

There is no doubt, however, that with the financial markets in the shape they are in and with up to 100 investment funds waiting to pounce on distressed loans, there will be some fire sales in 2009, says Mason. He estimates the discounts might reach up to 50 percent and will peak around the middle of next year. However, Mason doesn't think we will see a replay of the early 1990s, when billions of dollars' worth of loans were dumped on the market. “It's a carryover of what happened in 1992, when the sold loans ended up being worth more than they were sold for,” Mason says. “I don't see the banks just dumping it all out there. I know there are maybe 30 banks that the Fed is looking at [that are experiencing problems], but they are still holding on.”

Whether his prognosis is too optimistic depends on how many more bankruptcies in the financial sector we will see between now and the end of the year.

What if?

With Wall Street in turmoil, the question for retail real estate owners becomes, “How does this affect me?” That question is especially pressing if you have an asset that needs help. Say you bought a small property — with three tenants — and got the acquisition financed in 2006 or 2007. The generous lending environment at the time means that you got almost 100 percent financing and the loan assumed healthy annual rental bumps. In addition, to top it off, the first three years of the loan are interest-only. It seemed like a great deal at the time. Today, however, things are not looking quite as bright. Your mini-anchor closed shop a couple of months ago and then the other two tenants quickly followed. You've got no rental income. And you're rapidly approaching the date on which you have to start paying down principal — not just the interest. In the current environment, there are three possible outcomes.

Scenario 1, Refinancing: The outcome here depends on the kind of loan you got in the first place. If your loan is from a traditional lender, you've got a chance of working out a refinancing. Senior lenders — commercial banks and life insurance companies — are still providing commercial real estate debt, albeit on much more conservative terms. Most likely, to get refinancing you'll have to show that you've got one or more tenants lined up to fill your empty space. Even then, you'll probably only get 60 percent to 65 percent financing. So you've either got to come up with some cash yourself to fill the gap or you have to turn to a mezzanine lender for gap financing. The bright side is that banks in this climate probably don't want to take back your property, so they may give you some time to work things out. Even before refinancing, you may get six months to a year to try and become current on the loan.

Scenario 2: Sale of Distressed Debt: If you've got a CMBS loan, the situation becomes a bit more dicey than if you had gotten financing from a bank or insurance company. You will have to work with a master servicer to try to get an extension, but the process will be more time-consuming and onerous than with a traditional loan because every stakeholder in the conduit will have to agree to any new terms. Moreover, in most cases, issuers of conduit loans are prohibited from reworking the actual financial terms of a loan. In that case, they may give up and sell your loan to a distressed debt investor rather than try to work with you. Your loan may end up in the hands of a distressed debt investor. They may acquire your loan for 20 cents on the dollar. If that's the case, they may not be interested at all in reworking your situation. Instead, they'll just want to recoup their investment plus a little more. They may settle for squeezing 25 cents on the dollar out of you, which would represent a healthy 25 percent return for them. But they are highly unlikely to be interested in helping you do what you can to turn the property around.

Scenario 3, Foreclosure: Try as you might, you just can't convince any tenants to lease space at your now-empty center. You worked with your lender as much as you could. They gave you a six-month extension and then another. But despite your best marketing efforts nothing you did brought any tenants to your property. At this stage, you decide to throw in the towel. The lender repossesses the property. Now it becomes their problem. They either will try to re-lease it themselves or sell it to a turnaround specialist for a song.

Scenario 4, Limbo: What if you decide to throw in the towel, but the lender won't let you? You can't pay down your debt even if you wanted to. You can opt to let the lender begin the foreclosure process. But the lender will have its own challenges. After all, the last thing Lehman Brothers wants right now is troubled real estate to try and turn around. In this situation, the lender may decide to just keep the loan in limbo. You're not paying, but they're not foreclosing either. They're happy with the status quo until the market turns and possible buyers emerge. In the meantime, you will continue to be the proud owner of an empty strip center.

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