A Structured Finance Hangover

At the height of the commercial real estate market's historic up cycle in 1999, collateralized debt obligations emerged on the scene. In fact, during that time Wall Street began devising a number of complex investment vehicles, including the CDO, which is an asset-backed structured credit product comprised of different tranches of fixed-income assets based on risk.

Investment banks utilized the CDO to pool thousands of subprime mortgages and then sell them to life insurance companies, pension funds and other institutional investors across the globe, promising to convert stable income streams.

Investment banking firms estimated that 90% of these borrowers would pay their subprime loans on time. Closer to 80% paid their mortgages on time, causing investors to lose money. Arguably, investment banking firms took an even bigger hit following the downfall of the CDO market, including Bear Stearns and Merrill Lynch, which recently reported a $9 billion writedown in assets during the first quarter of 2008, among others.

In 2007, $28.6 billion of commercial real estate CDOs were issued, according to the Mortgage Bankers Association, a 22% decrease in issuance compared with 2006, when $36.7 billion were issued.

CDOs invest in the cash flows of a property, rather than investing directly in an asset's underlying collateral, the intent of commercial mortgage-backed securities. Another important difference is that the assets comprising CDOs are often changed or swapped while the assets of CMBS issuances remain constant.

If investors desire a low-risk part of a CDO with a lower yield, they acquire a senior tranche while other investors purchase the riskier parts of the CDO. In the event of defaults, the riskier pieces take the biggest hits. Therefore, it is important for CDO investors to monitor credit performance and the expected cash flows of the CDO's assets.

Commercial real estate CDOs were no different for the shopping center sector than for other major types of investment real estate. The CDO was a financing vehicle for retail, apartment, industrial, office and other product types. Once a lender underwrites an asset, it decides how to structure financing for each transaction and then determines how to break it up to sell to investors.

Due to the housing crash and credit meltdown, the structured finance industry has virtually dried up. When CDOs were in use, one could package almost any type of risky loan and sell it off as a secured investment to institutional investors. But due to the capital markets crisis, buyers in today's market cannot price the inherent risk in these deals.

As a result of the CDO fallout, today's retail buyer must place a much larger equity piece into a deal in the form of a higher down payment, or pay all cash. A year ago, retail investors were required to put 10% to 25% down. Today, lenders require a down payment of 30% to 35%. Lenders are also requesting recourse on all or part of the debt. A year or two ago, they were issuing non-recourse debt.

This trend has slowed transaction velocity in the retail real estate sector. Sellers are reluctant to price their deals to the yield requirements of current buyers. Meanwhile, a majority of today's buyers are waiting for prices to drop. While investors wait, the retail investment sales market decelerates.

The restructuring of the securitized debt market could take 18 to 24 months. Even then, this investment vehicle is unlikely to function in its previous form. In past economic cycles, by the time the Fed began to cut rates dramatically, the economy was already in recession, and the past two periods of contraction each lasted only eight months.

If the same pattern holds true, retail real estate investors may be able to get the best of both worlds by purchasing assets in the near term, taking advantage of price adjustments and lower interest rates now, and still reaping the benefits of improving occupancy and rent growth as a recovery builds momentum.

Retail real estate will not experience a major price correction due to relatively healthy fundamentals. However, prices are adjusting according to property quality, strength of local markets and risk profile. Based on the high volume of capital still attracted to retail real estate, many investors are already preparing for the next expansion cycle.

Bernard Haddigan is managing director of Marcus & Millichap's National Retail Group. William Hughes, SVP and managing director of Marcus & Millichap Capital Corp., contributed to this piece.

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