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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   September 2011

Debt Capital Growth Gains Momentum

The return of CMBS and other debt vehicles may signal a resurgence in commercial lending

Many indicators suggest that the  market for commercial real estate debt capital has been growing this year. Numerous bank lenders have indicated they are more active; insurance-company lenders have continued to increase their portfolios for stabilized, income-producing properties; and perhaps most important, the commercial mortgage-backed securities (CMBS) market is one of the few securitization markets in the U.S. to reopen since the financial crisis.

The revival in CMBS really started in early 2010 with smaller, private transactions. This began the so-called CMBS 2.0, where loan underwriters and issuers have reverted to the simple and tight underwriting structures of early CMBS. CMBS issuance in 2010 and early 2011 are backed mostly by lower-leverage, higher debt-service-covering amortizing loans — a contrast to pro forma underwriting and interest-only loans common from 2005 to 2008.

Many expect CMBS issuance to reach at least $40 billion this year following a timid start in 2010, when CMBS issuance reached only about $11 billion. Although this is a small fraction of the nearly $230 billion issued at the peak in 2007, it is a welcome recovery from the paltry $2.2 billion in 2009. The return of CMBS conduit lenders is even better news for borrowers and commercial mortgage brokers. 

Regarding traditional bank lenders, according to this past April’s Second Quarter 2011 Senior Loan Officer Opinion Survey on Bank Lending Practices, 9.1 percent said banks eased standards for commercial real estate loans in the previous three months. About 40 percent reported stronger demand for commercial real estate loans, a significant increase from past years.

Insurance-company lenders have remained active, which is another positive for the market. According to a report from CoStar Group, insurance-company balance sheets are much further along the path to recovery than those of some banks. Consequently, insurance-company new loan issuance is not far from levels seen four to five years ago. Traditionally, insurance companies have provided new debt to the commercial real estate industry because this is a natural fit for their portfolios, matching duration and stabilized property cash flows with insurance-company liabilities. 

As of this past June, several discussions concerning restarting commercial debt obligation (CDO) issuance have occurred. There have been no new commercial real estate CDOs since early 2008. The re-emergence would be significant because CDO lenders traditionally were more flexible than other types of lenders in the variety and types of deals they funded.

It seems that the commercial real estate debt-market engine is becoming robust again. There is reason for caution, however. Several factors could stall a recovery, including:

  • The overall economy;
  • Rising interest rates;
  • Declining CMBS standards;
  • Increased regulations; and
  • Banking changes from Basel III.

The U.S. economy continues to grow at an anemic rate, which threatens the improvement in commercial real estate fundamentals. Despite massive amounts of liquidity poured into the markets through the Federal Reserve’s quantitative-easing programs, gross-domestic-product growth remains tepid, at 1.9 percent this past first quarter. Lenders’ concerns about occupancy levels and rental rates continue to grow, as the unemployment rate remains around 9 percent.

Short-term interest rates and long-term U.S. Treasury rates have remained at or near historical lows, yet most financial-market observers and economists question the sustainability of these interest-rate levels in the face of high federal government budget deficits and a national debt level greater than $14 trillion. Higher U.S. Treasury rates will impact loan underwriting, capitalization-rate assumptions and loan-takeout assumptions. 

Additionally, there are already signs that CMBS lenders may be undercutting their CMBS 2.0 standards. A resurgence of weak underwriting structures would undercut the momentum of the market. Even worse, this could potentially lead to another reduction in commercial real estate loan originations if CMBS investors resist this aggressive underwriting. Standard & Poor’s issued a report this past May indicating that some CMBS lenders and issuers were returning to “questionable old trends.” These include limited pro forma underwriting and overly aggressive property appraisals. New CMBS issuances are still being tentatively accepted by investors, so nobody will benefit if investors strike against a perceived resurgence of irresponsible underwriting. 

CMBS professionals are also apprehensive of regulatory uncertainty from the Dodd-Frank Wall Street Reform and Consumer Protection Act. This law is more than 2,000 pages and includes hundreds of new policies and regulations that are still being developed. The new risk-retention proposal for securitizations is key for the commercial real estate industry and would require that all new CMBS issuances keep at least 5 percent of each securitization through retention of the lowest-rated or riskiest collateral. This is being mandated for all new securitizations, not just CMBS. The proposal as currently drafted could constrain future CMBS issuance, however, because lender-issuers might not have enough capital to retain the bottom 5 percent of each deal. The CMBS market was originally developed and grew because lender-issuers needed a way to recycle capital for new deals. If lender-issuers are forced to retain a percentage of these loans, they may have less capital available for new loans. This proposal is still being reviewed and should be carefully watched. 

Meanwhile, large and regional U.S. banks face new capital adequacy and liquidity regulations from the Basel Committee on Banking Supervision, aka Basel III. Basel III has much tighter capital requirements similar to Dodd-Frank, but it also mandates new liquidity regulations designed to ensure that banks have adequate liquidity if another financial crisis occurs. Banks are concerned that these regulations are too broad and will make it more difficult for them to grow their loan portfolios.

Although more good news abounds than bad for the commercial real estate debt capital markets, there are still many potential clouds on the horizon. Commercial real estate brokers and their clients must be aware of these obstacles as they plan for future capital needs.


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