The subprime mortgage crisis is hitting the once-comfortable confines of commercial real estate.
To be sure, commercial real estate defaults are low, with a rush of capital into the market in the past five years. Still, even the largest portfolios are financing most of their deals through traditional and new debt instruments, making many nervous about such leverage at a time when mortgage debt is in trouble.
The leverage has fueled profits, but also could place future returns in jeopardy.
The pain will not be easy for those using a lot of leverage, Jacques Gordon, global strategist for LaSalle Investment Management Inc., Chicago, a real estate investment management firm.
Investors have to be careful in a frothy market. What happens when liquidity dries up or when lenders start tightening their criteria? Mr. Gordon said.
There are already small warning signals. Capital from institutional investors might slow this year as pension plans, endowments and foundations have already invested much of their increased allocations. (See related story on page 37.)
Easy debt has increased the use of leverage across most real estate strategies. Commercial mortgage-backed securities and mezzanine lenders are using 80% leverage, according to a report by Principal Real Estate Investors, Real Estate Research Corp. and CBRE/Torto Wheaton Research. Even the most stable real estate carries between 20% and 40%, the report noted.
Privatizations of real estate investment trusts has 60% to 70% leverage, but often more is being used. For example, Equity Office Properties $36 billion sale to Blackstone Group includes more than 90% leverage. And consultants say typical leverage for non-core real estate funds is between 70% and 90%..
The capital markets and regulators are watching the real estate markets, said Stan Ross, chairman of the Lusk Center for Real Estate at the University of Southern California, Los Angeles. As a result, lenders are becoming more sensitive in screening properties before making loans and are offering slightly less attractive terms, he said.
We might see lower loan-to-value ratios and some fee and interest-rate changes, Mr. Ross said.
Already there have been subtle changes, with some lenders recently making loans for 75% of the propertys value, rather than 80%, he explained. Mr. Ross added hes heard of minor changes in the lower quality, unsecured levels of debt on properties.
But any changes in loan terms could increase the cost of deals and lead to lower returns, he said.
Two weeks ago, the prices of middle- to bottom-rated commercial mortgage-backed securities as well as collateralized debt obligations dropped as a result of the blowup of the subprime mortgage market, said Joe Rubin, principal, transactional real estate practice, Ernst & Young LLP, New York. And the CMBS market has driven much of the mergers and acquisitions of real estate investment trusts, he explained.
Top rated CMBS also dropped, but those have since recovered. However, the subprime mortgage crisis spilled over into commercial real estate because the same investors make both residential and commercial investments, he said.
If they get nervous on one side, psychologically it tips over to the other side too, Mr. Rubin said. If residential gets bad enough, it would affect the whole economy, and commercial funds would be impacted.
Whats more, the U.S. Controller of the Currency, Federal Deposit Insurance Corp., the Federal Reserve and the Office of Thrift Supervision last year floated a joint proposal that lending institutions should take more risk management measures, including continued exposure monitoring and possible market downturn analysis in the commercial sector. Since then, regulators have also raised concerns over the level of bank exposure to commercial loans as a percentage of their overall capital, Mr. Rubin said.
I think the regulators are nervous and already have written some proposals dealing with their concerns that the market might get weak, Mr. Ross said. But, so far, there have not been high rates of defaults and delinquencies on commercial loans, he said.
Investment managers are wondering how mortgage-backed securities will be affected by the fallout in the subprime mortgage industry, said Stephen M. Coyle, managing director, portfolio manager of Citigroup Property Investors, New York.
Commercial real estate is awash in debt capital, and in the past five years, lenders standards for writing loans have slackened, he said.
If interest rates should rise or capital flows into real estate slow, then there would be more pain in the debt side than equity, he said. Thats why Citigroup Property Investors is investing in only equity funds in its multistrategy fund of funds, he said.
We have not committed to any debt-focused funds over the last several years, Mr. Coyle said. Debt is cheap and not adequately compensated.
Mr. Coyle believes there will be some negative impact on commercial real estate from the subprime loan market blowup.
I do think there will be impact on investor price of commercial debt from the residential fallout, Mr. Coyle said. Ive heard it is happening, but it is so far not supported by the numbers. Commercial buyers of debt paper are looking carefully at all low grades of residential and commercial paper.
The blowup in the subprime mortgage market will temper some investors purchase of commercial and residential debt, because the yields are similar, he said.
Worried about spreads
Some investment managers are becoming concerned with the increased spreads between secured real estate instruments (such as CMBS and CDOs) and Treasury bonds.
CMBS, the below-investment-grade piece, is the worst place to be today, Mr. Coyle said. Five years ago, it was a great place to be.
The next two years will be significant for CMBS, said Larry Kay, director in structured finance at rating agency Standard & Poors, New York. A large number of the loans used in CMBS about $40 billion will be coming due, and the question is whether they will be paid off or go into default, he said. We have to wait and see.
CDOs carry the most risk because unlike CMBS, they are not regulated by the Internal Revenue Service, Mr. Kay said. They are not fixed vehicles, meaning the collateral can be sold off during the course of the loan to pay off any underperforming portions of the debt instrument. Some investors see them as bundled junk bonds sold off as higher-grade debt, and theyve become very popular with private equity and hedge fund buyers for extra financing on deals above what a bank would lend, especially in the past year.
Real estate is becoming more commoditized through structured finance, he said.
Still, some investors are hedging their bets and making plans to take advantage of any downturn by increasing their investment in the sub-prime real estate market, including Goldman, Sachs & Co. and Lehman Brothers Inc.
Private equity investors using the newest types of debt to finance deals are also reserving some equity in their funds in the event of a market downturn or an interest rate hike, said USCs Mr. Ross.
A lot of people are waiting on the sidelines the same as vultures, maintaining liquidity and looking for distressed buying opportunities, Mr. Ross said. Private equity funds are allocating a portion to cash, because they are waiting to see if there is distressed fallout here.