Think Realty - Lawrence Fasslet - 23 November
After-Effects of the Great Recession
A huge number of commercial mortgage-backed securities (CMBS) conduit loans had been originated during the years immediately preceding the 2008 recession. Some observers cite an estimated $1.4 trillion in commercial mortgages that were originally due to mature between 2014 and 2017. The amount was significant; some estimates placed the CMBS issuances’ portion of overall commercial real estate (CRE) to be as much as two-and-a-half times higher than the CMBS amount that matured from 2012 to 2014.
A Trepp report showed the incoming “wave:”
Concerns Arose on Many Levels
Pre-Recession Loans Were Generally Over-Leveraged—CMBS loans in 2005-2007 are thought to have been aggressively underwritten, with high loan-to-value (LTV) and debt service coverage (DSC) ratios. Current market underwriting parameters generally demand stricter terms.
Markets Were Concerned with Interest Rates—As commercial real estate valuations generally rebounded from the depths of 2008-09, observers have begun to worry that a market “top” might be approaching. And if interest rates were to rise significantly, that might translate to higher cap rates and lower valuations—so that loans that had initially been aggressively underwritten anyway might be difficult to refinance.
Oh, What a Difference a Few Years Makes
To most people’s surprise, though, interest rates that were already low at the beginning of 2016 continued to fall.
Interest Rates Stayed Low—From 2014 until the recent election, even as market observers kept watching for the U.S. Federal Reserve to increase interest rates, it never really happened. A single token move in December 2015 did little to interrupt the long-term trend. Unemployment decreases and macroeconomic growth rates never seemed strong enough for the Fed to move decisively away from its accommodative stance.
10-yr Treasury Bond Yields – 5 yrs to Nov. 14, 2016
International events, such as Britain’s vote to leave the European Union, caused additional concern. In that country’s real estate market, for example, four major real estate funds promptly froze withdrawals to slow an anticipated exodus of nervous investors. It became difficult for the Fed to increase interest rates during such periods of uncertainty.
Strong Market Allowed for Early Re-Financings—In addition, healthy real estate market fundamentals enabled many owners to increase rents and income, which contributed to an increase in property values and made refinancing easier than it otherwise would have been. Borrowers took advantage of the strong market fundamentals, the availability of debt capital and relatively low interest rates to defease CMBS loans and refinance properties before their underlying loans matured.
In 2015, more than 1,300 loans totaling nearly $20 billion were defeased or replaced by government securities. That’s up from the full-year activity in 2014 and well above the $11.8 billion in 2013. As a result of the early refinancing and defeasance activity, the volume of maturities slated for 2016 and 2017 was reduced 17 percent from the $232 billion that had originally been estimated in 2015.
Most Maturing CRE Loans Seem in a Good Place
Treasury markets (which directly influence CRE loan interest rates) recently reacted to President-elect Donald Trump’s pledges to boost infrastructure spending and cut taxes, moves which could boost growth as well as deficits—both seen as catalysts for higher inflation and inflation expectations. Threats to impose large tariffs against Chinese and Mexican imports would, if realized, also likely add to inflation expectations.
Nevertheless, interest rates would have to rise substantially for debt service coverage levels to become a CRE refinancing issue during the next two years. Interest rates remain below where most loans were originated in 2006 and 2007. Trepp, a leading data and analytics research firm, estimates that 96.5 percent of loans slated to mature through 2018 would, at current interest rates, be able to meet a customary 1.2x debt service coverage ratio. Trepp estimates that with a 100 basis point increase in interest rates, the proportion of loans meeting that DSCR hurdle would likely fall to 94 percent, and if rates climb by 200 bps, a further fall to 89.1 percent could be expected.
Difficulties remain, however. The Dodd-Frank and Basel III banking regulations enacted in the wake of the Great Recession made it somewhat more costly—in terms of required minimum capital reserves and liquidity—for banks to hold commercial real estate loans. Banks may thus have somewhat constricted capacity to refinance commercial mortgages. Moreover, new CMBS issuance in 2015 totaled only $95.6 billion, less than what had been expected.
The Wall Street Journal recently highlighted an example of the tightening of credit markets. Anthony D’Agostino recently struggled to refinance the loan he and three other doctors used to pay for the building that houses their private medical practices in Naples, Florida. They built the two-story, Spanish-style building with palm trees outside in 2006 with a $4.8 million loan that became part of a commercial mortgage-backed security. As the loan on the Banyan Professional Center neared maturity this spring, Dr. D’Agostino said a local bank he contacted offered steep terms, including a 20 percent down payment, and gave a low appraisal for the building, which limited how much the bank would lend. “It was ridiculous,” Dr. D’Agostino said. “We had never been late with payments, and our building is fully occupied. It should have been a no-brainer.”
Online Marketplaces Continue to Change the CRE Lending Market
Helped by recent low interest rates, the CRE lending markets have managed to keep up with the worrying wall of maturities. Nevertheless, many real-estate owners who refinance their maturing debts will have to find alternative sources of funds, said Paul Fitzsimmons, head of CMBS research at Kroll Bond Rating Agency. Such waves of maturing CRE loans thus remain a source of some worry for some existing CMBS bondholders; a mini-wave of maturities of 5-year loans done in 2007 sent 2012 delinquency rates to an all-time high—and volume was only about half of the current expected wave.
This current wave presents opportunity for newer types of commercial loan originators. Online marketplaces such as RealtyShares may be well positioned to provide competitive bridge financings to refinance maturing loans. These new lenders of “bridge” and permanent loans to help prevent maturity defaults are well positioned to take up the slack to the extent that markets face capacity constraints.
These online lenders have already made big strides in providing competitive bridge financings that provide borrowers with the “runway-extending” financing needed to re-stabilize a property. Many of these lenders are increasingly moving toward permanent loans as well—and if the conventional lenders remain unable to adequately service the CRE market, the opportunity for these newer players will only increase.
If the supply-and-demand fundamentals remain favorable to lenders, then they should be able to extract a sufficient risk premium that reflects the limited supply of capital as compared to the underlying property risk. The next few years could, in fact, turn out to be a great time to be investing through these online lenders.