If you haven’t read Jesse Eisinger’s column
on the CMBS market in the latest issue of Portfolio, do check it out –
it’s very good. As a special bonus for Market Movers readers, I followed up
with him this morning, with a question about whether the market is insolvent
or "merely" illiquid. Here’s my question, followed by Jesse’s reply.
Q: Clearly demand for commercial mortgage-backed securities
has plunged, and there’s no almost no liquidity at all in the commercial-property
sector. But I’m interested: do you think this is a liquidity problem or a solvency
problem? Many of the office-building purchasers were happy with debt service
payments greater than cashflows, on the grounds that tenants were paying below-market
rates and that cashflows would improve substantially when leases expired. Do
you think that such faith was misplaced? Do you think that rents will go down
rather than up? And is there any evidence of that happening yet?
A: You are certainly right that for now, the commercial market
is facing a liquidity problem now and not a solvency problem. Delinquencies
have risen off the lows of earlier this year, but not much.
The main difference in the commercial market is that supply didn’t rise as
much as it did for the housing market.
So, does that mean if the liquidity panic subsides, the commercial and CMBS
markets will be fine? I doubt it.
The problems with the residential market didn’t start because of oversupply,
but because of bad loans — loans made to borrowers who depended on
refinancing and price appreciation to afford their loan payments. The
"values’ in the "loan-to-value" ratios that lenders used were
in both residential and commercial. The problems in the housing market
started before prices went down; all it took was for prices to flatten and
the subprime borrowers who had 2/28 mortgages couldn’t refinance and
couldn’t afford their loans. That’s pretty extraordinary.
So, I foresee similar things happening in the commercial real estate market.
Borrowers depended on above-normal increases — in rents or appreciation —
to afford their loans. Values rose to nosebleed levels and lending standards
dropped. Both borrowers and lenders made assumptions about future cash flows
and appreciation that were unsustainable. If rents merely fail to continue to
rise, many borrowers will have problems, I suspect. The Peter Cooper Village/Stuyvesant
town purchase is emblematic of this since the assumptions that went into the
purchase were that they would be able to wrest rent increases that were substantially
above the historical norms.
Also, it’s worth noting that around 80% of commercial loans were interest
only in recent periods, about double from four years ago. In the first quarter,
90% were IO. So these borrowers are going to be highly vulnerable to liquidity
issues. Of course, the Fed rate cuts would help in that instance, if the lending
rates follow. But if the banks and CMBS investors are being hit elsewhere, perhaps
they won’t be interested in commercial real estate loans and securities.
Moreover, prices in commercial real estate are already falling. Brian Fitzgerald
of Wachovia estimated that prices had already fallen around 5% to 10% in major
markets by late fall. That will accelerate, I am guessing.