Illiquidity and Insolvency in the Commercial Real Estate Market

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

falsely high,

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.

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