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According to the preliminary numbers compiled by Real Capital Analytics and set forth in the Second Quarter 2007 Real Estate Insights of Principal Global Investors, approximately $250 billion of commercial real estate transactions closed during the first six months of 2007. Moreover, the Commercial Real Estate/Multifamily Finance Quarterly Data Book issued by the Mortgage Bankers Association on June 28, 2007 noted that the level of commercial/multi-family mortgage debt outstanding grew to a record $3 trillion at the end of the first quarter of this year. To understand the current lending environment in the commercial real estate sector, one must examine certain developments in the mortgage banking industry, particularly the increasing market share held by lenders that secure funding through the structuring and sale of commercial mortgage backed securities (“CMBS”). According to the Quarterly Data Book, CMBS lenders issued $137.6 billion of securities during the first half of 2007, a volume that represented a 55% increase over the securities issued during same period in 2006, and as of the end of the first quarter of 2007, 22% of the commercial/multifamily debt outstanding was held in the form of CMBS and other asset-based securities (as opposed to 53% of such debt being held by commercial banks and life insurance companies). The Quarterly Data Book also noted that CMBS lending was responsible for almost 60% of the twelve-month increase in commercial/multifamily debt outstanding. According to an August 12, 2007 Reuters article, 40% of commercial mortgage loans made during the past two years were slated for securitisation. The keen competition among CMBS lenders to secure a share of this heated market brought with it generous loan terms. The loosening of underwriting criteria (such as interest-only loans, increased loan-to-value ratios, and the underwriting of “expected” or “pro forma” rental streams) has been evident for some time. In an April 10, 2007 special report, the rating agency Moody’s Investors Service opined that “the negative credit implications of the ongoing erosion of conduit [CMBS] loan underwriting, particularly the increase in leverage, now exceeds the benefits of generally positive property market fundamentals.” Moody’s and other rating agencies have since increased the subordination levels (i.e., the percentage of a CMBS offering that is not given the highest credit rating) on individual securitisations, thereby resulting in a lower overall proceeds received by CMBS lenders. Given the rise of CMBS financing, it is not surprising that a dislocation in the primary and secondary markets for CMBS securities can (and does) have a significant impact on the entire commercial real estate sector in the US The recent problems faced by investment funds holding residential mortgage-backed securities (“RMBS”) supported, in part, by sub-prime mortgages in the US have made headlines, and such problems have affected the market for all fixed income securities, including commercial mortgage-backed securities. Investors in commercial mortgage-backed securities (some of which also invest in RMBS securities) have responded to these developments by exiting the market for CMBS securities or by demanding greater compensation (i.e., a greater interest spread above the “risk-less” 10-year US Treasury bond) for the perceived heightened (but hard to quantify) risk posed by the commercial mortgages underlying the CMBS securities. In particular, the purchasers of the “first loss” tranches of securities (the so-called “B-piece buyers”) have increased their scrutiny of the underlying mortgage loans and exercised their increased leverage to reject certain loans from the pool of mortgage loans being securitised. As the result of this perfect storm in the CMBS market, CMBS lenders have “re-priced” their loans to meet the higher criteria now being imposed by CMBS investors. Not surprisingly, loan originations have plummeted as transaction structures based on previously available debt costs have become unfeasible. As indicated in an August 7, 2007 Structured Products Research report, analysts at Wachovia Capital Markets, LLC expect the origination of fixed-rate CMBS loans to fall by 80% or more during the second half of 2007. Balance-sheet lenders (e.g., commercial banks, insurance companies, and pension funds) have access to a more secure source of funding and thereby can offer more competitive loan terms. Of particular note to potential Irish investors is the ramped-up lending activity of the major Irish banks. Prospective purchasers of US commercial real estate can now expect limited interest-only periods, lower loan-to-value ratios, higher required debt service coverage ratios, and tightened loan covenants. Purchasers that counted on highly leveraged structures will have to step back from prospective acquisitions, or seek to secure more expensive “mezzanine” financing (i.e., debt secured by a pledge of equity instead of a direct lien on the real estate) to make-up for equity shortfalls. The rising cost of debt and the competition from fewer qualified purchasers may well lead to a moderation or even a decline in the pricing of commercial real estate. As a consequence of these lending constraints, cash purchasers (particularly those with cash denominated in euros) or purchasers needing lower levels of financing currently possess a significant economic advantage as to acquisitions in the US Irish investors are presented with an opportunity to obtain higher returns than those available to them in the Irish real estate market. Although cap rates for US commercial real estate declined through the second quarter of 2007, those cap rates are still generally higher than those for comparable properties in Dublin, which, according to a recent assessment by RREEF Real Estate Research, are 4% or less. In its Summer 2007 RERC Real Estate Report, Real Estate Research Corporation noted that cap rates in the US at the end of the second quarter ranged from 5.7% in the multifamily sector to 6.8% in the suburban office sector. Moreover, a broad-based increase in cap rates is expected. As stated in its recently published report “The Global Credit Market Meltdown: Implications for US Commercial Real Estate,” Principal Global Investors look for an increase of 50 to 75 basis points or more in cap rates to attract sufficient equity capital for acquisitions of properties in secondary or tertiary markets, while cap rates for properties in primary markets may be “much less dramatic.” Irish investors may need to extend their investment universe beyond Boston, Chicago, Los Angeles or New York (the so-called “Aer Lingus Cities”) to second–tier cities such as Charlotte, North Carolina, which has the lowest vacancy rate (3.4%) of any central business district among major US cities. As the result of the current disruption in the CMBS market, Irish investors having a relatively long investment horizon can take advantage of buying opportunities in the US real estate market. Cash-rich investors can capitalise on their significant advantage over their highly leveraged competitors and strike very favorable terms with both sellers and lenders. In assessing potential opportunities, investors may find it worth their while to extend their sights beyond the preeminent markets to less familiar markets in the US Sunbelt. Charles D. Lansden is a partner in the Real Estate Department of Katten Muchin Rosenman LLP. John F. Curry is a 2003 graduate of University College Dublin and an associate in the Real Estate Department of Katten Muchin Rosenman LLP. Both Mr. Lansden and Mr. Curry are located in the Charlotte, North Carolina office of Katten Muchin Rosenman LLP. Katten Muchin Rosenman LLP is a full-service law firm with offices in Charlotte, Chicago, Los Angeles, New York, and Washington, D.C. and the affiliate office of Katten Muchin Rosenman Cornish LLP in London. © Copyright 2007 by Finfacts.com |
