Finding Funding’s Future
by Mark Levine
Summer has nearly passed us by, and therefore it’s time for a semiannual review of where we’ve been this year, and where we are going before the year comes to a close. For starters, this has been one of the most uneventful years that we’ve witnessed in a long time when it comes to the world of commercial real-estate finance. There have been very few significant deals closed. There have been even fewer capital market securitizations of commercial mortgages. The major players in the industry have not made significant moves in one direction or the other when it comes to their desire to finance commercial real estate. The industry seems to be in a wait-and-see mode that is lasting longer than most people anticipated.
This is great news. After more than two years of absolute chaos in the industry and in the financial markets as a whole, some semblance of calm and stability is a very welcome sign. No news is good news for now. In fact, compared to 2009, the markets are almost vibrant. Through the end of June this year, overall domestic commercial mortgage-backed securities (CMBS) issuance was approximately $5.3 billion. This greatly exceeds the almost nonexistent CMBS issuance for the same period last year, and is even greater than the overall 2009 domestic issuance of $3 billion. But getting a sense of confidence from those numbers would be like determining that your car is fast just because it beat a bicycle in a race. Compared to years past, particularly those immediately preceding the financial meltdown, $5.3 billion of issuance is nothing. In fact, that would be a decent week, or even just a large, single deal back at the peak of the market. But we like to think that the glass is half-full, so we’ll remind ourselves that anything in the billions of dollars is far superior to nothing.
In another sign of good news, CMBS spreads have improved significantly, at least from the viewpoint of a buyer or a mortgage borrower. Despite the aforementioned slow activity in the new issuance market, secondary trading activity has been relatively robust throughout the first half of 2010. Throughout 2008 and 2009, activity was essentially at a standstill and therefore an efficient market just did not exist. With buyers and sellers coming together this year, however, the markets are once again witnessing efficient pricing points. Thus far, these points appear to be significantly lower than in recent years, thanks to some restored confidence in the product, demonstrated by the increased trade volumes.
For instance, standard fixed-rate CMBS bonds, with a “Triple-A” rating by the rating agencies and a 10-year original term, traded at approximately 350 basis points over the swap rate near the end of June. With the swap rate and treasury rate nearly equivalent to each other at press time, at just over 3%, this equates to an interest rate of approximately 6.5%. Remember, this is just on the “AAA” portion of a mortgage bond, and not necessarily indicative of an actual mortgage rate, which we’ll discuss soon. The spread of 350 basis points represents the lowest point in approximately two years, and is a very significant drop from the highs of over 1,000 basis points in late 2008 and early 2009.
In terms of actual mortgage rates, the story is similar. With some increased activity in the new issuance market, and especially with notable activity in the secondary trading market, originators of loans have some more clarity on where to price new mortgages. Without this clarity, there existed a relatively huge risk premium that the originators would need to build into new loans, in order to protect them if their views of pricing were off the mark. However, the newfound efficiency and expectations of stability have presented an opportunity for originators to once again compete at market levels.
As we all know, competition generally benefits the consumer, which in this case is the mortgage loan borrower. Indeed, asking spreads on new mortgages have been steadily declining in nearly exact coincidence with increased market activity in the world of CMBS. For example, the spread for a new multifamily loan at approximately 55% loan-to-value was approximately 200 basis points over the treasury rate as of June. Again, with the treasury rate at approximately 3%, this equates to a mortgage rate of approximately 5%. At the beginning of this year, however, the spread for an equivalent loan was closer to 250 or 275 basis points, or over 25% higher than the current spread. With the 10-year treasury rate near 3.75% at the beginning of the year, the aforementioned new mortgage would be originated with a rate well above 6%.
So, the newly discovered calm and stability in the market actually represents significant progress from where we stood 12, and even 6, months ago. There is no longer a feeling that the world is falling apart around us, and there is once again some appreciation and demand for commercial mortgage products. However, let’s not pretend that we are completely out of the woods. Although the capital markets have shown improvement, and the consumer can now benefit from this, the underlying problems associated with commercial real estate and commercial real-estate loans have certainly not disappeared. While the debt capital markets are similar to the stock markets in that they tend to look forward several quarters, let us not forget that the fundamentals of commercial real estate have not recovered and in fact are likely still in sharp decline.
For example, the Wall Street Journal recently reported on increasing office vacancy rates across the country, citing the national average vacancy rate of 17.4%. The amount of occupied office space has declined by approximately 133-million sq. ft. since 2008, and this number continues to climb. With increased vacancies comes decreased asking rents, of course, and average rents for new leases are significantly below those at the peak of the market. Fundamental performance of other commercial property types is behaving similarly, and without a quick turnaround in the general state of the economy and employment levels, there is little relief in sight.
On the other hand, the news in the multifamily sector is a bit more promising at this point. According to a separate analysis by the Wall Street Journal, apartment vacancies declined earlier this year for the first time in three years. The average vacancy rate for apartments nationally was 7.8%, down from a peak of 8% at the beginning of the year. Again, there is an inverse relationship between vacancy and rents, and indeed apartment rents have increased slightly since occupancy rates have stabilized and begun to turn around. In addition, landlords are reporting significantly fewer concessions to attract new tenants, another sign that supply and demand could be reaching a balance once again. The study attributes this improvement in performance to higher consumer confidence, fewer job layoffs, and primarily a recent tendency for renters to obtain their own apartments in lieu of living with multiple family members under one roof.
More than half of the year is behind us and clearly it has been a time of uncertainty and mixed messages. What will the remainder of 2010 bring to us in the commercial real-estate industry? As the past two years have taught us, it would be quite dangerous to venture a guess. The only thing about which we can be certain is that there will be continued uncertainty. However, the good news is that the fluctuations should begin to wane and the modest amount of stability that has crept into the markets early this year should continue to feed upon itself and grow.
Over the next several months, various CMBS originators are expected to sell more pools of loans into securitizations. With significant amounts of cash in the hands of both domestic and foreign investors, the general expectation is that demand for these mortgage securities should be relatively robust. If the securitizations go well, meaning that all bonds are sold at increasingly tight spreads, more players will jump back into the game and competition will once again drive attractive deals for borrowers. This not only benefits customers of CMBS-type loans, but other lenders, such as local banks and Fannie Mae/Freddie Mac, which will also face increased competition and will price new loans accordingly.
Fighting that tide of tighter loan spreads, however, will likely be increasingly strong momentum of rising treasury rates. From January to April of this year, the 10 year treasury rate remained in a relatively tight range of 3.5% to 4.0%. However, beginning in May and continuing through the summer, rates declined sharply and even dipped below 3% for a brief period. This decline in rates is attributed to revised expectations of slower economic growth, lower inflation, the inability to improve upon our unemployment problems and the general concerns that all of the economic stimulus efforts are not improving the state of our economy. That’s a lot of bad news, but of course the good news for borrowers is that mortgage rates have remained low.
Well, in my opinion, things can’t get much worse. Barring the feared “double-dip” recession, I expect our economy and our unemployment picture to gradually improve over the next six months, albeit at a very slow pace. If the government can get itself out of the business of trying to control markets, and if it can save itself from imposing too many constrictive regulations upon financial firms and other businesses, growth prospects for the next several years should improve.
Because markets look forward, any improved expectations for the next several years will have an immediate impact on the fundamentals of today’s markets.
Therefore, any newfound optimism regarding employment, consumer confidence, inflation, and especially the aforementioned state of the capital markets will have an immediate impact on rates. It should mean that investors will withdraw money from treasuries in favor of more aggressive opportunities, and that the government will be forced to raise benchmark rates in order to stem the always-feared inflation predicament. Both scenarios result in a world with increasing interest rates, the magnitude of which is anyone’s guess. What we do know is that the year 2011 will be upon us in practically no time, and with it comes renewed hopes for continued progress toward stable and efficient markets that we have so sorely missed for too long now.
The opinions expressed in this article are those of the author, and do not necessarily reflect the viewpoint of the SFAA or the SF Apartment Magazine. Mark Levine is an independent consultant with more than 12 years of experience in commercial real-estate finance and investment banking. He can be contacted at firstname.lastname@example.org. Copyright © 2010 by Black Point Press. All rights reserved.