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Commercial Real Estate Bytes 

2008 Real Estate Outlook
4/7/2008
Published by Tremont Realty Capital

While this article is supposed to be about the outlook for the 2008 real estate industry, the savvy reader will be struck by how much space is devoted to credit market status and projections. Members of the real estate community with gray hair will recall a time when our industry was “in its own orbit”. Historically, real estate cycled, but rarely in sync with the rest of the economy: it either lagged or  led.     Today, especially with how intrinsically real estate is capitalized via capital markets, an erosion of investor confidence in the seemingly unrelated world of corporate, asset backed and sub-prime bonds, has direct and lasting impact on the commercial real estate world. Hence, a real estate outlook without a capital markets overlay would be like a review of next year’s NFL season without mentioning the New England Patriots!

During a late 2007 Mezzanine Debt Conference, much of the discussion centered on the current credit market chaos. Panelists debated whether we have a “real estate problem” or a “credit problem”. The consensus seemed to reflect that there is clearly a current real estate crisis in for-sale housing and land today. Concern was also expressed that the lingering credit crisis is leading to significant layoffs in the financial sector, which in turn has cascading effects on layoffs in supporting industries: case in point, Orange County, California where many Subprime Lenders are based, has seen office vacancy rates jump, and in New York, CMBS professionals are simply waiting for the pink slips. Just 60 days ago, few were willing to project a 2008 US recession, today many feel we are currently in a recession. The ramifications of such an event on the real estate markets are mostly dependent on how wide spread it is and of course, the duration: clearly the more quarters we go with negative growth, the greater the strain on employment, consumer spending and expansion. Since these factors are the drivers of the real estate industry, all are closely watching national events and economic news for signs on how the economy is breaking. Consumer spending results from the Christmas season are in, and most retailers had disappointing revenues with sales down over year prior figures. The exception to this trend was value retailing such as Wal-Mart and Costco, which led all retailers with solid gains. The fact tends to point to consecutive spending by consumers.

The lack of credit manifested itself in the fourth quarter, with institutional sales dropping to a fraction of the prior year’s levels. However, it appears that many issuers are working diligently to clean up their portfolios. While new credit is still difficult to obtain, many existing loans are now being offered at reasonable discounts. This is a good sign for the markets since “accepting the pain”, recognizing portfolio miss-pricing, and the freeing up of lending ability needs to occur before any “normalcy” can return to the markets. The loan discounts are delivered in two popular ways: A) absolute principal discounts against legal collectable note amount, B) Below market financing. Absolute principal discounts are for both credit and rate adjustments. For example, an issuer makes a $20 million 85 percent loan-to-value (LTV) bridge loan at LIBOR +200. Today that loan should be priced at LIBOR +400. This might require the loan to be sold at $18 million. In addition, if the loan was poorly underwritten with very aggressive lease-up assumptions, such that even at $18 million the real LTV is 90 percent. This would result in an additional discount of $1 million. Therefore the note in this example would be sold for $17 million. These discounts are typically just for rate adjustments. For example, an issuer makes the same bridge loan in the above example, but here there is no credit impairment. In this example an issuer makes the same bridge loan in the above example, but here there is no credit impairment. In this example, the issuer sells the note at Par, with 80 percent financing at LIBOR. This allows the buyer to get the appropriate yield for this loan. Some are criticizing the latter discount process since it does not actually remove the asset form the issuer’s portfolio, it simply pays it down slightly and re-characterizes it. It is unclear if such structures will actually obtain sales treatment for the seller and free up new lending power.

The rocky road to recovery in the Credit Markets continues as lenders and issuers make progress detailing their troubled assets in early 2008. Tremont’s survey of industry participants reveals that most feel the market is at least 75 percent through disclosure of problem assets. In addition to new large write downs coming from Merrill Lynch ($15 billion as reported by the New York Times), several large credit card companies including Capital One and American Express have announced either increased loan loss reserves or actual write downs. The latter events are likely more associated with the overall economic slowdown than the Credit Market problems however the lines between these events are becoming blurred. Historically, Credit Crisis’s become exasperated when “bad news” filters out over long extended periods. “Bad news” is obviously defined as when companies disclose losses. In its extreme, bad news reveals corporate failures and bankruptcies. Drawn-out revelation of bad news has a tendency to erode market confidence across sectors. We are coming up on the one-year anniversary of when the subprime crisis news broke out on a national scale. The first half of 2007 saw the failure of many companies who were active in the subprime industry. Since then, the business press has regularly identified various Funds with super-leveraged esoteric investments that have failed probably the most publicized being the several Bear Sterns funds that were dissolved. To date, well publicized “bad news”, combined with individual net worth declines from the weak housing market, have finally combined to cause the US consumer to slow spending, leading to the present risk of a widespread recession. To date, the commercial real estate credit crisis has been predominantly a function of the frozen securitization market, caused by investor loss of confidence in underwriting and bond ratings. Noteworthy is the fact that the underlying commercial real estate assets have largely continued to perform with relatively low vacancy and rising rents. Furthermore, Commercial mortgage backed securities are enjoying delinquencies below 1 percent for all asset types. The risk for 2008 is that the looming economic downturn or recession will eventually lead to actual real estate related problems and potential defaults, creating a whole new series of new “bad news” just as the original causes of the credit crisis resolve. Hopefully, the recent aggressive action of the European Central Bank in providing $500 billion liquidity to the market, in tandem with Fed Chairman Bernanke’s statement to resolve to use his office to fight off a recession, will successfully keep a recession to a minimum and help to avoid a downturn in real estate fundamentals. an issuer makes the same bridge loan in the above example, but here there is no credit impairment. In this example, the issuer sells the note at Par, with 80 percent financing at LIBOR. This allows the buyer to get the appropriate yield for this loan. Some are criticizing the latter discount process since it does not actually remove the asset form the issuer’s portfolio, it simply pays it down slightly and re-characterizes it. It is unclear if such structures will actually obtain sales treatment for the seller and free up new lending power.

The rocky road to recovery in the Credit Markets continues as lenders and issuers make progress detailing their troubled assets in early 2008. Tremont’s survey of industry participants reveals that most feel the market is at least 75 percent through disclosure of problem assets. In addition to new large write downs coming from Merrill Lynch ($15 billion as reported by the New York Times), several large credit card companies including Capital One and American Express have announced either increased loan loss reserves or actual write downs. The latter events are likely more associated with the overall economic slowdown than the Credit Market problems however the lines between these events are becoming blurred. Historically, Credit Crisis’s become exasperated when “bad news” filters out over long extended periods. “Bad news” is obviously defined as when companies disclose losses. In its extreme, bad news reveals corporate failures and bankruptcies. Drawn-out revelation of bad news has a tendency to erode market confidence across sectors. We are coming up on the one-year anniversary of when the subprime crisis news broke out on a national scale. The first half of 2007 saw the failure of many companies who were active in the subprime industry. Since then, the business press has regularly identified various Funds with super-leveraged esoteric investments that have failed probably the most publicized being the several Bear Sterns funds that were dissolved. To date, well publicized “bad news”, combined with individual net worth declines from the weak housing market, have finally combined to cause the US consumer to slow spending, leading to the present risk of a widespread recession. To date, the commercial real estate credit crisis has been predominantly a function of the frozen securitization market, caused by investor loss of confidence in underwriting and bond ratings. Noteworthy is the fact that the underlying commercial real estate assets have largely continued to perform with relatively low vacancy and rising rents. Furthermore, Commercial mortgage backed securities are enjoying delinquencies below 1 percent for all asset types. The risk for 2008 is that the looming economic downturn or recession will eventually lead to actual real estate related problems and potential defaults, creating a whole new series of new “bad news” just as the original causes of the credit crisis resolve. Hopefully, the recent aggressive action of the European Central Bank in providing $500 billion liquidity to the market, in tandem with Fed Chairman Bernanke’s statement to resolve to use his office to fight off a recession, will successfully keep a recession to a minimum and help to avoid a downturn in real estate fundimentals.                                        

Polk Properties offers over twenty years of Real Estate experience that you can trust and depend on. We focus on long range portfolio management and tailor each portfolio to deliver value with measurable returns. We have sold and leased a rich variety of product types in the market place. For an insightful analysis of your current real estate holdings and an overview of the opportunities the market extends, contact Michael Polk at Polk Properties.

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