The Commercial Mortgage Securities Association (CMSA) gathered in New York last week amidst a firestorm of financial distress and a radical shift on Wall Street.
On most panelists' minds was the impact that present investment banking changes would have on commercial mortgage vacancies, particularly in New York. Also much discussed was the possibility of further stress in the overall sector because of consumer troubles and heightened investor fears.
"Lehman Brothers was a leader and innovator in the CMBS market," said a panelist, who further noted that the CMBS sector has also had to say goodbye to other bulge-bracket firms in the past several months.
Indeed, among all firms Lehman had the highest exposure to commercial real estate-backed securities with $39.5 billion.
Morgan Stanley is not far behind with $31.5 billion in exposure, Brad Hintz, an analyst at Sanford C. Bernstein, estimated earlier this year (ASR 3/3/08).
But the problems in the sector have been driven by pricing and not by credit, according to panelists at the half-day conference. Panelists stressed that investor hesitation is more a product of fear than fundamentals. "We need to have a weekend where a major financial institution doesn't fail. I am more worried on Friday at 5pm than on Monday at 9am," another panelist said. The market needs to see these negative events stop before it can recover, he said.
Indeed, CMBS defaults are expected to be .4% compared with 14% on the RMBS side and 29% in subprime RMBS, a panelist said.
However, ultimate losses will vary based on the severity of the financial crisis. The cumulative loss rate in the sector could range from 1% to 10%, a panelist estimated. For a shallow recession, the loss expectations among panelists stood around 3% to 3.5%. Regarding a possible deeper recession those numbers jumped to between 6% and 7%.
The disappearance of major financial institutions will certainly put pressure on the property demand-side, depending on how the office space is divided up. In its purchase agreement for certain Lehman Brothers assets, Barclays bought the firm's Midtown headquarters, totaling approximately one million square feet of space, and two data centers, according to reports. Lehman owns or leases over two million square feet total in Midtown, and it was unclear at press time how the balance would be divided.
Merrill Lynch is also big presence in downtown Manhattan, occupying 4.2 million square feet at its headquarters at the World Financial Center, reports said. It is still unclear how Merrill real estate will come out of the buyout by Bank of America.
Panelists expected that vacancies from troubled financial institutions would almost certainly have a near-term impact on the commercial real estate market. "Rents will severely soften in New York," a panelist said.
Consumer-driven properties like hotels were also highlighted as properties to be cautious of, especially since they are more leveraged. Panelists cautioned against properties with residential exposure and low barriers to entry like condominiums.
While delinquencies are expected to rise, the tone of the conference was hopeful. "Soft if a good relative performance, everything else is really bad," a panelist said.
As far as buying in the CMBS market is concerned, investors are focusing on the triple-A paper, which last week priced at 300 basis points for a triple-A A4 bond, for example, a panelist said. "Anything less than triple-A is the Wild Wild West. You have to put a gun to people's heads to get bids."
Investors, however, have taken on more exposure to the assets as banks seek to delever their balance sheets, although there is still a lot of capital sitting on the sidelines for the triple-A as well as the high yield paper. What is gone is the middle investors that buy the single-A and high 'B' paper, a panelist said, since these buyers, in some deals, run the risk of being completely wiped out.
While the potential for a developing covered bond market has been touted as a method of boosting liquidity in the credit markets, banks will have to structure these deals so that the profit is greater than the retained interest in the bond. That doesn't get rid of delinquencies, a panelist said. "It is not a silver bullet."
In order to get the seated capital back in play, the securitization market will need to step up its efforts toward better disclosure, panelists said. Demand will also need to stabilize to jumpstart the sector. In the meanwhile, floating rate and IO loans that are approaching maturity will most likely be extended by at least one 12-month period, with another extension possible due to the lack of capital to refinance.
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