The commercial real estate (CRE) market, and CMBS as a component of this sector, has not been immune from the problems brought on by the financial crisis.
However, despite these hurdles, experts said that investors are once again beginning to show a strong interest in this sector.
Additionally, CRE market participants are starting to see some of the benefits from QE2, although the optimism is tempered by the current unstable employment and regulatory environment.
On a macro perspective, Lisa Pendergast, managing director in the MBS/ABS/CMBS group of the fixed-income division at Jefferies & Co., said that the market is factoring in some potential QE2 re-flation. "This bodes well for the CRE market," she said. "However, improving CRE fundamentals are ultimately linked to job creation."
In terms of how the different CRE asset classes will perform, Pendergast said that, to some extent, the sectors that have reset to market already, such as the multifamily and industrial sectors, will not feel as much volatility going forward. "These assets have already reacted to the downturn in economic growth," she said.
Multifamily, for instance, has shorter lease terms than, for example, office. So rents have already reset to today's lower levels, she said.
What's more, the reality is that there is strong demand for apartments as the homeownership rate, which peaked at 69.1% in 2005, is projected to fall back to the historical average of around 64%,, according to Pendergast.
"Multifamily also has benefitted from the attractive and consistent financing made available via the GSEs, which has allowed this asset to perform better," she said.
However, Pendergast said that asset classes such as office - which have long-term leases and were shielded from the effects of the recession - will experience more stress as the terms of the leases end and rents re-set to today's lower market levels.
This will have an impact on CMBS, given that some 35% of CMBS conduit/fusion pools are collateralized by loans secured by office properties, she said.
"The extent of the damage will depend on one, whether QE2 yields the intended results and two, how quickly a re-inflation of the U.S. economy leads to job creation," Pendergast noted. "Even donning my optimistic hat as to QE2's prospects for succeeding, I have my doubts that it will have an immediate positive effect on CRE fundamentals."
Current Investor Demand
However, there will always be appetite for commercial properties that provide buyers with good value.
According to Ron D'Vari, chief executive officer and co-founder at NewOak Capital, there's substantial demand from both U.S. and international investors for U.S. commercial real estate assets.
"They are getting to like assets that bring cash flows," D'Vari said. "We are finding a heightened interest in various real estate asset types, such as office and multifamily, both in primary and secondary markets."
He said that what investors essentially consider are cash-flowing properties in major metropolitan areas at cap rates in the 5% to 6% range to double-digit in secondary cities based on realistic net operating income forecast.
"Given where the interest rates are, this is considered attractive because Treasurys are 2% to 3% lower than that and they are still providing a premium yield with additional upside due to income expansion and capital gains from inflation," D'Vari said, adding that it is attractive to have both current income and inflation upside.
"Investors are starting to feel that they could miss the boat if they don't invest in commercial real estate equity and mezzanine at these levels," he explained. "We are beginning to see that the market has stabilized and that there's a chance that supply will be limited while demand keeps growing."
Currently, D'Vari noted that there seems to be stronger interest from lessees to lock up longer-term leases, which increases the cash-flow stability of the underlying properties. "There are still a lot of troubled real estate assets that are hidden and haven't been worked out yet - there's true positive momentum on the other side," he said.
JPMorgan Securities analysts said that for the next year, the theme of "haves" versus "have nots" will play a more prominent role.
They explained that loans and bonds that have strong collateral should get considerable attention, while properties that are in secondary or tertiary markets and, correspondingly, bonds that are backed by weaker mortgages will "languish."
"Similarly, commercial property prices should continue to recover, but unevenly," they wrote. The better assets that are located in primary markets will benefit the most from capital flows, they said. Meanwhile, for mid- and lower-tier assets that are in secondary and tertiary markets, the economy will have to make a rebound before these properties can recover.
Uptick in Lending
D'Vari noted that there is an increased interest in lending. "We are seeing the origination guys jockey around for position - so the JPMorgan's and UBS's of the world," he said. NewOak, he said, provides underwriting support services with the demand picking up.
The origination market is seeing reasonably healthy property LTVs. "There's a good amount of equity capital providing healthy first loss. The reason lenders are okay is that they have a significant amount of equity in the property supporting their loans," he said, adding that the right equity owners are also pretty smart operators.
"Frankly, I have encountered situations where an entity has called me to say that it has gotten clean with its past obligations and is ready to restart fresh," he said. "Where did they get their equity capital? These guys sourcing and operating expertise are sought after - smart money provides them with non-discretionary capital for acquiring assets at attractive valuations and operating them."
D'Vari enumerated the factors that bode well for commercial real estate: QE2 has created enough liquidity; the Federal Reserve is becoming more reasonable as money has been sitting on the sidelines; with the low interest rates, cashflows should be worth more; and lenders have become more sophisticated.
"There's more confidence building it out, which is the key factor," he said. "One day lending by the medium and smaller banks in general will come back, and people are going to be positioned for the next cycle."
New-Issue CMBS Market
On the CMBS front, although the complete reopening of the new-issue market is also expected to be hampered by regulatory uncertainty, transactions are expected to come to market mostly in the latter part of next year both from new originations and refinancings.
"Regulatory uncertainty is likely to persist in 2011," JPMorgan analysts wrote. "Not only will this introduce bouts of volatility, but it could also limit issuance relative to our expectations." They added that issuers might instead access the private market, which in turn might change the CMBS investor mix.
In terms of new-issue volume, Jefferies' Pendergast is expecting 2011 volume to hit $25 billion to $35 billion; part of this volume would come from those 10-year CMBS loans originated back in 2001. With the higher capitalization rates on mortgages originated in 2001 of around 8.5%, Pendergast said, there's a good chance that the values on these assets are still higher today than they were when originated.
Moreover, most of these loans were privy to the old-fashioned concept known as amortization, so they have paid down some since origination. "This is certainly fodder for my view that volume will be two to three times more in 2011 than what we saw in 2010," she said. "I suspect that the majority of new-issue CMBS will be issued during the later half of 2011, with the first half of 2011 seeing a slow but steady increase in volume."
Some loans originated in 2006 will also need to be refinanced in 2011, although these mortgages will probably have a more difficult time because of the lower underwriting standards and excessive leverage points over that period.
"Clearly the strongest borrowers associated with the largest, highest-quality loans/markets will want to negotiate with special servicers," Pendergast said. "Positively cash-flowing properties will be favored and these types of loans are the most likely to be granted some form of modification."
She added that, "The lending markets will remain highly bifurcated - with growing competition for high-quality loans, with increasing leverage the likely result. To the good, the leverage factor has become far more transparent compared to prior valuations."
Alternatively, according to Pendergast, she expects that special servicers will be quicker to take back smaller loans secured by assets in stressed, non-core markets. "Whereas 2010 represented a year of expected losses, 2011 is likely to usher in realized CMBS losses," Pendergast said.
JPMorgan analysts said that in terms of new-issue CMBS transactions, there have been various structural changes made to cater to investors' concerns, which include underwriting robustness, senior bondholders' voting rights, the specific events that determine when control over the special servicer shifts, and the separation of the B-piece buyer from the special servicer.
"We think that deals that were issued in 2010, and those that will be in 2011, represent the best combination of structural integrity and conservative underwriting that we are likely to see in this cycle," analysts wrote. "Conservative underwriting, however, is usually the first metric to loosen when competition increases."
They added that given that most Wall Street firms are originating commercial real estate loans or rebuilding their businesses so that they can do so, it is inevitable that underwriting standards will deteriorate through the next year.
Regulatory Picture
In terms of regulatory issues, Pendergast said that CMBS market participants are looking closely at the notion of risk alignment.
"Unfortunately, the CMBS sector has been lumped in with the residential sector, which has forced us to spend considerable time and effort explaining that there are significant differences between the two," she said. "The notion of risk alignment is very different for the two real estate markets given the differences in deal composition and structure."
She added that risk retention for CMBS can take a variety of forms, with retention potentially held by the originator, securitizer, or B-piece investor. "The B-piece buyer re-underwrites the loan and would be required to retain the risk for a stated period of time," she explained.
Risk retention, according to Pendergast, should be applied in conjunction with transparency, disclosure, and more in-depth representations and warranties.
"I believe that if these aspects of CMBS were strengthened, regulators and investors would be much more inclined to adhere to the option of allowing risk retention by the B-piece buyer," Pendergast said.
