Brian Lancaster, head of MBS, CMBS and ABS strategies at RBS Securities, believes investor demand will remain intact and likely will continue to drive CMBS yield premiums narrower in 2010.
According to the veteran market observer, who sat for a Q&A session with Investment Dealers Digest, securitization of commercial real estate mortgages will pick up, but values of income-producing properties could fall another 10% or so.
Lancaster's forecast for spreads comes at time when triple-A CMBS have already narrowed to 400 to 500 basis points off swaps, from 1,500 a year ago. Going forward, he says, "you could see 10-year triple-A spreads get to inside of 300 basis points given their relative cheapness relative to corporate bonds and other sectors, limited supply, and the growing availability of repo," he says. "By summertime you could see super-senior paper of high-quality deals trade inside of 300 basis points. New issue super-senior paper could be inside of 100 basis points."
At the same time, liquidity in the secondary market of CMBS should improve further. "Bid offers should continue to get tighter," Lancaster said.
A longtime veteran of the real estate finance industry, Lancaster recently sat down with IDD to offer some of his expectations for commercial real estate. Following are some excerpts from that interview.
IDD: What's your outlook for commercial real estate?
Lancaster: We expect to see commercial real estate prices bottom in the summer of this year. If you look at where leverage and financing costs, [net operating income] and the return on equity were before the markets crashed, and you look at required returns on equity today, NOI and where the financing is, we expect prices to be down on average 50% from peak to trough. The peak was around February 2007. We are currently down about 40%. So, we are almost there.
IDD: This is across all property types?
Lancaster: No, depending on the property type, tenanting and location, values could be down more or less, but on average we think down about 50% is about right. More simply, CRE prices went parabolic from 2004 to 2007. While improving fundamentals played a role, prices were largely driven by cheap money, high leverage for the properties, plentiful and cheap leverage for the bonds, and aggressive underwiting and CRE CDOs.
IDD: CDOs played such an important role because they soaked up all of the mezzanine and low-rated paper.
Lancaster: The biggest increases in commercial real estate property values took place between late 2003 and 2007. Ironically, 2004 was also when the Fed actually started raising rates; 2004 was also the advent of the managed commercial real estate CDO. That led to a huge amount of new financing available for mezzanine finance, debt backed by the owner's equity, B-notes and B-pieces.
Those markets used to be the purview of a small number of lenders and servicers and carried high spreads. Once you could throw those highly leveraged, previously high-yielding assets into a CRE CDO, that brought borrower financing costs down further and borrowers could buy properties with minimal equity in them. That financing is not there so we basically have got to revert to price levels before the 2003-2004 run-up. That's about a 50% decline
IDD: Among all the property types, where have you seen the most extreme price declines?
Lancaster: The most extreme declines have been in the hotel sector, which is pretty typical. Retail and office has also fallen. Geographically areas like Florida, Vegas and Arizona have been the hardest hit. Apartments have also declined but not by nearly as much. The reason for that is, primarily, that you could get financing from Fannie Mae and Freddie Mac throughout the crisis and, of course, still can. That never shut down unlike the private commercial real estate financing markets. Fannie and Freddie continued to support the apartment sector so those prices have not declined by as much.
IDD: A large part of that decline in hotels is tied to a drop in consumer spending?
Lancaster: Yes. It is pretty typical in these down cycles, 24-hour leases and high fixed costs, absence of financing. It's a combination of the declines in discretionary consumer spending which would, of course, impact leisure travel. But it's also been declines in corporate spending. Now that corporate profits are improving we would expect to see more business-oriented hotels pick up in value.
IDD: The decline in value leads to problems with people's ability to refinance. Are you worried about this given the drop in the value of properties?
Lancaster: Certainly. This is a big issue. The good thing is that a lot of the properties that have fallen in value from the peaks in 2007 and 2006 don't have to be refinanced for several more years. They are mostly 10- and five-year loans. The loans that are at risk are five-year loans originated in 2005 and have issues and some of the older 10-year loans if the properties are not in good shape. What we are seeing a lot of is extensions.
IDD: Those extensions come from the servicers.
Lancaster: Exactly. The key is that servicers will do extensions provided the borrowers show good faith and write a check. It's not like you can walk in and say 'I want an extension.' The reasons have to be sound like the property still has a cash flow ... a borrower needs to re-tenant a building and has to be willing to put up some money.
IDD: A big part of the CRE market were the conduit programs. Have they reopened?
Lancaster: They have already started to reopen. I think the DDR [Developers Diversified Realty] deal was very significant. That was the official starting gun reopening the market. It was not the classic conduit deal because it was a single borrower, but it was very significant in that the borrower's cost of funds was around 4.25%. It was extremely attractive to the borrower. That deal has been followed on by others.
IDD: Are these all Talf deals?
Lancaster: No they are not. The DDR deal was a Talf deal. But the other deals were not Talf. The market is weaning itself off of Talf, which is a good thing. If you look at the spread between Talf-eligible CMBS bonds and non-Talf eligible CMBS, they are increasingly narrowing. That would argue there is less need for Talf. In some sense, Talf is not relevant currently.
IDD: Do you think the market needs and extension of TALF?
Lancaster: It would not hurt [to get an extension of Talf], Currently it is less and less necessary, particularly as private repo is coming back. Yet it's always good to have it there as a backstop.
IDD: Are people buying non-Talf deals because they want the extra yield? And are the loans being written at more stringent terms than before?
Lancaster: Yes, that is definitely going on. In the new deals that [more stringent underwriting] is true. Underwriting is very conservative and the main focus is debt to yield.
IDD: How much CMBS issuance did we see in the U.S. last year?
Lancaster: Until the DDR deal it was virtually nothing. It was about $2 billion. The year before [2008] was about $25 billion if you include domestic and international. That compares with $220-plus billion in 2007. In 2010 we will see, maybe, $20 billion. It may be $1 billion a month in first half and $2 billion a month in the second half.
IDD: Will the CRE CDOs come back?
Lancaster: I could see re-Remics for CRE CDOs. I don't see people doing new CRE CDOs this year. The desire is for simplicity, transparency and conservative underwriting. People will want to have static pools. People want to know what they are getting. That would preclude the managed CRE CDOs.
IDD: When it comes to regional differences in commercial real estate, are there any regions that lag others?
Lancaster: Some of the worst commercial real estate markets in the U.S. are in areas such as Florida, California, Arizona and Nevada. Those states have the highest unemployment and there was a contraction in the number of households. That's putting pressure on the apartment market. Some of the highest delinquency levels in CMBS are in Arizona, which is 12%, Nevada is 13%. Michigan is 11%. Florida is about 9%.
IDD: When it comes to conduits, are they underwriting loans again?
Lancaster: It's tentative and careful and definitely not business as usual. It's not the widget factory again. Some are working on brokered deals. Some are working on principal and balance sheet deals or [are] in process with risk committees to get approval. The industry is slowly starting to pick itself up. We still have a long way and unsecured corporate finance is a competing alternative, but it is still a 180-degree change from a year ago when people were just laying professionals off. One conduit actually hired two analysts. There is less leverage and no IO [interest only loans]. There is much less leverage, debt to yield is the new LTV/DSCR and loans are shorter and amortizing.
