Even as CMBS financing is slowly regaining form, with anticipated issuance of up to $40 billion this year, practices that contributed to the last downturn are slowly creeping back into the picture. This is a topic that was discussed at the CRE Finance Council's June convention in New York.
While these practices, such as cap-rate compression, could pose a concern in the long term, in the shorter term economic woes are more of an issue for the commercial real estate (CRE) sector.
With the economy hitting a soft patch at the time of the convention and various economic indicators showing a slowdown, speakers believed that the softness would rub off on the CRE sector.
Also clouding the economic picture, Richard Parkus, a Morgan Stanley executive director, pointed out that the Federal Reserve's monetary accommodation through a second round of quantitative easing is ending soon.
While there is some speculation about the possibility of another round of quantitative easing, or QE3, Parkus sees this as unlikely. And with the emphasis on debt reduction efforts, fiscal policy is also likely to be less supportive to economic growth.
In addition to domestic issues, events in Europe relating to the handling of Greece's debt crisis are also "redefining our view about future growth upon which [CRE] real estate growth is predicated," Parkus stated.
He anticipates that this "new degree of uncertainty about future growth will likely have a dampening effect on leases and the robustness of recovery" in the CRE sector.
Already, he is seeing a bit of difficulty for interest-only loans of the 2005 to 2006 vintage to refinance.
A slowdown in growth means that "over the next few years, fewer loans that would have been able to escape will be able to escape," he noted.
However, it is not yet a certainty that economic growth will continue to slow and Morgan Stanley economists expect growth to pick up in 2H11, Parkus said.
Even if slowing growth does not cast a shadow over the sector, repricing of commercial real estate prices is not done yet, according to Sally Gordon, a managing director at BlackRock.
She expects that weaker properties will take longer to see a price recovery, although stronger properties, sought after by life insurance company investors, are recovering faster.
Gordon bases her view on the fact that CRE debt outstanding as a percentage of U.S. gross domestic product is still above its long-term average of 17%. In 1Q11, this figure was at 20% of GDP, compared with 24% of GDP at its cyclical peak in 2008.
While excess leverage was cited as the culprit in the recent downturn, oversupply was the problem during the early '90s downturn. Thus, since excess supply was not an issue, industry participants were erroneously complacent during the recent boom.
This just shows that it is difficult for quantitative models, based on historic events, to capture signs of trouble that do not follow previous patterns, according to Gordon.
"Models are a necessary tool, but they are not sufficient," Gordon said. She would like models to take into account different market dynamics, even those that are not quantifiable, going forward.
Erin Stafford, a managing director with DBRS, noted that the rating agency, for one, has made changes to its CMBS rating model in view of experiences during the recent downturn.
DBRS is basing its estimate of loss in case a bond defaults more on debt yield, a measure that compares a property's cash flow to loan amount.
While the rating agency is still interested in measures such as loan-to-value ratio, it has found that LTV is a less reliable measure of loss severity, given the slackening in underwriting standards and the cap rate compression that occurred during the last downturn.
Lowering of cap rates led to inflated property values and made for higher leverage levels in the last cycle. It seems the lessons of the last cycle have not been entirely learned, given that cap rate compression may be getting back into the picture.
Some speakers at the convention said that investors are accepting lower returns in search of yield. They see this as more of a driver for cap rate compression than any differences in property fundamentals.
However, according to DBRS data, although cap rates on the more recent deals have gone down compared to last year's deals, and LTVs have gone up, recent deals do have more of a representation of higher-quality properties in the better markets.
However, Parkus noted that, looking at the whole picture, while underwriting is weakening, it is not weakening to the same extent as during 2006 and 2007.
While interest- only loans are coming back, they look different this time, according to Daniel Sefcik, a BlackRock managing director, considering that lenders are now engaged in more rational decision making about this loan product.
One factor that may temper the risk appetite of lenders, causing them to opt for lower LTVs and higher debt service coverage ratios, is that there is a lack of dependable hedging mechanisms in the current market, given the lack of CMBS 2.0 deals, according to Paul Vanderslice, managing director at Citigroup Global Markets.
