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Signs of a rebound.

There are growing signs that the worst may be over in commercial real estate. But then again, that may not be universally true--consider Southern California.

COMMERCIAL REAL ESTATE--these three words have generated uniformly negative feelings from financial institution executives during the past few years. The reasons for this general antipathy are many and have been widely publicized.

During the past few years this market segment has gone from being the darling of many mortgage lenders to the goat. This fall from grace has all taken place in less than a decade's time. In the early 1980s, when mortgage funds chased transactions, commercial property lending was believed to be the most efficient and profitable use of lendable funds (from the perspective of fees and yields).

Less than 10 years later this segment of the industry had become a pariah in the eyes of many. It was also considered the cause of many financial institution failures.

Well, don't look now, but the market and investor sentiment may have turned once again.

The commercial market decline actually got its start in the 1980s, when commercial real estate, driven by tax considerations rather than market economics, expanded dramatically, creating an inevitable imbalance between existing supply and demand. Next came enactment of the Tax Reform Act of 1986, bringing with it revisions that largely removed passive tax loss considerations, which quickly slowed commercial real estate investment and, ultimately, construction as well.

Lenders and developers were slower than investors to wean themselves from the higher rates, fees and profits that historically were associated with this market. But fundamental economics eventually prevailed at the point where supply greatly outreached demand.

The inevitable result, a simultaneous rise in vacancy rates and declining rents, hit the market with a tremendous one-two punch. And then, as if that wasn't enough, came the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). The act's risk-based capital requirements and its much harsher treatment of commercial real estate mortgages looked to be the final knockout punch for an already weary market.

The aftermath of the commercial real estate lending boom has been equally well documented. Mortgage delinquency and foreclosure rates soared, ultimately reaching historic highs. Underwriting guidelines, mandated by prudence as well as by fear of regulators, tightened considerably, and many traditional commercial lenders left the market entirely to improve their risk-based capital ratios and sagging financial statements. Other lenders turned their attention and personnel resources to the job of minding growing inventories of non-performing mortgages and real estate-owned (REO) properties.

Exodus from the market

Throughout calendar year 1991, more than half of the traditional commercial mortgage lenders were entirely out of the market for new loans. For many lenders, their only "new" loans were involuntary rollovers (maturing loans where the originating lender is protecting the investment by refinancing). Market values of performing and non-performing commercial loans plummeted in some markets by as much as 30 percent to 50 percent.

Lenders wishing to sell commercial mortgages to improve their risk-based capital ratios found few, if any, buyers. When the immense commercial portfolio that the Resolution Trust Corporation (RTC) was required to liquidate was added to the market, it made the task of even finding a willing buyer even harder. Furthermore, sellers lucky enough to find a buyer discovered buyers were willing to pay no more than $.50 per dollar of book value. From the viewpoint of both commercial real estate lender and servicer, the situation was far from rosy. In fact, it was downright depressing.

Market conditions were so bad that many economists were predicting (many still are) 10 to 15 years before the market would turn around.

The story of the next few years has been equally well chronicled. The economy as a whole went into recession, unemployment rolls grew dramatically, particularly for white-collar workers, and talk of the "credit crunch" was everywhere. Loan funds dried up and, in many cases, disappeared completely. Default and foreclosure rates hit all-time highs. Loan servicers were asked to perform more and more tasks for the same fee as they received in earlier times when the market was healthy and delinquencies were far less prevalent.

At the same time that this was occurring, capital market yields in general dropped substantially. Yields on 30-year Treasury bonds hit 20-year lows (at the time this article was written they were less than 7 percent). Equity investment opportunities, as measured by the S&P 500 for 1992, posted a return of only 7.6 percent. Yields for certificates of deposit were less than 5 percent. Lending rates for prime mortgages dropped to decade lows. Very few commercial mortgages were done at prime commercial rates.

What was not widely noticed was the fact that cash-on-cash returns for performing commercial real estate had begun to look more attractive in relative terms. Debt service requirements at lower rates became much more achievable. Investors, unsatisfied with lower rates of return, began looking for higher returns, even with the accompanying higher risks, in order to provide themselves with a "yield pop," which was largely missing from other investments in the marketplace.

Commercial Mortgage Default Rates

 Delinquent In Foreclosure

3/91 4.77 2.18
6/91 5.41 2.48
9/91 5.75 2.79
12/91 5.93 2.87
3/92 6.42 3.2
6/92 7.53 3.5
9/92 7.37 3.27
12/92 6.62 3.16

Source: American Council of Life Insurance

Emerging signs of life

Slowly, signs began to appear that the hard times in the commercial real estate market may have bottomed out. The operative words here are "may have," because there are certainly market areas and property types for which this is definitely not the case. Two widely acknowledged examples of places where the bottom has not been hit are the Southern California market and the whole category of office buildings, regardless of geographic location.

Nevertheless, the commercial real estate market still has many obstacles in front of it. Certainly one major obstacle was deftly identified by a speaker at the Mortgage Bankers Association of America's (MBA) Commercial Real Estate Finance/Multifamily Conference in Orlando earlier this year. The commercial real estate market in this country includes approximately $250 billion of mortgage debt held by life insurers. Nearly 30 percent of this debt will mature in the next two to three years. This is a tremendous amount of debt that will need to be refinanced voluntarily or involuntarily. With insurance companies (historically major lenders in this area) implementing their own risk-based capital requirements for financial statements in 1993, the source for these funds and the future of the market is far from clear.

Even so, after conceding that this and other obstacles lie ahead of us, there are still signs that the commercial real estate market has bottomed. The signals are far from conclusive, but investors are beginning to look for those higher rates of return in investment vehicles previously out of favor.

What are some of these newly attractive investment vehicles? Would you believe real estate investment trusts (REITs)? Yes, REITs. As recently as January 14, 1993, a USA Today article discussed investors "flocking" to REITs. With good reason: REITs (equity, not mortgage) had one of their best years in 1991, with an average return of 36 percent. Excluding REITs that specialized in health-care facilities, equity REITs last year had an average total return of 20.7 percent.

Mortgage REITs have been laggards by comparison, still suffering from defaults and a rising incidence of healthy borrowers repaying their debts in order to refinance at today's lower rates. But in this strong performance by equity REITs we see at least one sign that the bottom of the commercial real estate market may have been reached, leaving nowhere to go but up.

What property types are the favorites of the REITs? In 1991, the star was health-care facilities. In 1992, the leader was apartment complexes. Shopping malls and apartments look to be the favorites so far in 1993. The cellar dweller for each of the past few years has consistently been office buildings. Geographically, you cannot make broad assumptions that hold true. You need to do your market research. The only general consensus is that the Southern California market has yet to hit bottom (largely due to aerospace and military downsizing).

Commercial Mortgage Interest Rates(*)

 Five-Yr. Seven-Yr. Ten-Yr.

2/91 9.25 9.625 9.875
3/91 9.375 9.625 9.875
4/91 9.375 9.75 9.875
5/91 9.625 9.625 9.875
6/91 9.625 9.875 10
7/91 9.6875 9.9375 10.125
8/91 9.4375 9.875 10
9/91 9.25 9.375 9.625
10/91 8.875 9.125 9.375
11/91 8.875 9.125 9.375
12/91 8.75 9.125 9.375
1/92 8.75 8.875 9
2/92 8.75 8.875 9.25
3/92 8.875 9.125 9.4375
4/92 8.875 9.125 9.375
5/92 8.875 9.125 9.5625
6/92 8.5625 8.9375 9.3125
7/92 8.1875 8.75 9.0625

Source: Barron's

* Balloon terms

The second and third signs that the commercial real estate market may have already bottomed are visible in the mortgage delinquency and foreclosure rates. In September 1992, commercial mortgage delinquency rates, according to the American Council of Life Insurance, dropped for the first time in more than 24 months. Simultaneously, commercial mortgage foreclosure rates dropped for the first time in more than 27 months. It is interesting to note that the direction of both rates turned simultaneously in September 1992. Admittedly, this is far from a trend, but it is a change in the direction of default rates, which is a factor that warrants close watching during the next year and beyond. This is especially true because during this time massive amounts of required refinancings will be working their way through the market.

Wall Street's renewed appetite

Another sign of the market's turnaround is the dramatic increase in interest by Wall Street investment banking firms. Several of these firms have recently set up or are in the process of setting up commercial mortgage conduits. A few of these firms that were marketing their conduits at the MBA Commercial Real Estate Finance/Multifamily Conference were Daiwa Securities America, Inc., The First Boston Corporation and Kidder Peabody/Commercial Mortgage Credit.

Another firm, Bear, Stearns & Co., Inc., has already set up a commercial mortgage conduit. These conduits are largely interested in multifamily properties currently. At the same time, these firms are relatively new participants in the commercial real estate arena actively looking to acquire new commercial mortgages. In addition, many of these same players are openly discussing the purchase of performing commercial loans of other types and, in some instances, non-performing commercial loans. The reason for the current preference for multifamily properties generally traces to the higher level of homogeneity among that property type, which facilitates the securitization of the mortgages.

RTC playing key role

Another sign of an upturn in the commercial real estate market is the increased discussion and activity in the field of commercial mortgage securitization. In part, this is due to the volume of offerings successfully brought to market by the RTC in the past two years. Securitization of commercial mortgages had been discussed for nearly 10 years, with little or no activity actually taking place until the RTC arrived on the scene. Through December 1992, the RTC had securitized more than $32 billion of mortgages, and, of that, nearly 34 percent were multifamily and commercial properties. That represented approximately $11 billion of commercial mortgage securities coming into the market.

These offerings by the RTC may have broken the logjam that has prevented widespread commercial mortgage securitization. Securitization of these assets also reduces capital requirements for the banks, insurance companies and other entities that traditionally have held commercial mortgages on their books. Increased securitization may well provide a renewed source of funds for commercial mortgage lending, at lower capital costs under risk-based capital requirements for both banks and insurance companies.

There is yet another sign of a possible turnaround that is worth a look. Consider the availability of funds for commercial real estate lending for the coming calendar year 1993. MBA released the results of a survey of midsized life insurance companies in mid-February regarding their plans for commercial real estate mortgage lending. The survey was completed during early February 1993.

Forty-four midsized life companies responded to the survey. (The survey described midsized life companies as those whose preferred loan size is less than $12 million.) The combined mortgage portfolio of the life companies responding had a total value of $52 billion--roughly 22 percent of the $240 billion in commercial mortgages held by all life companies. The results of this survey might be surprising to some lenders.

The following is a summary of the findings:

* Eighty-two percent of the respondents planned to lend on commercial properties in 1993.

* The aggregate lending goals in dollars of the respondents were 27 percent greater in 1993 than in 1992. Those companies seeking investment opportunities had a combined 1993 lending goal of $4.6 billion versus $3.6 billion in 1992.

* Respondents who planned to be out of the market anticipated being out of the market for an average of two years.

* Respondents' perceptions of the commercial real estate market in 1992 were as follows: 7 percent said it was "significantly better;" 34 percent said "slightly better;" 50 percent said "about the same;" 9 percent said "slightly worse;" and 2 percent called it "significantly worse."

* Property type preference of the respondents was (in order of preference): industrial; apartments and medical offices; and retail.

While the survey was not statistically valid in the strictest sense, it did provide an encouraging impression of the market, based on the views of a major segment of the commercial real estate lending industry. The impression provided was not a resounding endorsement of the strength of the market, but it does appear clear that the market is no longer headed downward.

Permits promising

Yet another statistic that should bode well for the future of commercial real estate is the level of new building permits for commercial structures. Commercial construction permits fell steadily from November 1989, when they were at nearly $110 billion, to approximately $65 billion in November 1992--only three years later. Most property types are at or near 20-year lows in construction activity.

While this, by itself, is not a positive sign, it does help minimize the absorption that must take place for market forces to reach the equilibrium that must exist in healthy markets. The lower levels of new construction look most positive for apartments because the supply-and-demand conditions for this category were more in balance than for other property types. Office buildings are again the hardest-hit sector. This is due largely to the size of the initial imbalance and the concentration of consolidations and layoffs on white-collar workers during the most recent national recession.

Healthier financial institutions

An additional factor that points toward an upturn in the commercial real estate market is the improved financial condition of many financial institutions. While many people suffered during the "credit crunch" of the past few years, the remaining healthy financial institutions have significantly improved their balance sheets during the last year or so. Capital positions of many organizations have improved, and other institutions have restructured their balance sheets.

The president of the Federal Reserve Bank of Kansas City, Thomas M. Hoenig, was recently quoted as saying, "The banking industry right now in this region and really nationwide is very good. Banks on the whole earned better than 1 percent on assets." That is nearly four times better than the same industry did less than 10 years ago in 1986.

This increased capital will permit some organizations to sell non-performing commercial assets even at the loss levels that current prices will generate, without causing difficulties with regulators. There also has been a healthy consolidation of commercial mortgage origination and servicing within the industry during the past few years that should set the stage for a more stable market.

In conclusion, there are a growing number of positive signs that indicate the commercial real estate market is no longer on its downward slide. While it is still too early to call the turn in the market with certainty, it may, in fact, have already happened for some property types and geographic regions.

Investors looking for higher yields in the marketplace are once again beginning to look to commercial real estate assets. Commercial real estate mortgage delinquency and default rates finally may have peaked and started moving in the other direction. New participants are entering the arena in the form of commercial mortgage conduits. Commercial mortgage securitization, talked about for more than a decade, now is actually happening at the RTC in a capacity and format that is setting the standard for the industry to follow. Funds for commercial real estate lending are becoming more plentiful, although the availability of these funds will be closely tied to the progress of the heavy volume of mandatory refinancing that will occur in the next few years.

Building permits for new commercial construction are still at very low levels. If they remain at these levels (and the overall economy improves), then the supply/demand imbalances that still exist in the market will dissipate.

Finally, the health of financial institutions in this country has improved significantly in the past few years. This bodes well for all mortgage lenders. Add to this the new administration's plans to reduce some reporting to regulators and loosen requirements for certain types of loans, and the forecast looks better (but still not quite rosy).

As we all know, forecasting is an endeavor fraught with pitfalls. It will be months, if not years, before this marketplace returns to a level of equilibrium. The go-go years of the mid-1980s are gone--hopefully forever. A healthy market needs to be based upon basic economics, not tax gimmicks. The only thing that is constant is change. We hope the change we are seeing now represents a restoration of the commercial real estate market to good health. Only time will tell.

Tom R. Dalton is an independent mortgage/real estate consultant who works extensively with the Clayton Group in New York City and in Reston, Virginia.
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Title Annotation:commercial real estate recovery
Author:Dalton, Tom R.
Publication:Mortgage Banking
Article Type:Industry Overview
Date:Jul 1, 1993
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