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The need for new money.

The credit crunch is the key constraint to a recovery in commercial real estate.

ODD THOUGH IT MAY SOUND, THE COMMERCIAL REAL estate market can't return to normal transaction volumes until mortgage money is readily available. And that availability of funds awaits significant restructuring of commercial property finance--meaning new lenders, additional sources of capital, greater securitization.

This structural change is necessary because savings and loans are largely out of the business; banks are in hiatus as they deal with problem portfolios; and insurance companies are reducing their exposure to real estate (permanently).

Commercial real estate finally bottomed in 1992, but the market will not bounce back to life quickly: this trough will be a wide one. Before prices can stabilize and good-quality buildings be offered for sale, the "junk," or distressed, properties have to sell at deep discounts. Opportunistic purchasers of troubled real estate typically have used substantial leverage; but seller financing is often the only mortgage source available today, and sellers are facing up to this fact very slowly. The credit crunch is the key inhibitor of real estate recovery, as is explained later in this article.

The 1990s will be characterized as a bifurcated decade for real estate. The early years, say 1990 through 1994, are the transitional period of secular change in the industry--and that transition is probably 65 percent to 70 percent completed. Eventually, we will reach the last half of the decade, which will be a time of much healthier supply/demand relationships, solid economic return and strong investment interest in real estate equity and debt.

The industry restructuring now under way consists of several elements:

Gradual absorption of excess space--Because of the stumbling economy and continued downsizing, this is occurring very slowly.

Transfer of a significant fraction of the total inventory from weak hands to capable owners--Unfortunately, foreclosure takes a long time, especially when the original owner faces significant tax recapture and has a strong incentive to stall. The speed of transfers is beginning to pick up. However, in the best office market in the country (Washington, D.C.), there still have been so few sales that people active in the area can list all of them.

The distressed real estate has to be cleared out of the way before good assets will be brought to market. Right now, prices are perceived as too low, so nondistressed owners are disinclined to sell.

Permanent shrinkage of overall employment in the industry by at least one-third--This is largely done.

Downward adjustment of property valuations to reflect a prolonged period of low effective rents--The 1992 year-end valuations probably touched bottom.

Extremely limited new construction--Although there is virtually no speculative construction, a surprisingly large amount of build-to-suit activity is occurring--for big box retailers and for corporate offices, manufacturing and distribution facilities. This has a dampening effect on absorption of existing space.

And, finally, evolution of new methods of financing real estate--We believe this is the root problem and the reason that a full commercial real estate recovery will be slow in coming.

Disposition paralysis

Despite frequent claims to the contrary, today's disposition paralysis is only partially the result of too wide bid-and-ask spreads. Rather, it is primarily caused by the fact that, generally speaking, only all-cash buyers have been able to operate in the marketplace. This has had several implications:

* On the principle that "cash is king," buyers are behaving like vultures and are only willing to make acquisitions on extremely favorable terms. (Some people who thought they made attractive purchases two years ago are regretting those deals because rents kept falling. That experience has toughened today's buyers.)

* With vultures as the active buyers, only desperate owners are bringing their properties to market, as mentioned earlier. On average, the available properties are of poor quality.

* Consequently, institutional investors have very few potential purchases to consider. An estimated $12 billion in pension fund money is available to acquire investment-grade properties--but there is very little to buy. (The $12 billion estimate comes from the "1993 Real Estate Capital Markets Report," published by The Institutional Real Estate Letter, Walnut Creek, California.)

* With the exception of true "vulture pools," most all-cash buyers are institutional. However, junk needs to be cleared out before the real estate market can return to an even keel and investment-grade properties can trade again. That brings us back to the fact that the typical, noninstitutional, opportunistic buyer needs to use leverage--but it is not obtainable today.

* This means that, in the short run, financial institutions trying to dispose of foreclosed real estate have to provide seller financing, just as the Resolution Trust Corporation has done. Some banks have awakened to reality; but as with everything else in this real estate depression, progress is slow.

* In the longer run, alternative capital sources must be developed for commercial mortgages. The strongest candidates are pension funds and individual investors. This requires structural change in real estate finance; it is not simply a cyclical issue.

History helps explain

To fully understand this thesis, a little history is helpful.

Deregulation of the savings and loan industry in 1983 to 1984 permitted thrifts to invest in a wider variety of assets than single-family homes and government securities. Within a very short time, huge flows of capital from savings and loans created competitive pressures in the commercial mortgage market, bidding down interest rates and relaxing credit standards.

At the same time in the mid-1980s, insurance companies began to look to the commercial mortgage market as a high-yield investment alternative. After examining delinquency and foreclosure statistics from the prior four years, they were encouraged by a very modest loss history. (The trough in foreclosures in the early 1980s is clear in Figure 1.) Additionally, development of the Guaranteed Investment Contract (GIC) market provided insurance companies with a large and ready source of funds for mortgage investments.

Simultaneously, domestic money center banks were focusing on commercial mortgages as well. They needed high-yielding investments to improve earnings devastated by losses from loans to developing countries; also, loan demand from corporations was dwindling because they were turning to public financings. Instead of requiring developers to have "take out" financing arranged before breaking ground, commercial banks offered open-ended construction loans or miniperms. Consequently, in addition to fulfilling their traditional role as providers of risky construction and development financing, they eliminated the "check" or "balance" of a second, permanent lender.

International banks, led by the Japanese, also thought the mid-1980s were an excellent time to enter the commercial mortgage business. Not having U.S. loan origination networks, most offshore banks purchased participations in commercial mortgage loans originated by American money center banks. This enabled the U.S. banks to accelerate their activity because they kept only small portions of the loans themselves while generating handsome syndication fees.

By 1987 and 1988, every cylinder was firing at maximum capacity. Savings and loans, domestic and offshore banks and insurance companies committed unprecedented sums to the commercial mortgage market; and the large credit companies were in the picture as well. As shown in Figure 2, the flow of funds into commercial real estate debt peaked in 1987. The market's response to all of this activity was predictable: yield spreads collapsed to approximately 100 basis points (bp) over U.S. Treasuries for high-quality financings, while trophy deals were priced with credit spreads as low as +85 bp.

Then money dried up

The party ended in 1990 and 1991; and by 1992, as a result of record loan losses, commercial mortgage funding had virtually disappeared. When the money dried up, mortgage yields moved up dramatically, as portrayed in Figure 3. Nonetheless, funds remained scarce because virtually all of the traditional lenders were unable to put new money out.

As reflected in Figure 4, banks hold 36 percent of commercial mortgages. Because most banks are still overwhelmed by foreclosure and REO (real estate owned), their staffs would not dare make new loans.

Insurance companies, who currently account for 23 percent of commercial mortgages, probably have another round of foreclosures ahead, as old leases roll over at lower rents and debt service can't be supported in an additional array of office buildings. Insurance companies also have new risk-based capital requirements that impose significant reserve penalties for real estate debt and equity holdings. Furthermore, the rating agencies and insurance company stockholders and directors are petrified of real estate. (A handful of insurers are making new loans on existing properties, but the majority are not committing new mortgage money and are barely coping with rollovers.)

Savings and loans hold 16 percent of commercial mortgages, but they will not be future players.

In essence, the sources of 75 percent of commercial mortgages are out of the market today, which explains the credit crunch and also explains why new money sources must be developed.

There needs to be, and there likely will be, a secular change in the structure and practices of real estate financing. The foundation of this change will be the introduction of additional capital sources as pension funds, mutual funds and individual investors ultimately become the new "permanent" sources of commercial mortgage capital. The industry will gradually take on many of the characteristics now found in the residential mortgage market.

Traditional participants will fund only a small percentage of loans relative to their historical levels. However, some formerly active players are likely to form strategic alliances in order to preserve their real estate finance organizations. An example is the newly formed venture between Equitable Companies Incorporated and Donaldson, Lufkin & Jenrette, Inc. (DLJ), both in New York City. Equitable will originate loans and use their balance sheet to warehouse the loans on an interim basis. Credit and underwriting decisions will be made jointly by Equitable and DLJ. After a suitable portfolio of loans has been created, DLJ will remarket the loans via securitization.

This venture has effectively become a mortgage banking operation. Similar "conduits" have been established by Daiwa Securities, America Inc., New York City, and other large financial institutions. We believe the market will see development of many such ventures as traditional mortgage holders seek to retain some role in the process they dominated historically.

This funding process and other related schemes still will be subject to the availability of capital from the new sources cited earlier (e.g., pension funds) and the ultimate depth of the securitized marketplace. If these new capital sources are going to make a sizable and permanent commitment, they will need a new operating system with professional management intermediaries. These new managers will be charged with executing and supervising underwriting, research, servicing and other practices relevant to the commercial mortgage business.

To date, the intermediaries fulfilling these roles have been bond managers and mutual fund analysts skilled in the evaluation of corporate bonds. Because Wall Street has equated new securitized mortgage products to corporate bonds, the existing managers have effectively been "buying the rating" issued by one of the major rating agencies. Credit analysis has essentially been subordinated to third parties.

We believe that permanence will come to the system only when a group of intermediaries skilled in both real estate and the fixed-income market form businesses to invest in commercial mortgages. The fundamental evaluation of the creditworthiness of a particular mortgage requires the experience and expertise of an organization that has practiced real estate finance for many years. Knowledge of and access to the latest in financial engineering is important. However, the experiences of the last several years should firmly establish the need for sound underwriting philosophies and criteria and for experienced professionals to execute these strategies.

In summary, the old system of real estate financing is broken. A new process is emerging, but its viability is dependent on the development and permanence of new capital sources. These new sources, in turn, require a new infrastructure whose ultimate foundation is based on experienced real estate/fixed-income professionals.

A sense of urgency

There is a sense of urgency to this transition, because at least $600 billion of commercial mortgages--half the total market--are rolling over between now and the end of 1996. When these numbers are compared with the negative mortgage flows of the last two years, the crisis proportions of the credit crunch become clear.

Because many lending institutions have no choice but to roll over existing loans, they certainly will not be making new ones--which paralyzes potential buyers of property just when they perceive that good deals are emerging.

From a fixed-income investors' standpoint, commercial mortgages are one of the very few extremely attractive options today. Loans that would carry AA ratings, or at worst A ratings, are priced to produce B-level yields. Gradually, this is attracting the attention of institutional fixed-income managers.

The key to improving the equity real estate market is to ease the credit crunch. The industry, as a whole, has to work to bring new investors into the commercial mortgage market so that buyers can once again use leverage--albeit prudently this time.

M. Leanne Lachman and Gregory A. White are managing directors of Schroder Mortgage Associates, a pension fund advisory firm in New York City. (The authors have retained copyright to this material.)
COPYRIGHT 1993 Mortgage Bankers Association of America
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Article Details
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Title Annotation:Cover Report: State of the Industry; commercial real estate
Author:Lachman, M. Leanne; White, Gregory A.
Publication:Mortgage Banking
Date:Oct 1, 1993
Previous Article:Lessons learned.
Next Article:After the party.

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