Why has the sub-prime mortgage debacle resulted in a credit crunch on commercial mortgage backed securities lenders (CMBS) as well? Well, most insiders don’t believe it is a direct result of the sub-prime hangover. They believe it has been in the works since the beginning of the second quarter when Moody’s issued a warning that it was increasing the subordination levels due to aggressiveunderwriting on deals towards the end of 2006 and the first quarter of 2007. CMBS lenders pool loans totaling hundreds of million of dollars and resell them as bonds to the secondary market. Those bonds are chopped up and rated at various grade levels depending upon risk or the subordination of the bonds. Moody’s assigns grade levels to these bonds just like they do with corporate bonds.
CMBS lenders were providing 10 year interest-only terms along with high leveraged loans in some cases on properties where the cash flow was barely breakeven. Lenders have returned somewhat to a more stable level with minimal interest-only terms and debt service coverage ratios approaching 1.20x and greater.
Due to increased exposure to residential sub-prime losses, buyers of the investment grade tranches of CMBS as well as corporate bonds have exited the market to a flight to quality. They have been investing heavily in US Treasury Bonds which has resulted in a 40 basis point decrease in the 10 year T-Bill. This decrease has been offset with an increase in lender spreads by an average of approximately 50 basis points since mid July. The increase in spreads is a direct response to the anticipation of greater risk or the re-pricing of risk. With the increase in lender spreads and the tightening of their underwriting guidelines, cap rates are poised to rise. Some of the institutional equity groups have already been increasing their exit cap rates by 50-100 basis points. All of these factors are going to have a negative effect on asset valuations.
So you may ask: Are there other commercial lenders, other than CMBS lenders, that do not have as much exposure to the sub-prime losses out there that may be able to provide debt at a lower cost? A lot of real estate investors expected the balance sheet lenders, such as the Life Companies, to undercut the CMBS lenders. But these balance sheet lenders are opting to purchase bonds rather than take the whole loan exposure and risk at comparable spreads to CMBS lenders.
At the end of the day, loan proceeds will be challenged due to the recent increase in cost of funds. Long term interest-only and high octane (leverage) loans will no longer be available, or at least for the next few years. Lenders are going back to fundamentals as they are paying particular attention to the strength of the sponsor, amount of cash equity being invested, and upfront reserves for potential leasing/operating events. Much of this was put into place back in May when Moody’s issued their warning.
In conclusion, lenders will slowly loosen up their underwriting guidelines and tighten up their spreads due to competitive pressure. A lot of experts are comparing this event in the marketplace to what occurred in 1998, which took approximately 6 months to fully correct. In 2001, the market recovery was shorter, approximately 4 months.
Myers St. George
Investments and Acquisitions
Macon Commercial Office