Few expect to see defaults rise in 2004, but bad loans could spell trouble for lenders and borrowers
Michael Gottlieb
Ask 100 commercial real estate professionals to name one factor that sustained the industry during the economic downturn, and you'll get 100 identical answers.
Low interest rates drove capital into the marketplace, with commercial originations exceeding $100 billion for the year nationwide, according to the Mortgage Bankers Association. Low interest rates also allowed owners to insulate themselves against default as they watched occupancy and rents fall.
Federal Reserve Chairman Alan Greenspan has indicated that short-term rates will remain low in the near future and most experts predict that rates are unlikely to move significantly in a presidential election year.
That's a good thing for borrowers and lenders alike. Experts predict that workouts and defaults will be rare this year.
Lenders, who still remember the blood bath of the early '90s, have been disciplined in their underwriting, focusing on cash flow rather than asset values distorted by the flight of capital from equity markets.
As a result, most loans have a healthy cushion insulating them from interest rate increases, according to Greg Rickard, senior vice president and regional manager of KeyBank.
"We'll need a move of 200 to 300 basis points before problems occur," he said.
Thomas R. Sherlock, executive vice president of Buchanan Street Partners, agrees. He is bullish on 2004 due to the improving economic fundamentals, the low cost of capital and prudent underwriting.
"You see aggressiveness, but you don't see rampant disregard for prudence," he said. "I don't scratch my head and say, 'What the heck were they thinking?'"
Interest Rate Insulation
To get a sense of just how much the low interest rates benefited the industry just compare default rates from the most recent economic downturn to the rates from the early 1990s.
According to a report by Wachovia Securities, bank real estate delinquencies ranged between 18 percent and 15 percent in 1990, 1991 and 1992 as the national vacancy rate hit about 12 percent.
From 2000 to the present, however, delinquencies hovered around 4 percent while national vacancies nearly doubled from their low of 6 percent in 2000.
"Superior real estate valuations and lower debt costs have greatly benefited commercial mortgage performance, whether off-balance-sheet in the Commercial Mortgage-Backed Securities market or on-balance-sheet at banks and insurance companies, where loan delinquencies remain a fraction of 1990 - 1993 levels," according to the Wachovia report, "Rates, Real Estate and Real Estate Strategies: Outlook 2004 - A New Paradigm Emerges."
Not surprisingly, California has been particularly strong in this regard.
According to the California Mortgage Bankers Association's Sept. 30 Quarterly Delinquency Survey, 99.71 percent of the $56.2 billion California commercial real estate loans serviced by 18 mortgage banking firms were either current or one payment delinquent. This translates to a delinquency ratio of 0.29 percent and represents the 20th consecutive quarter in which the state's ratio has been below one half of one percent.
A number of factors could put upward pressure on interest rates, including record federal budget deficits, solid improvement in the stock market and the devaluation of the dollar, which could raise prices on imported goods.
Stan Ross, chairman of the board of the University of Southern California's Lusk Center for Real Estatecolor>, said developers and owners will have ready access to capital this year, but they need to lock in financing before interest rates start to increase. Otherwise, companies with substantial floating-rate debt will be squeezed if their borrowing costs rise faster than their property income.
"In 2004, interest rates will be the wild card for real estate," he said, "rates will go up - the questions are, when, how much and how fast?"
In "Emerging Trends in Real Estate 2004," a joint industry survey produced by the Urban Land Institute and PriceWaterhouseCoopers, this year should determine the true health of private-lender portfolios as "watch lists are brimming and most observers expect problem loans to increase as markets bottom out and struggle to recover."
Tangled in CMBS
The remarkable lack of troubled loans across all sectors of the real estate industry has been a boon for securitized borrowers.
Though complex to workout, CMBS loans have come to dominate the finance industry.
The CMBS market emerged from the near collapse of commercial real estate financing in the early 1990s. In 2000, the Federal Reserve estimated that 19 percent, or almost one-fifth of all outstanding commercial mortgage debt in the United States was securitized, according to a report by James R. Butler Jr. and Jeffrey E. Steiner, partners in the Los Angeles office of Jeffer, Mangels, Butler & Marmaro LLP. This amounted to nearly $281 billion in mortgage loans, an amount that has grown by $50 billion a year.
"This market has never been tested by the very economic stress that gave it birth," the report stated.
But restrictions on handling troubled loans can present problems for borrowers when their loans get into trouble.
The entity that holds CMBS loans is designated a Real Estate Mortgage Investment Conduit to avoid federal income taxes. Stiff rules limit changes to REMIC loan pools. The substitution of collateral or significant modifications of existing loans - actions that could be taken by a borrower during a workout - could result in losing REMIC status and a significant tax penalty.
"Any material changes to a loan makes it a new loan," Butler said. "There is nothing you can do about it."
Due to the complexity of the CMBS structure, REMICS tend to favor foreclosure over workouts.
"It isn't something where CMBS people are meaner," Butler said. "It is other things, tax rules, the [Pooling and Servicing Agreement], nobody's going to violate that or you will never have lunch in this town again."
Fitch Ratings recently warned that participated commercial mortgage loans are becoming increasingly complex and agreements requiring multiple parties in servicing and workout decisions will "frustrate borrowers, delay necessary action to preserve collateral, increase trust expense and result in additional and unnecessary losses," according to a recent report by the rating agency.
"Fitch is concerned that recent participated loan structures are inefficient and the lack of uniform intercreditor provisions and serving procedures are causing confusions in the market," said Daniel Chambers, senior director of Fitch Ratings. "Fitch is concerned that history will repeat itself, and the lessons we learned with syndicated loans from the early '90s will be forgotten."
The investment rating agency forecasts increasing CMBS loan defaults in 2004 as real estate performance lags economic growth. Nonetheless, Fitch had an upbeat outlook this year.
"Echoing the resiliency of overall structured finance performance is that of U.S. CMBS, which has been stable throughout 2003 and looks to remain stable in the coming year," said Claire Mezzanotte, managing director at Fitch.
What to Watch in Workouts
Workouts have become significantly more complex, if not impossible in some cases, with the growing use of CMBS, mezzanine and conduit loans.
Rickard pointed to several potential problem areas that could force workouts or defaults in commercial loans should interest rates rise.
Though the industry has long pushed for quicker loan processing, loans without thorough intercreditor agreements could create problems.
"Deals put together on a shoestring, I think there could be some real battles," he said.
Also a rise in rates and the corresponding increase in capitalization rates could "nuke" an investor's equity account on repositioning deals.
"If you are looking at the prospects of increasing interest rates, the smart guys are looking for a lock on the cost of funds," Rickard said. "It still doesn't protect your equity account.
"The scary place to be is if you are a short-term investor, a flipper. Those are the guys who can be vulnerable in the next 24 months," he added.
Another risk lies with fixed, full-leverage, 5- to 10-year conduit or life company loans made within the past few years. Rising capitalization rates could create a refinance risk, he said.
"If interest rates increase, rate of returns will decrease and your property will be worth less," Rickard said.
"You could come out of the back end with a LTV greater than the market is willing to refinance that loan."
Eric Bergstrom, president of Bergstrom Capital Advisors, said that most senior lenders would be insulated in the event of an interest rate rise.
"If we are going to see any challenges it is going to be from the mezzanine debt, who maybe financed 2 or 3 years ago," he said. "If they lent on aggressive pro formas, some of them may have trouble with an exit strategy. They might have to extend a loan or restructure a loan."
Still, he expects interest rates to remain steady in 2004.
"There is a lot of room left before we get up to normalized interest rates," he said.
Butler said he has been surprised at how well troubled loans, particularly hospitality loans, have been handled by the industry.
"Certainly there has been a lot of pain, but the results have been relatively benign," he said. "I think there may be a higher percentage of owners and investors in the CMBS market that are institutional big boys."
When a CMBS loan that runs into trouble and is faced with foreclosure, Butler said, "there is more of a tendency to say, 'that's the way it is.'
"They might not like it, but they understand and say, 'well, here are the keys.'"