Mortgage-Bond Selloff Threatens Commercial Property Rebound

Property at Risk of Rising Vacancies From Government Cuts
A sign advertising property for lease hangs on a building in Bethesda, Maryland. Reduced federal spending may boost commercial real estate vacancies as tenants lose sales from one of their biggest customers: the U.S. government. Photo: Christopher Powers/Bloomberg

The nascent recovery in U.S. commercial real estate may be cut short as Europe’s debt crisis and Standard & Poor’s credit downgrade of Treasuries send borrowing costs to their highest in more than a year.

The outlook darkened in the past month amid a selloff in securities linked to debt on properties such as office buildings and retail outlets. Top-ranked commercial mortgage-backed securities yielded about 298 basis points, or 2.98 percentage points, more than Treasuries as of yesterday, according to a Barclays Plc index. The yield was last that high in July 2010. The spread jumped 35 basis points last week and is up 89 basis points since the end of the second quarter.

Further cracks emerged on July 27 when S&P pulled its rating on a $1.5 billion bond sale by Citigroup Inc. and Goldman Sachs Group Inc., roiling the $600 billion CMBS market. The banks had already been forced to overhaul the transaction to increase collateral protection and boost yields to attract investors.

“It’s another hiccup we didn’t need in this recovery,” said Dan Fasulo, managing director at New York-based property-research firm Real Capital Analytics Inc.

The CMBS market provided the cheap debt financing that drove commercial real estate to record highs in 2007, and sales of the securities were starting to come back gradually until last week’s upheaval.

For Wall Street firms seeking to package commercial-property loans into securities, the widening of spreads eroded potential profits, said Mark Zytko, co-chief executive officer at Mesa West Capital, a Los Angeles-based company that oversees $2 billion in real estate loan funds. That will discourage additional lending, leaving buyers and owners seeking to roll over their debt with fewer financing options.

Caution Seen

“It’s a significant increase in the cost of capital,” Zytko said. “It will cause dealers to become much more cautious in putting their pools together.”

About $158 billion of CMBS is slated to be refinanced through 2014, according to Citigroup data.

CMBS sales soared to a record $234 billion in the U.S. during the peak in 2007, according to data compiled by Bloomberg. More than $22 billion of commercial-mortgage bonds have been sold this year, compared with $11.5 billion in all of 2010, the data show.

JPMorgan Chase & Co. said July 22 it reduced its forecast for CMBS sales this year to $30 billion to $35 billion from a November forecast of as much as $45 billion. After the selloff, previous forecasts were probably too optimistic, according to Kevin Thorpe, chief economist of Washington-based property broker Cassidy Turley.

Smaller Markets

“So far it has not blown up any deals from the sales side,” said Spencer Levy, executive managing director in Baltimore at CB Richard Ellis Group Inc., the world’s largest commercial-property services firm. “If it does lead to a sustained expanded cost of capital, we would certainly see it put pressure on pricing for some deals.”

A slowdown in CMBS sales would hurt lesser-quality properties in smaller cities the most, said Jim Sullivan, manager of North American real estate investment trust research at Green Street Advisors Inc. in Newport Beach, California. That’s because owners of premium real estate have other sources for loans, including insurance companies, commercial banks and the U.S. government-controlled Fannie Mae and Freddie Mac, which finance most apartment loans.

“The losers are probably properties that are a little down the quality spectrum and in secondary markets,” Sullivan said. “There’s plenty of capital for the best assets in the best locations.”

Sale Planned

Deutsche Bank AG and UBS AG are going ahead with a $1.4 billion CMBS pool, including the first sale in the public market since November 2009. The deal is linked to 43 loans on 64 properties, according to a person with knowledge of the offering, who declined to be identified because terms aren’t set. Frankfurt-based Deutsche Bank and Zurich-based UBS slashed the size of the deal from $2.2 billion as spreads widened, preventing the banks from closing all the planned loans, according to people familiar with the offering.

S&P on Aug. 5 cut the U.S.’s AAA credit rating for the first time, criticizing the nation’s partisan political process and lawmakers for failing to cut spending or raise revenue enough to reduce record budget deficits. The action triggered declines in stocks and added to investor jitters that Europe won’t be able to contain the debt crises within the single-currency zone. U.S. stocks rose the most in more than two years yesterday after the Federal Reserve said it would maintain record-low interest rates through mid-2013.

Citigroup, Goldman Setback

The rating cut on Treasuries came a week after Citigroup and Goldman Sachs were forced to shelve a $1.5 billion CMBS offering that had already been placed with investors after S&P said it wouldn’t rate the notes because of a discrepancy in how it graded the transaction. S&P’s decision came after investors pushed back on deal terms and demanded higher yields on $3 billion of bonds sold the prior week.

The gloomier outlook for commercial real estate follows a strong first half. U.S. property investments more than doubled in the second quarter to $55.6 billion, led by retail market sales of $15.2 billion, according to Real Capital. New commercial listings jumped 79 percent to $76.2 billion as rising prices encouraged owners to offer assets for sale, the firm said.

In addition, new mortgage defaults, foreclosures and transfers of loans into special servicing slowed to $12.3 billion last quarter, the lowest since the onset of the recession, according to Real Capital.

Since early 2009, investors flocked to high-quality assets, such as office towers in major coastal cities like New York and San Francisco, and to apartment buildings, buoyed by surging rental demand in the wake of the housing crash.

Uneven Recovery

Real estate offered higher yields than bond alternatives, and commercial occupancies on average were starting to climb, prompting landlords to raise rents and test the market for property sales. Publicly traded U.S. REITs, a barometer of high-quality, income-producing property, more than tripled from their March 2009 lows to their peak this year on July 22. REITs have lost 16 percent since, compared with the 13 percent decline by the S&P 500 Index of large U.S. stocks.

Outside of the urban centers and major cities, property values haven’t recovered.

“We’ve seen it happen in New York but it hasn’t happened in the rest of the country,” said Jeffrey Oram, executive managing director in Parsippany, New Jersey, at Colliers International, a commercial-property broker. “Lots of places are just trudging along at the same rate.”

Economic Concerns

Prices for the best properties and best locations have been bid up to levels that in some cases have surpassed the peak, said Green Street’s Sullivan. “There could be some room to go but it requires a confidence in economic growth that’s being undermined every day by the economic data we’re getting.”

The U.S. economy grew at a less-than-forecast 1.3 percent pace in the second quarter following revised growth of 0.4 percent in the first three months of the year that was less than previously estimated, the Commerce Department said July 29. Consumer spending grew 0.1 percent, the smallest gain since the second quarter of 2009, the final months of the recession. The nation’s unemployment rate remained above 9 percent in July.

The CMBS market reflects the nervousness about the broader economic outlook.

“If the spreads are widening, there’s going to be a reduction in liquidity and that has negative implications on commercial real estate just at the time we don’t need any more bad news,” said Lawrence Longua, a professor and director of New York University’s Schack Institute’s REIT Center.

Sales Hold Up

First-half property sales of $90.6 billion led Real Capital to predict in July that sales were on course to “easily surpass” $200 billion for the year. The bond market turmoil of late May and early June didn’t appear to hurt volume in the second quarter, though it “could temper closings in July and August,” Real Capital said in its midyear review last month.

Fewer CMBS sales will lead to “higher cap rates, period,” said Oram of Colliers. The capitalization rate is derived by dividing a property’s annual net operating income by its sales price. When prices fall, cap rates increase.

The historical cap rate based on transactions for the NCREIF Index was about 8 percent in the 20 years through 2010, according to the National Council of Real Estate Investment Fiduciaries. During the market peak in 2007, cap rates fell to as low as 4 percent on midtown Manhattan office buildings as prices soared to records.

“‘Cap rate compression got too far ahead of leasing fundamentals,” said Thorpe of Cassidy Turley.

Loan Alternatives

Life insurers, which typically finance the best-quality properties and hold the loans instead of packaging them for resale to investors, have so far not widened the spreads they’re quoting in response to the CMBS market, said Michael Riccio, co-head of national production in CB Richard Ellis’s capital markets debt and equity finance division in Hartford, Connecticut.

During 2005 to 2007, the firm depended on the CMBS market to finance about 40 percent of its deals, Riccio said. Life insurers supplied about 30 percent and the rest came from government-owned mortgage finance companies, banks and pension funds. In the second quarter, CMBS business was up fivefold from a year earlier, although it made up less than 10 percent of the total.

“There is a whole segment of the world that needs CMBS and it’s very important it doesn’t go away,” Riccio said.

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