The “Credit Crisis” in Commercial Lending and the Effect on Your Real Estate Practice
The recent “credit crisis” affecting commercial lending might have a profound effect on real estate in the near future. The fallout from the subprime debacle and the sudden collapse of the Commercial Mortgage-Backed Securities (CMBS) market has dramatically changed the lending landscape. Long-term practitioners will recall that most real estate commercial loans were historically made by local and regional banks and life insurance companies: “relationship” lending was the only effective way for borrowers to find the debt capital necessary to buy or build commercial real estate. During the mid-90s, this practice changed. Banks and life insurance companies began to package commercial loans in large mortgage pools, and the interests in these pools were sold as bonds to foreign and domestic investors. This CMBS market, as it became known, maximized the liquidity available to finance commercial real estate. The available liquidity, in turn, led to an efficient or perhaps overly heated market for acquisition and disposition of real estate assets. Prices for commercial property increased significantly, in part as a result of available credit. Borrowers and lenders relied far less on relationship lending. Real estate loans became an easily available commodity. Lenders aggressively competed for borrowers. Real estate development and construction activity escalated as construction lenders lent funds in markets with sharply decreasing capitalization rates and a near certainty of “take-out” offered by the CMBS market. For those borrowers that were selling housing lots or condominiums, the “take-out” took the form of appreciating housing markets and ready buyers.
Sudden and recent changes in the housing and CMBS markets, however, have radically altered the core assumptions of the recent past. To provide some perspective, approximately $200 billion of commercial real estate loans were processed through the CMBS market in 2007. In 2008, less than 10 percent of that figure will occur. The cutback in available liquidity is forcing developers and buyers to scramble as they search for secondary and tertiary lending sources. Portfolio lenders such as banks and life insurance companies do not have the available capital necessary to replace the liquidity shortfall. Such lenders are instead tightening lending standards, extracting higher interest rates, shortening loan terms, and demanding full recourse liability.
It might appear that the subprime and CMBS market problems are irrelevant to the real estate practitioner’s day-to-day practice in Washington State. Fortunately, our part of the country has been insulated from some of the economic contortions affecting other areas of the country. It might be a mistake, however, to assume that new market forces will not impact many of our clients, including the family who owns a highly appreciated piece of property, the homebuilder, the small company looking for construction financing to build a new plant or office, or the classic big-time developer of commercial and multifamily projects. This article will discuss the origins of the CMBS market, describe what is happening to CMBS and the overall real estate lending market, and attempt to offer some practical suggestions to the practitioner who wants to assist real estate borrowers, sellers, and buyers during these tumultuous times.
The History of the CMBS Market
The CMBS market that developed in the mid-1990s reflected an innovative and sophisticated process to create a national lending market and securitize interests in commercial real estate loans as a liquid investment. Prior to the emergence of the CMBS market, commercial real estate loans were “portfolio” loans originated by a lender (typically a bank or insurance company) and held on the lender’s balance sheet until the loan was paid. The CMBS allowed for securitization of commercial real estate loans. In a CMBS transaction, individual commercial mortgage loans, with different loan amounts secured by different types of property in different locations, are pooled and contributed to a trust. The trust, in turn, issues bonds that typically vary by duration, yield amount and priority of payment. Bond purchasers choose bonds based on a credit risk rating with differing expectations for yield and bond term duration. Investors rely on national rating agencies to allocate credit ratings to the separate bond classes issued by the trust. Typically, the trust is created as a real estate mortgage investment conduit (REMIC) that allows pass-through tax treatment. The price for bonds issued in the REMIC generally reflects the understanding that a pool of loans is worth more than the aggregate value of all the loans contributed to the REMIC.
The REMIC structure attracted a wide number of corporate and foreign investors, which led to favorable pricing for borrowers. Many practitioners witnessed the evolution of commercial lending in the past 10 years as loans made for properties in Spokane, Vancouver, Puyallup, and Wenatchee were no longer held by local and regional banks but were immediately transferred to national “loan servicers” located far from Washington State.
Standard underwriting practices, pooling of performing and nonperforming loans across the country, and the securitization of commercial real estate loans to corporate and foreign investors, all characterized the CMBS market. The growth in CMBS was dramatic because of the inherent efficiencies of the loan pooling approach in contrast to historic portfolio lending. In 1995, total commercial real estate loans outstanding were approximately $1.014 trillion. CMBS represented approximately 5.4 percent. By 2005, total commercial real estate loans outstanding were approximately $2.618 trillion. CMBS represented 19.9 percent of this total and represented 37 percent of all commercial real estate loans issued in 2005 alone. In fact, from 2004 to 2006, CMBS originations outpaced commercial bank portfolio origination during 12 of 14 quarters. In 2007, there were approximately $200 billion of newly issued CMBS loans, despite a dramatic drop-off in the last half of the year.
The CMBS market emerged in part as a result of the 1980s Savings and Loan meltdown and the ensuing formation of the Resolution Trust Corporation (RTC). The RTC acquired a significant number of loans and assets from defaulting savings and loan institutions. Wall Street recognized the need for a large amount of capital to liquidate billions of dollars in real estate assets and loans held by the RTC. However, without standard underwriting practices or an official rating system, it was not possible to attract the necessary capital from corporate and foreign investors. As a result, major bond rating agencies and uniform underwriting standards were formulated in the early to mid-1990s, which allowed for the subsequent pooling of mortgage loans and the securitization of the mortgage pools.
As mentioned earlier, most commercial real estate lending in the past was done on a portfolio basis by banks and insurance companies. Most banks, however, faced lending limits tied to the amount of deposits they held and loan allocation requirements imposed by regulators, which restricted the amount of commercial real estate loans a bank could have on its balance sheet. Regulators did not want to repeat the savings and loan fiasco and thus regulated the commercial real estate loan activity of banks. Moreover, because bank loan limits are tied to the amount of deposits held, which deposits are inherently short-term in nature, banks were further limited in the size and term of loans they could hold on their balance sheets. Accordingly, most banks were able to provide short-term construction financing for real estate borrowers, but were limited in their ability to issue longer-term “permanent” loans. Life insurance companies often played the role of the long-term lender. A life insurance company is not bound by depositary restrictions and is generally in a better position to manage its long-term cash position to issue longer-term loans to borrowers. However, most life insurance companies limit their exposure for real estate loans to approximately 5 percent to 30 percent of total assets. Additional restrictions often include a limit on any individual loan (i.e., not to exceed 1% of aggregate assets).
The inherent restrictions facing banks and life insurance companies effectively limited the total amount of debt capital available to commercial real estate borrowers. Given the limited number of banks and life insurance companies, borrowers were forced to compete by promoting only the higher quality real estate assets, offering personal guaranties and personal balance sheets, and fostering longer-term working relationships with certain banks and life insurance companies. CMBS fundamentally changed the behavior of borrowers and lenders.
Securitized lending, available through the CMBS process, introduced a massive amount of new liquidity available for commercial real estate lending. Banks were in a new position to originate loans and then sell those loans without the restrictions of lending limits based on deposits or regulatory restrictions applicable to portfolio loans. The formation of REMICs essentially allowed nontraditional lenders (such as corporations and foreign investors) to become commercial real estate lenders by purchasing bonds in the new mortgage pools. Loan terms changed dramatically. Banks could make nonrecourse loans. Banks could offer long-term loans (i.e., 10-year loans rather than shorter-term loans) because the REMICs were structured as longer term investments. Banks became sales agents for the CMBS market. Because CMBS fostered a much more efficient process to raise debt capital, borrowers had greater access to available credit. Banks were forced to compete for customers on the basis of slight variations in interest rate spreads and commercial real estate loans became akin to commodities. Life insurance companies created CMBS departments to be competitive with banks selling loans to the CMBS market.
The freely available credit also had a direct impact on the overall real estate market. Buyers with easy access to credit competed with each other to acquire properties on a much more rapid basis. Cap rates plummeted in many parts of the country as the CMBS market matured into a highly efficient source of capital for real estate. Of course, CMBS was not the sole reason for property appreciation, but it was a significant contributor to the increase in value. The timing of real estate transactions changed dramatically as well. Long-term practitioners remember well that many property acquisitions were structured with much longer due diligence and financing periods. Recently, many acquisitions were structured with 30-day due diligence and 30-day closing periods. Financing of late was not much of an issue because the available credit from the CMBS market eliminated many of the inherent delays that were a necessary part of a real estate acquisition. Construction lenders also were more willing to make construction loans because of the confidence lenders had in the “take-out” chances offered by CMBS. Moreover, the heated real estate market, created in part because of available credit, gave lenders confidence in project valuations as general property values across the country continued to escalate.
What a Change a Year Can Make
The CMBS market took 10 years to develop and was becoming a predominant source of capital for real estate transactions. In late 2007, the bottom fell out. There are a number of possible explanations for the collapse of the CMBS market, including overly aggressive underwriting, loss of investor faith in the CMBS market’s assessment of project valuation and risk, and fears of repeating the “subprime” mess, but one effect of the collapse is clear: The projected CMBS issuances for 2008 will be less than 10 percent of what occurred in 2007.
During the past few years, the CMBS market began to offer aggressive loan products to feed its accelerated growth. For example, of the aggregate $723 billion CMBS loans outstanding in 2007, at least 53 percent were interest only loans; 25.6 percent of these loans had a partial interest-only term, and 27.4 percent were interest-only for the full term of the loan. In addition, loan-to-value (LTV) ratios changed during the past few years, with loans often exceeding 80 percent LTV ratios for commercial real estate. Many loans were issued on a ten-year, nonrecourse basis. The loosening underwriting standards occurred as CMBS investors continued to have faith in the increasing property valuations across the country, and banks and life insurance companies competed with the CMBS market for deals. Investors and lenders assumed that property appreciation would resolve any underwriting concerns with project cash-flow, and would offer the most compelling exit strategy for borrowers and lenders. Given years of rapid escalation in property values, this investor and lender optimism was well founded. However, the house of cards could be shaken if commercial banks and CMBS investors lost faith in the core assumption that property valuation escalations were sustainable or even accurate in the first place.
The recent “subprime” mess and the precipitous drop in single-family home values across the country provided the first shock to the CMBS market. The subprime situation is beyond the scope of this article, but few practitioners are unaware of the daily news reports describing dramatic changes in homeowner lending, loss of home values, failing investment houses, etc. Many of the nation’s largest commercial banks were also heavily involved in the residential home loan business and have already suffered enormous losses because of home loan write-downs. Nearly 18 of the top 20 largest lenders currently have significant balance sheet problems because of home loan losses. The sharp downturn in the value of residential housing led in part to increased risk concerns for commercial banks in their underwriting of commercial loans. In fact, commercial bank portfolio lending dropped from $37 billion in the second quarter of 2007 to $9 billion in the third quarter of 2007. In addition, regulatory concerns escalated because of bank exposure to residential and commercial real estate.
The sudden loss of residential home values also led to another factor that affected the CMBS market. There is a perception that rating agency assessment of property valuations and risk was inaccurate. The credit rating agencies assessed risk for issuances of home loans packaged in similar pools known as mortgage backed securities or MBS. Part of the “subprime” mess is an overall recalculation of risk assessment for home loans and a general downgrading of MBS issuances. The downgrading that occurred created a general concern that the credit rating agencies were off track in assessing the risk of commercial real estate loans. The perception is that the risk of commercial property loan defaults will occur at a much greater rate than forecasted in the rating agency assessments. Because CMBS investors rely heavily on the credit rating agencies, it is not difficult to imagine a sudden loss of investor interest in CMBS issuances if the investors lose faith in the credit rating agencies and their ability to accurately assess risk.
The combination of bad news offered by the home loan crisis, a tightening of underwriting standards by commercial banks, and an overall unease in the perceived valuations of commercial real estate provided the ingredients for the CMBS collapse. The investors who purchased REMIC bonds issued from the CMBS market suddenly stopped buying.
The full extent of the CMBS and subprime loan problems is not known at this time. What is known is that there is not as much liquidity in the overall market for commercial real estate loans. Loans are harder to find and are far more expensive. For the near term, it is likely that several trends will affect commercial real estate loans. Interest rates have increased in the form of higher spreads charged by lenders. That is why loans are more expensive even though the U.S. Treasury rates have dropped in recent months. For example, it was common in 2007 to find loans with interest rates equal to 90–150 basis points above 10-Year Treasury rates. Today, spreads have jumped to 200–300 basis points and spreads can vary wildly in a day. The higher rates are required to attract investors back to the CMBS market. Banks, however, are unwilling to issue loans based on spread assumptions in an unstable market because they will suffer great losses if they issue a loan with a loan spread that is actually less than required by the CMBS market. Many borrowers will not accept the current spreads because the higher interest rates derail their acquisition pro formas. There is even a wide perception that the demand for CMBS will not occur again for some time. The CMBS collapse is based in large measure on investor loss of confidence in the market’s ability to accurately assess credit risk even though the actual foreclosure and loan loss rates for commercial properties have not increased significantly. The actual loan watch list for loans issued between 2005–2007 (when many “interest-only” loans occurred) has increased recently and there is fear that foreclosures and loan losses are just around the corner. If there is an increase in foreclosures beyond forecasts, the absence of CMBS investors could be long-term.
In addition to the loss of CMBS dollars, real estate borrowers also face loan limits affecting the portfolio lenders. As mentioned earlier, many of the large commercial banks have adverse balance sheet issues that curtail their ability to make additional loans. Commercial banks are also negatively impacted by regulatory requirements. Many commercial banks must increase their capital reserves for anticipated loan losses, in part because of regulator evaluation of portfolio risk, which is changing quickly in light of the commonly accepted wisdom that property values are decreasing in many markets. A recent change to the Financial Accounting Standards Board (FASB) standards might limit commercial bank lending capacity. The new rule (157) requires that the property securing many commercial real estate loans be valued on a current market basis rather than original appraised value. The more stringent rule could impact capital reserve requirements, which further limits the ability of commercial banks to make loans.
The liquidity shortfall due to the CMBS collapse combined with fewer loan dollars available from commercial banks will mean tougher underwriting standards for any new commercial real estate loans. Interest rates are higher. Loan terms are shorter. Loan to value requirements have increased for many lenders. Full recourse lending is becoming common again as nonrecourse financing options are prohibitively expensive for most borrowers. Property values are flat or declining in many markets, partly because debt financing is far less available and much more expensive.
What Effect Does This Have on My Practice, and What Can I Do About It?
The recommendations described below are my own and based solely on my experiences to date. It may be difficult to see how the macroeconomic forces affecting lending and commercial real estate can affect the day to day lives of practitioners and their clients in Washington State. We seem to be insulated from the severe problems occurring in other parts of the country. I believe, however, that our local market is more linked to the national credit and lending market than in prior years and that many of our clients will be caught off guard by the sudden change in the overall lending environment. We can be helpful by being proactive.
1. Dust off the loan documents . The practitioner should pull out copies of the loan documents affecting his or her clients and confirm the maturity dates for each loan. Borrowers do not have the luxury of assuming that debt financing is easily available to refinance loans that mature in the next few years. In fact, borrowers should assume that it may take 8–12 months to refinance a commercial loan. The practitioner can be helpful in advising the client well in advance of the impending maturity date and the market changes that may have a dramatic impact on available loan terms. Advising the client well in advance that he or she should expect tougher loan-to-value ratios and shorter loan terms will help the client prepare to raise the additional equity necessary to comply with new lending requirements. Perhaps the client needs to discuss the additional equity requirements with his or her partners. Perhaps the client needs to position the property for sale because the property cannot be refinanced and the client cannot raise additional equity. Perhaps the client needs to work on project performance to increase cash flow to support higher values for property to satisfy tougher LTV ratio requirements. All of this requires time and the practitioner can really help a client by advising them to work on these approaches far in advance of an impending loan maturity date.
2. Approach existing lenders early. Sometimes, lenders are willing to extend loans if a borrower gives them enough notice to process the request in a reasonable manner through their credit committees. This approach does not work for borrowers who already have CMBS loans in an existing mortgage pool but can work for portfolio lenders and construction lenders. Many borrowers today are not able to easily refinance loans and have to seek extensions of their existing loans. Some lenders are using the last minute extension request to demand onerous conditions including increases in interest rate, loan remargining (pay down of a portion of the loan to improve the lender’s LTV ratio), and personal recourse. Some lenders are simply refusing last-minute requests because of outside pressures described above that have nothing to do with the underlying property performance. Generally, however, it is wise to resurrect the “relationship” lending approach of several years ago and approach the existing lender early. Discuss the loan maturity date and the refinancing obstacles with the lender. Try to negotiate loan extensions. Many banks are willing to consider loan extensions for a fee or an increase in interest rate. For some clients, the cost is well worth it if they extend the loan to avoid a premature sale of the project or refinancing on terms that will not work well. Many people believe that the crisis affecting the overall lending environment will be worked out over time and that liquidity flow will increase. Many borrowers, however, will be hurt badly by premature sales or adverse refinancing of projects. In fact, if you are helping a client with a new construction loan, encourage the client to add as many loan extensions or “miniperm” options as possible because the client cannot assume that “take-out” financing will be available in the near future. In the recent past, borrowers based construction loan timing on their forecasts of project completion and income stabilization necessary to obtain a permanent loan. Today, borrowers have to also factor credit market uncertainty in that mix and give themselves more time.
3. Broaden the net. As commercial real estate lending became more widely available, borrowers had the luxury of viewing loan originators as commodity brokers. Today, borrowers have a much smaller pool of available and willing lenders. The practitioner can help clients by encouraging them to approach many lenders and qualified loan brokers to address their loan requirements. I cannot emphasize enough the level of change in the lending environment. Major lenders that were firmly affixed in the commercial real estate lending business only last year have completely shut down their real estate lending operations. There are some estimates that at least 500 banks across the country will go under in the next year or two. Borrowers can’t rely on the lending sources they used in the past. Lenders that are still active in making construction and permanent loans are inundated with loan requests and can be very choosy. The practitioner can again really help the client by facilitating new lender contacts and encouraging the client to sit down with a number of lenders on a face-to-face basis to discuss their lending needs. This can include introductions to new mezzanine debt sources. The aggressive LTV ratio lending offered by commercial banks and CMBS lenders in the past is gone. Borrowers can still find loans for quality projects with LTV ratios in the 50–60 percent; however, many clients do not have the equity necessary to satisfy the LTV requirements. A practitioner can help by introducing the borrower to new mezzanine debt sources which are developing to help borrowers with the extra equity necessary to obtain debt financing. Of course, mezzanine debt sources can be very expensive but it might be the only available option to borrowers to avoid foreclosure of a project.
4. Recourse is here to stay . Practitioners should advise clients that they should not assume that nonrecourse financing is easily available. Practitioners should advise clients to properly analyze the effects of recourse liability. For example, many recent permanent loans were nonrecourse and borrowers did not face personal liability for loan loss unless caused by “bad act” reasons such as fraud, misappropriation of insurance or condemnation proceeds, etc. Today, borrowers should consider ways to negotiate recourse liability with lenders. The practitioner can help clients by offering ideas such as partial recourse based on overall net worth or liquid net worth tests, lender requirements to foreclose on the property prior to seeking remedies against a guarantor, and recourse-sharing arrangements among co-owners or partners in the borrowing entity. Long term practitioners dealt with these issues prior to the emergence of the CMBS market and we must resurrect that analysis for recourse loans today.
5. Advising property owners and sellers. The credit crisis affecting commercial real estate will negatively affect property values. Cap rate reductions in the past few years reflected, in part, easily available credit. The higher cost and unavailability of debt make it much more difficult for buyers to purchase properties based on recent cap rates. Accordingly, cap rates will probably rise. It is unclear if property values will stay flat or decrease in value for an extended period. A practitioner can offer valuable advice to clients owning commercial real estate by recommending strategies to “ride out” the volatility in the credit markets. For example, property owners that have to sell property in the near future will likely not get the price they could if they sold at a time when the credit markets stabilize. Some property owners have to sell because their loans become due. Some property owners have to sell because a family is closing an estate or the partners do not want to pay for a capital improvement. The practitioner can suggest “bridge loan” strategies for these clients to allow them to retain the property for a short time, ride out the credit market volatility and then position the property for sale. There are nearly 700 investment funds for “distressed properties” that have been created recently precisely in anticipation that property owners will have to sell at inopportune times. The practitioner can provide enormous value to a client by assisting them with strategies that avoid sale at an inopportune time.
I am interested in creating a subcommittee for the Washington State Bar Association, Real Property, Probate and Trust Section, to assist bar members with timely market information and information-sharing about the commercial lending crisis. If you have any interest in joining a subcommittee, please let me know.
Daniel C. Vaughn is at the Seattle, Washington, law firm Cairncross & Hempelmann, P.S. Dan received his J.D. from University of Nebraska in 1986 and speaks to many industry and legal groups on matters related to real estate and business law. Dan can be reached at (206) 254-4484 or via email at DVaughn@cairncross.com.
“ The “Credit Crisis” in Commercial Lending and the Effect on Your Legal Practice” by Daniel C. Vaughn, WSBA Real Property Probate & Trust Newsletter, 35:2 Summer 2008, Copyright © 2008 by the Washington State Bar Association. Reproduced with permission. All rights reserved.
© Copyright 2009, American Bar Association.