Capital Markets Update I December 2009

According to this capital market report from Grandbridge Real Estate Capital the commercial lending market is slowly improving. Despite the economic challenges continuing into last quarter of 2009, there are some encouraging signs in the financial system and within the commercial real estate market today. GDP growth turned positive during the third quarter, and the Federal Reserve raised its estimate for economic growth next year. The Fed’s projections call for GDP growth between 2.5 percent and 3.5 percent in 2010. Also, the national unemployment rate improved to 10.0 percent in November from 10.2 percent the previous month. Even with these developments, Chairman Bernanke recently tempered expectations for a swift recovery, “Despite the general improvement in financial conditions, credit remains tight for many borrowers,” he said, and the job market “remains weak.” He continued, “The economy confronts some formidable headwinds that seem likely to keep the pace of expansion moderate.” Commercial real estate fundamentals lag the economy and other factors remain as impediments. ReisInc., reported that third quarter 2009 sales activity fell 90 percent from its peak in the second quarter of 2007, and according to Moody’s/REAL Commercial Property Indices, commercial real estate prices have dropped 41 percent since October 2007. While the commercial real estate market is in the midst of a correction, transactions are taking place and capital remains available at historically attractive rates.

The acute challenge that borrowers face today is that lenders are writing lower leverage loans compared to earlier this decade and forcing borrowers to de-lever commercial real estate; leverage will likely remain constrained until the acquisition market returns and price discovery is realized. The result is a growing importance of equity for acquisitions and refinances. While this is a challenge, debt borrowing rates have improved over the last several months and lower leveraged transactions can attain long-term fixed rates near 6 percent; many multifamily transactions are locking rates close to 5.5 percent.

The most significant news in the commercial real estate debt market is the announcement of the first commercial mortgage-backed securities (CMBS) transaction in the U.S. since mid-2008. The Developers Diversified Realty (DDR) transaction was the securitization of a $400 million loan made by Goldman Sachs Group and backed by 28 shopping centers owned by DDR. It was expected that most bond buyers would utilize the Fed’s Term Asset-Backed Securities Loan Facility (TALF) to provide low interest loans to purchase the securities. Surprisingly, TALF was used to acquire only 22 percent of the eligible bonds, meaning the remaining securities were purchased with cash from private market buyers, according to Commercial Real Estate Alert. Although the transaction was unique in that there was only a single borrower and terms were much more conservative than CMBS loans executed in years past, the success fueled hopes that CMBS can again become a viable capital source for commercial real estate and that investors are willing to purchase well-underwritten securities.

Freddie Mac, Fannie Mae and HUD FHA continue to provide liquidity to the multifamily debt market. Recent news articles have focused on the uncertainty of the government-sponsored platforms, noting the massive losses from single family loans and deterioration of their multifamily portfolios. However, according to the Federal Housing Finance Agency, the firms’ loans or guarantees on apartments total $300 billion, only a fraction of the $5 trillion of single-family loans that Fannie Mae and Freddie Mac hold or guarantee. The fact is that today the Agencies’ appetites for multifamily lending remain robust. Responsible for 84 percent of all multifamily lending last year, they continue to provide liquidity to the market over the short term.

The Federal Housing Administration (FHA) has greatly increased its relevancy in the multifamily debt marketplace. In recent months requests for FHA financing for both multifamily construction and permanent debt have exploded. Historically, FHA loans were used as an affordable housing lending source, but now HUD financing is available for both market-rate properties and properties with income restrictions. The most appealing feature of FHA loans is the availability of higher leverage — FHA will lend up to 90 percent of transaction costs on many multifamily deals.

Freddie Mac remains active and pricing is very competitive through its Capital Markets Execution (CME). With CME, multifamily loans are pooled and securitized allowing the Agency to maintain high production levels while managing the size of its balance sheet. Freddie Mac also has a Capped ARM program for borrowers who wish to take advantage of lower short-term rates and prefer the prepayment flexibility. The Freddie Mac Capped ARM allows for a floating rate for the full term with an established maximum interest rate. The cost of purchasing the cap is financed by Freddie Mac as part of the rate. Today, Freddie Mac loans can attain leverage up to 75 to 80 percent and rates are in the mid 5 percent range.

Insurance companies and portfolio lenders continue to provide loans with increasingly competitive rates to stabilized assets. Helped by historically low Treasury rates and falling corporate bond yields, some insurance companies have recently quoted low leverage transactions below 6 percent and overall borrowing rates have decreased, as illustrated in the chart below. Investment managers within these institutions see the market for commercial real estate debt as an opportunity to make long-term, well-underwritten loans to quality borrowers. Credit officers across all lending sources continue to spotlight borrowers’ balance sheets and schedules of real estate owned to make certain that maturities in coming years are appropriately addressed while reviewing the performance of other real estate assets to ensure that borrowers have the financial strength to endure this real estate cycle. Leverage remains a constraint, as very few insurance companies are willing to lend more than 70 percent of value.