FEATURE ARTICLE, JANUARY 2008

CREDIT CHALLENGES IN 2008
RBC Capital Markets looks at how 2007’s volatility will impact the coming year.
Daniel Smith

Much of 2007 was marked by turmoil in global capital markets and commercial real estate. People with limited commercial real estate experience might think the year was disastrous. Those who have a longer commercial real estate history have seen much worse, particularly markets in which commercial real estate collateral suffered significant defaults and delinquencies.

Hype aside, the primary result of 2007’s volatility and ensuing correction is largely a return to the underwriting fundamentals of a stable commercial real estate market — one characterized by a variety of lenders, more realistic standards, stable, albeit wider spreads and the ability to finance sound deals in every property sector across the northeast and the United States.

Even with these fundamentals in place, the outlook for commercial real estate in 2008 is still somewhat uncertain.

A Rollercoaster

Last year was a wild ride even for those accustomed to Wall Street’s ups and downs. Rampant volatility appeared almost overnight. Many lenders stopped lending. Capital markets and traditional lenders abandoned loose underwriting practices. Aggressive structuring such as full-term interest-only loans disappeared. Cash equity became a requirement. Spreads widened to levels not seen in years.

The collapse of the residential subprime mortgage market is largely to blame. Concerned about potential losses, investors who were buying bonds collateralized by subprime mortgages as well as bonds collateralized by commercial real estate loans reacted quickly. Some investors stopped buying bonds entirely; others bought only commercial real estate bonds that reflected cautious lending practices and offered higher returns.

The agencies that rate CMBS bonds responded to investors’ concerns by criticizing aggressive underwriting standards. Rating agencies also raised subordination levels on CMBS securitizations, which immediately reduced every capital markets lender’s returns.

In the face of volatility, skittish investors, higher subordination levels and lower returns, many lenders temporarily withdrew from the market. Others continued lending with wider spreads and more conservative underwriting standards to accommodate investor and rating agency concerns. Many lenders have laid off numerous staff in response to the downturn.

Looking Ahead

Some of 2007’s extremes have already moderated and many CMBS lenders have returned to the market. However, the underwriting shift that took place in 2007 will remain constant, which will contribute to short-term uncertainty until the market responds to securitizations of loans reflecting the new standards.

In addition to continued conservative underwriting standards and deal structures, equity requirements and wider spreads, the commercial real estate landscape in 2008 will likely also include:

• Reduced CMBS Originations. CMBS originations in 2008 are projected to be approximately 50 percent of those in 2007. Sellers are not willing to accept reduced prices; buyers are not willing to pay 2007 prices. As a result, many buyers and sellers will sit out the first half of 2008.

• Potential Retail Challenges. It is not yet clear whether the subprime meltdown and reductions in residential property values will lead consumers to rein-in holiday and general spending. If so, tenant credit quality and retail property prices could suffer.

• Limited Development. Financing new development will be more challenging in 2008, largely because lenders will require more equity and less speculative deals. Construction financing will most likely come from traditional lenders such as local banks, although parameters will be conservative.

• Growth in Texas. Texas faces unique opportunities in 2008. In contrast to price increases on the western and eastern United States that were driven by foreign investment, values in Texas have been driven largely by population growth and economic diversification. Office and retail rents also have been been growing, but the potential for economic slowdown may reverse the trend. In addition, the infrastructure required to support current and future growth is of mounting concern and many local communities are addressing immigration issues.

• Increased Demand for Multifamily and Self-Storage Properties. The multifamily and self-storage sectors stand to gain noticeably in 2008 as people who lose their houses move into apartments and seek storage for overflow belongings. Many markets are already experiencing reduced vacancy rates and increased rents.

Although 2007’s volatility was largely triggered by the collapse of the residential subprime mortgage market, the primary impact on commercial real estate was a market stabilization some would say was long overdue.

Underwriting standards had become too aggressive. The risk of overbuilding was looming, along with a potentially more serious credit crunch caused by significantly reduced occupancy rates and falling rents.

The more conservative financing landscape that is likely to emerge in 2008 should ultimately benefit the entire commercial real estate market. Buyers accustomed to zero equity and aggressive pricing and deal structures may disagree. But investors with cash equity are starting to shop and initiating transactions that should be completed mid-2008.

Once the short- and long-term effects of the subprime meltdown are fully known, the more stable environment that will result from 2007’s corrections should foster a stronger, more stable commercial real estate market in 2008 and beyond.

— Daniel Smith is managing director for RBC Capital Markets’ Real Estate Mortgage Capital.

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