The Domino Effect: The Credit Crunch Triggered by the Meltdown in the Subprime Mortgage Market Has Had Spillover Effects in the Commercial Mortgage Market. Commercial Mortgage Lending Executives and Analysts Share Their Views on How This Has Changed the Market
Bell, John, Mortgage Banking
The nation's commercial lenders in 2008 will be facing rougher financial market conditions. The source of much of the turbulence will be the hangover from the credit crunch of 2007. Compounding the challenges will be the ongoing fallout from the swift collapse of the subprime mortgage market on the residential side. [??] While the commercial and residential lending markets are separate markets, they are related and extremely sensitive to each other's financial health, industry sources point out. That was clearly evident in mid-2007 as the subprime mortgage market suddenly turned south and investors on the commercial side reawakened to risk. [??] The credit markets experienced a sudden severe and widespread reversal in investor risk sentiment and a resulting flight to safety, according to the Expectations & Market Realities in Real Estate: 2008 report, co-produced by Des Moines, Iowa-based Principal Real Estate Investors; Chicagobased Real Estate Research Corporation (RERC); and Boston-based CBRE/Torto Wheaton Research, a business unit of Los Angeles-based CB Richard Ellis Group Inc. [??] The Expectations report concedes that the credit squeeze was triggered by the subprime residential mortgage debacle, but notes its true origins lie elsewhere. [??] These origins, the report says, include several successive years of increasing appetite for risk on the part of investors spread across the globe; an increasing use of leverage throughout the financial system; and the growing dominance of complex structured finance products in the credit system, which turned out to be riskier than most investors had envisioned.
Yellow flag is flying
As a result of all that, the yellow caution flag is out for the commercial real estate market and is likely to stay there for an extended time, the Expectations report notes.
Thomas Jaekel, chief investment officer of Chicago-based Wrightwood Capital, a leading provider of value-added capital to the commercial real estate industry, traces the evolution of the crisis: "At mid-year 2007, there was hope that disruptions in the single-family market would be contained within that market. But that changed in August 2007, when investors became nervous about the commercial market. They theorized that the same lax credit standards taking place in the residential market would also take place in the commercial market."
Jaekel says investors holding commercial mortgage-backed securities (CMBS) bonds concluded that default rates were very low, and expected higher rates as a consequence of what was happening in the residential markets. They wanted to sell, but found limited demand.
That triggered a spiral effect, which slowed willingness to originate new loans, putting the brakes on lending activity. "The financial markets are built on trust," he observes.
Robert Bach, senior vice president of research and client services for Chicago-based Grubb & Ellis Co., picks up the story: He says the credit market turmoil disrupted many investment transactions by shutting off the spigot of easy money that fueled the market in recent years. As a result, investors and lenders piled into risk-free Treasury securities, driving prices up and interest rates down for those instruments while forsaking riskier investments.
Bach concurs with the Expectations report in observing that the credit market turmoil amounts to a global repricing of risk--a reaction against lending practices that had become too aggressive across a variety of debt instruments, asset classes and economic sectors, of which commercial real estate was just one.
Many of these same conclusions are affirmed in the Emerging Trends in Real Estate 2008 report, co-produced by the Washington, D.C.-based Urban Land Institute (ULI) and New York-based PricewaterhouseCoopers LLC.
The report concludes commercial real estate investors merely overspent and were overleveraged, bidding up prices well beyond what reasonable revenue forecasts could support. …