The market crash of 2008 was caused primarily by overleveraging in residential real estate, but also in commercial real estate. In this article, we explore the refinancing issues ahead for commercial real estate.
The market crash of 2008 was caused by overleverage – primarily in residential real estate, but also in commercial real estate. Debt financing came easy as banks grew their commercial real estate (“CRE”) lending in every year from 1994 through 2008. Access to debt became even easier when commercial mortgage backed securities (“CMBS”) were introduced to the market to securitize mortgages and sell them to investors. By 2007, CMBS issuance was $229 billion and surpassed the growth in CRE loans from banks for the first time. As the markets around the world crashed in 2008, both sources of loans dried up and have been shrinking on a net basis ever since.
Banks in the U.S. have decreased their CRE portfolios by $489 billion from 2009 to 2012, and CMBS in the U.S. has decreased by $107 billion in the same time frame. The problem with the decrease in financing isn’t necessarily that it is stopping new real estate development, but instead that it is hindering the refinancing of existing debt. Much of the CMBS lending in the past had 10 year maturities, so as we approach the 10 year anniversaries of the most active CMBS lending years, there is going to be significant loan demand and no apparent source of funding.
Banks have shrunk their CRE loan portfolios from a high of 14.0% of total assets in 2006 to 10.5% of total assets at the end of 2012, which is the lowest it has been in 20 years. If we assume banks have stopped shrinking their CRE portfolios, and they will continue to refinance existing loans on their books, then CMBS is the next major worry. Insurance companies and pension plans can provide some of the funding, but they have never been a major source of CRE debt historically and have always been very conservative lenders. Additional equity is another funding option, but the only way equity will flow into the market in enough volume to make up for the debt shortfall is if there is a significant enough decrease in the value of the real estate to make the market very compelling for equity investors. Of course, if that happens it will cause more properties to fall below their loan- to-value covenants, making refinancing more difficult, and exacerbating the refinancing problem. So, it appears that the most likely, and necessary, source of funding to solve the issue will be more CMBS lending.
As you can see in the chart below, the CMBS market all but died in 2008, but has been experiencing a modest resurgence recently. In 2012 there were new CMBS issuances of $48 billion, and in 2013 new issuances have been healthy through February. The CMBS resurgence needs to pick up and remain strong through at least 2017 or the U.S. will likely see significant commercial real estate debt defaults and a sharp decrease in commercial real estate prices starting in 2015. Hopefully Wall Street will be able to find enough buyers searching for extra yield to solve the $500+ billion refinancing issue we are facing.
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Steve Sprindis is co-founder and managing director of Waypoint Private Capital. © 2013 Waypoint Private Capital, Inc. All Rights Reserved.