August 2, 2009
By Malay Bansal
Much has been written about the issues faced by Commercial Real Estate, extent of losses the CMBS bonds will sustain, whether the TALF, PPIP and other government programs will help, and if the commercial real estate market is showing signs of bottoming or is going to keep declining a lot more. There are various views which all seem plausible. If you are not professionally involved in real estate, or if you do not already have a definite view, how do you go about developing your own opinion? This article is an attempt to help with that process.
First step in the process is defining the problem being faced by the CRE market. It is a complex problem and yet the best description of it I have seen is a simple one sentence comment reportedly made by a panelist at a recent industry conference organized by CMSA:
“We have gone from a 6% Cap, 80% LTV world to a 8% Cap, 60% LTV world.”
That is another way of saying the CRE market faces a double-whammy of falling prices and reduced availability of debt, but the use of numbers in this short one sentence elegantly and succinctly captures the essence of the problem. A simple example will help explain.
Let’s take a commercial property, say an office. It is year 2006, property generates $600,000 in rental income per year, and cap rates are 6%. That results in value of $10 mm (600K/6%). In an 80 LTV world, Larry the Landlord buys the building for 10 mm, borrowing 8 mm (80% of 10 mm) for 5 years from a CMBS lender, and using 2 mm of his own money. Now fast forward to a time closer to loan maturity. In the new world, cap rates are 8%, so the new value is lower at 7.5 mm (600K/8%), and the new loan amount is 4.5 mm (60% of 7.5 mm). To refinance, Larry needs to pay off 8 mm, but can only get 4.5 mm in new loan. So, he needs to come up with 3.5 mm. If he has that money or can raise it from somewhere else, he can refinance the old loan and continue to own the property.
If Larry can not raise the additional amount, or if he does not think that it is economically worthwhile to do so, then the loan is foreclosed, and one option for the lender is to sell the property. Ideally, the property can be sold for 7.5 mm, the new value. In the worst case, there should be plenty of buyers at 4.5 mm (since one can buy the property no money down using the 4.5 mm debt available in the new world). The actual price will be somewhere between the two depending on how many buyers are there with cash available to buy, and what is their view of real estate prices in future.
By using the above numbers, we can quantify the range of expected losses in cases of sales:
|Decline or Loss||%Decline or Loss|
|Property Prices||2.5 to 5.5 mm||25% to 55%.|
|Borrower’s Equity||2 mm||100%|
|CMBS debt||500K to 3.5 mm||6.25% to 43.75%|
If you layer in other factors, for example, if you assume that building’s cash flow decreases by 15% due to higher vacancy or lower rental rates (or the actual rent is lower than the assumed rent in aggressive underwriting), the numbers become worse:
New cashflow is 510 K, which results in new value of 6.375 mm, and new loan of 3.825 mm. With a new buyer paying something between 3.825 mm and 6.375 mm in case of a sale, the range of losses is:
|Decline or Loss||%Decline or Loss|
|Property Prices||3.625 to 6.175 mm||36.25% to 61.75%.|
|CMBS debt||1.625 to 4.175 mm||20.31% to 52.19%|
Broad ranges for sure, and you can quibble with the cap rates or LTVs, or the fact that this simple analysis ignores other expenses and complexities, but these are back-of-the-envelope numbers, and give you an idea. For CMBS deals, you also need an estimate on how many loans in a given deal will default. If you assume approximately 40% losses on defaulting loans, then defaults on 20% of loans in the pool will result in 8% losses on CMBS deals, which is somewhere in the middle of the range of losses being predicted by many of the market participants.
Loan extensions can postpone the problem, but not necessarily avoid it, unless the property prices go back to the old levels quickly, which no one expects.
Looking at the example above, one can clearly see the importance and impact of availability of debt. If debt up to 80 LTV were to become available again, that will narrow the ranges above significantly. Clearly, programs like TALF and PPIP that help increase availability of debt are helpful and important. But, they do not solve all problems. They do not help with the decline in value. That pain has to be taken, even though many are trying to ignore it. The current low transaction volume environment reduces confidence in valuations, but eventually volume and clarity on new valuations will both increase. Those who own commercial real estate property with a lot of debt and can not carry it through the downturn will suffer losses they have not recognized yet. But those who have cash and can buy properties at cheap levels in distressed sales will benefit. As always, it will be important to analyze and understand not just the sector, but the individual investments being considered.