How the Sub-prime Crisis Might Impact Commercial Real Estate?

How the Sub-prime Crisis Might Impact Commercial Real Estate?

by Gleb Nechayev, VP, Senior Economist
Jon Southard, SVP, Director of Debt Management and Valuation
Raymond G. Torto, Principal & Chief Strategist
Torto Wheaton Research

Headlines have blared these last few months on the evolving sub-prime crisis. Most of these stories fall into a "news" story category we term the …"maybe, perhaps, might, potentially…" view of the world. The media coverage is of this ilk because there are still many unanswered questions on how this industry will fare and how it will affect other industries. One area our clients have asked about is how the sub-prime issue will impact commercial real estate.

The effects on commercial real estate can come by several paths of transmission. One is through debt availability and pricing. Will the risk premium rise or the availability of debt fall, impacting commercial real estate pricing? Other paths of transmission pass directly from the economy to commercial real estate markets. Loss of jobs has multiplier effects from retail sales to construction. The office sector can see increased vacancy as tenants leave the sub-prime industry, and the housing market-particularly institutional multi-family-can be affected either by a flood of new tenants or a flood of formerly owned homes that are now rentals.

Paths of Spillover

Prior to last year, the housing market clearly boosted the economy. The collapse so far has taken away that boost, but has not taken the other sectors down with it. The recent rise in delinquency will likely extend this slow growth period, but it is harder to make the case that what is essentially 2% of the mortgage market will topple the entire economy. Remember, the numbers show that only a portion of the loans are risky loans, only a portion of these loans will become delinquent, only a portion of these delinquent loans will default. The question then becomes: what portion of the relevant market's, or the relevant bank's, or the relevant property type's demand base are these defaulted loans?

These proportions will determine the spillover to each property type and to each area of the economy. An economic sector such as homebuilders or banks that have put too high a percentage in risky residential loans, are closer up the chain of events and as such. Within commercial real estate, the property types that are closer to this transmission mechanism are those for which demand is provided by consumers as opposed to businesses. Retail and multifamily are, therefore, more likely to see decreased demand than are office and industrial properties.

This is exactly what we at TWR have been advising our clients for the past several years, as the size of the housing bubble became more obvious, along with the certainty that the Fed's program of rising short-term rates would surely affect it. Our position, then, is that the sub-prime mess is another collateral effect of the housing downturn.

But even a decrease in demand requires a few more steps in the chain of causality to affect rents. The decrease must be large enough to significantly raise vacancy and high enough to decrease rents significantly. This means that risky sub-prime loans need to lead to delinquencies, which need to lead to defaults, which need to lead to decreased demand which need to raise vacancies which need to decrease rents. If any of these effects are not particularly strong then the spillover will not transmit to the next step. In very few markets are the effects strong enough at each of these levels, except maybe the multi-housing market in certain location of the country.

The second area of transmission from the sub-prime meltdown is the financial market. Housing gave a boost to the economy and commercial financial markets have been supercharged in recent years by the wave of capital that has pushed down the risk premiums on investments. But some of the more visible events of the sub-prime crisis (the charge off from HSBC, the bankruptcy of New Century Financial and others), have raised spreads among the riskier investments in the CMBS universe-namely the BBB tranche.

Such spread-widening is a symptom of the re-evaluation of debt, not just real estate debt, but all types of fixed income debt, like emerging market government debt. Furthermore, the safest tranches have been little affected, indicating that it is not any characteristic of the commercial real estate fundamentals that is driving the widening in CMBS.

While we would like to believe that the underlying fundamentals of the market always drive prices, our explanation of the recent widening suggests that risk in the residential markets might be mispriced prior to the psychological re-introduction of risk as something that can actually affect returns. The transmission mechanism here flows through investor's minds rather than the actual results in the commercial real estate market.

But here again, there are a number of steps that must each be large enough to flow through to commercial real estate. First the rise in spread would need to be transmitted to the risky loans themselves, making it harder to make mezzanine debt or high LTV loans or hotel loans with diminished DSCR. Like with the supercharged residential market and sub-prime abuses, this may be a good thing for the market in the long run, as some have questioned whether this component of the commercial loan universe has gotten too large. However, this effect would need to be large enough to reduce capital in the market that cannot be replaced. For example, the risky loans could be replaced by the significant pension fund equity that surveys show is waiting to be employed.

Next, this drop in capital would need to be great enough to drive up cap rates because of fewer bidders on property. And remember, even if spreads on cap rates over treasuries widen, there is still the possibility that the treasuries themselves will continue at the lower levels seen since the emergence of these sub-prime problems. Similarly, loan terms on whole loans have appeared to be unaffected to date, from the borrower's perspective, because of the offset between rising spreads and falling Treasuries.

Then, for values to fall, the size of the cap rate rise would need to be large enough to outweigh the increases in income already set into motion by the low vacancy rates that the economic growth of the past few years has brought. If the first chain of causation to the fundamentals is weak, as described above, the second chain of causation through cap rates could also be offset by higher income.

Conclusions

The impact of rising defaults in the sub-prime segment of the U.S. residential mortgage market on commercial real estate could come through two channels: space market fundamentals and financial markets. Change in borrowers' wealth would reduce consumer spending and slow the economy, affecting demand for commercial real estate and rent growth. More stringent credit and a wider spread on loans would lead to fewer bidders, lower liquidity and higher cap rates. Both impacts carry risks of lower real estate prices.

Given that sub-prime mortgages still account for a relatively low share of the total residential mortgage debt outstanding, rising sub-prime defaults will slow both the economy and demand for commercial real estate-particularly its consumer-driven sectors: retail and multi-housing. Demand for apartments is expected to remain strong and could even see a potential additional boost as a share of defaulting sub-prime homeowners return to renting. At the same time, a sharp increase in new condominium construction at a time when both sales and pricing of existing condominiums are falling does carry a significant supply side risk. These risks are largely concentrated in markets where current pricing appears to be driven more by expectations of continuing local home price appreciation than by rent growth. It is here that we see the sub-prime impact play out through both channels discussed above, leading to slower rent growth and rising risk premiums, both to the potential detriment of prices.

References
·Berson, David. "What does the sub-prime mortgage market look like?" Fannie Mae Economic Commentary, March 26, 2007.

·Hagerty, James R. and Hudson, Michael, "Mortgage-Default Risks Rattle Bond Investors," Wall Street Journal, January 27, 2007.

·Hagerty, James R. and Lublin, Joann S. "New Century May Announce Bankruptcy Filing," Wall Street Journal, April 2, 2007.

·Mollencamp, Carrick, "In Home-Lending Push, Banks Misjudged Risk: HSBC Borrowers Fall Behind on Payments; Hiring More Collectors," Wall Street Journal, February 8, 2007.

·Zelman, Ivy, Dennis McGill, Justin Speer, and Alan Ratner. "Mortgage Liquidity du Jour: Underestimated No More" Credit Suisse Sector Review, March 12, 2007.

This is an excerpt of a longer paper to be published in CMBS World, 2007.

Return from Sub-prime Crisis to Real Estate Articles

footer for Sub-prime crisis page