Illiquidity and Insolvency in the Commercial Real Estate Market

by: Felix Salmon

If you haven't read Jesse Eisinger's column on the CMBS market in the latest issue of Portfolio, do check it out – it's very good. As a special bonus for Market Movers readers, I followed up with him this morning, with a question about whether the market is insolvent or "merely" illiquid. Here's my question, followed by Jesse's reply.

Q: Clearly demand for commercial mortgage-backed securities has plunged, and there's no almost no liquidity at all in the commercial-property sector. But I'm interested: do you think this is a liquidity problem or a solvency problem? Many of the office-building purchasers were happy with debt service payments greater than cashflows, on the grounds that tenants were paying below-market rates and that cashflows would improve substantially when leases expired. Do you think that such faith was misplaced? Do you think that rents will go down rather than up? And is there any evidence of that happening yet?

A: You are certainly right that for now, the commercial market is facing a liquidity problem now and not a solvency problem. Delinquencies have risen off the lows of earlier this year, but not much.

The main difference in the commercial market is that supply didn't rise as much as it did for the housing market.

So, does that mean if the liquidity panic subsides, the commercial and CMBS markets will be fine? I doubt it.

The problems with the residential market didn't start because of oversupply, but because of bad loans -- loans made to borrowers who depended on refinancing and price appreciation to afford their loan payments. The "values' in the "loan-to-value" ratios that lenders used were falsely high, in both residential and commercial. The problems in the housing market started before prices went down; all it took was for prices to flatten and the subprime borrowers who had 2/28 mortgages couldn't refinance and couldn't afford their loans. That's pretty extraordinary.

So, I foresee similar things happening in the commercial real estate market. Borrowers depended on above-normal increases -- in rents or appreciation -- to afford their loans. Values rose to nosebleed levels and lending standards dropped. Both borrowers and lenders made assumptions about future cash flows and appreciation that were unsustainable. If rents merely fail to continue to rise, many borrowers will have problems, I suspect. The Peter Cooper Village/Stuyvesant town purchase is emblematic of this since the assumptions that went into the purchase were that they would be able to wrest rent increases that were substantially above the historical norms.

Also, it's worth noting that around 80% of commercial loans were interest only in recent periods, about double from four years ago. In the first quarter, 90% were IO. So these borrowers are going to be highly vulnerable to liquidity issues. Of course, the Fed rate cuts would help in that instance, if the lending rates follow. But if the banks and CMBS investors are being hit elsewhere, perhaps they won't be interested in commercial real estate loans and securities.

Moreover, prices in commercial real estate are already falling. Brian Fitzgerald of Wachovia (NASDAQ:WB) estimated that prices had already fallen around 5% to 10% in major markets by late fall. That will accelerate, I am guessing.