Give Me That Old-Time Religion
[The Registry October 2011 Issue]
In the last 60-odd days Standard & Poor’s woke up and smelled the coffee not once, but thrice. First S&P yanked its seal of approval from the $1.5 billion commercial-mortgage backed bond deal underwritten by Goldman Sachs & Co. and Citigroup Global Markets Inc. The so-called “GC4 transaction” was then scuttled in late July. This had the immediate impact of shrinking the availability of commercial loans and increasing the cost of money.
Next S&P yanked the triple-A rating of the U.S. government in early August, which had the immediate impact of lowering financing costs for commercial real estate as the yield on 10-year Treasuries hit a new low.
Part of me applauds S&P’s insistence on tight CMBS underwriting standards. (Don’t we all?) I also hope that the debt-service-coverage calculations that S&P insisted were at the heart of its decision to pull back from the GC4 deal can be clarified—the sooner, the better. That would allow new CMBS issues to come to market.
But part of me wonders: why now? Not only was their timing a disaster for the GC4 offering, it put a shuddering chill over the reemergence of mortgage-securities debt. If S&P couldn’t analyze and figure out the details of debt-service-coverage ratios for the GC4 deal, why did it give preliminary approval to the deal? Either way, none of it is good news for Main Street commercial real estate, which desperately needs access to competitive mortgages—particularly non-recourse loans for smaller bread-and-butter deals.
Industry estimates of annual CMBS volume before S&P pulled the plug were as high as $50 billion for 2011. This pales in comparison to the $234 billion in 2007, but it is not bad for a securitization engine regaining a rhythm. Many commercial brokers in the trenches were seeing glimmers of non-recourse origination offerings for smaller deals and at slightly higher loan-to-value.
Revised estimates of deal volume for 2011 following the S&P pirouette now range from $30 billion to $35 billion. Twenty billion dollars of loan capacity is critical within the context of the $300 billion in commercial mortgages maturing this year, next year and in 2013, when every bit helps. The real blow was the loss of momentum and the nascent sense of normalcy.
These events can be summed up with the phrase: “flight to quality.” Said a different way, they illustrate a strong aversion to unforeseen or undisclosed risk.
But if S&P and other rating agencies are distancing themselves from the cozy relationship they have enjoyed with Wall Street, can we believe them? Or is this political theater to protect their highly profitable business model? Federal authorities are actively investigating S&P (both the SEC and the Justice Department) but have yet to report evidence to support a case.
The third strike called by our illustrious S&P umpire underscores the newfound religion: Fannie and Freddie and other federally-backed agencies also lost their top ratings shortly after a $2 billion JP Morgan Chase/Wells Fargo Freddie Mac securitization was announced, but before it was closed. The market shrugged its shoulders and closed the deal anyway. Simultaneous to the downgrade, global financial markets sprinted towards U.S. Treasuries and drove residential mortgage rates to their lowest levels in 50 years. So much for S&P being on the cutting edge of prognostication.
But let us step back for a moment. Doesn’t the notion that an independent third party (especially one with no liability) will diligently review the financial stability of an asset and give a reliable rating of credit quality seem like romantic nostalgia in light of the chicanery brought to light in the aftermath of the Great Debt Implosion?
It seems to me that we ought to return to something that might be called old-time religion, where I underwrite the specific commercial real estate asset that I intend to own (or loan against) myself. I don’t need or want a financial intermediary between me and my underwriting gospel. “Commercial real estate is tangible and transparent: Investors actually see the number of tenants and calculate the amount of rent they expect to receive each month,” says Kenneth R. Riggs Jr., president and chief executive of Real Estate Research Corp. Amen!
The current economic climate is, “ideally suited to commercial real estate, which remains a relatively stable investment, given our uncertain times and the volatility of financial markets,” Riggs says.
Stable yes; liquid no. Interest-rate risk is still embedded in the fabric of the current market even though the Federal Reserve has pledged to hold rates low for two years. The Fed’s stance is reassuring in the near term, but the question remains: When is the U.S. government going to get its own religion about balancing its bloated budget? We can only suspend our belief for so long and accept that global bond investors will swallow the ultra-low yields of Treasuries against accelerating inflation. This cannot continue forever.
In the meantime investors should get busy looking for commercial-property assets in a methodical manner—even if interest rates on commercial loans are higher than they could be with a vibrant CMBS market. Those investors who have access to capital have a distinct advantage and should be acquiring Main Street commercial real estate.
A delay in the rise of interest rates until 2013 or maybe even 2014 lengthens the runway for our economy to become airborne once again. Warren Buffett said recently in a Bloomberg interview that unemployment will fall quickly and the economy will be robust once the housing market comes back—and he’s right, but when will demand for new homes start to appear? In my opinion, not until a year has passed after all the foreclosures and glut of short sales have cleared the market, probably as late as 2015.
For commercial real estate investors, that means the next couple of years will offer great opportunity to acquire assets at relatively low values—not as low perhaps as during the heyday of the Resolution Trust Corp., but solid value nonetheless. A discerning and patient buyer with the discipline to stick to an underwriting path without excessive optimism will benefit and prosper.
Can I hear a hallelujah?
