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We all know that the markets aren’t what they used to be, and by now we also know that this sentiment not only extends to the housing and stock markets, but to the commercial real estate market as well. The media has been a flutter with reports on how the former two investment vehicles are performing, but little attention has been paid to what implications the economic fall-out may have on commercial investors going forward. This is likely due to the fact that a significant amount of the population invests in the stock market and owns homes. It may also be because the commercial real estate industry was one of the last tiles in the Dominoes rows to fall after a chain of events was set off by the subprime mortgage bust.

Regardless of why this once-thriving market sector has been overlooked, one thing remains clear: its investors know that the rules of the commercial industry are changing. What isn’t clear is what these new rules will be.

General Guidelines

There are two cardinal rules that lenders and borrowers forgot to abide by over the past few years. For borrowers, they failed to make good on their promises to pay back however much they accepted from the lenders. For lenders, they failed to lend only what they knew the borrowers could pay back. Now, trust is broken on both sides, and the media frenzy, not to mention the government interventions that followed, has shone a shameful spotlight on the entire real estate lending industry.
 
Though chaos ensued, everyone involved may have emerged a little wiser. “In today’s market, there’s not a lender in the world that doesn’t want to get paid back,” said Len Cisek, vice president of Ocean Pacific Capital, a worldwide commercial lending firm based in Irvine, CA. “[Lenders] don’t care if they could charge 12 percent or 15 percent interest, their goal now is to get paid back.”

Downtown Chicago
And with the numbers recently released by Fitch Ratings concerning the CMBS market, who could blame them? The global rating agency noted that CMBS loan delinquencies increased by 13 basis points in February. It also noted that although the commercial real estate industry remained fairly resilient through the third quarter of 2008, it experienced a 0.72 percent increase in commercial loan defaults between September 2008 and January 2009, when 1.15 percent of all commercial loans went into default.

This, of course, has caused lenders to scale back their offerings, up their standards and even stop lending altogether until the market appears to rebound. “There is no CMBS market [anymore],” Cisek said. “It ended 12 months ago. The only two companies in the CMBS market right now are Goldman Sachs and Morgan Stanley – and neither of those has made a loan in more than 12 months.”

So what does this mean for commercial investors, developers and owners? It means higher down payments, less opportunities for refinancing, more transparency and a closer look at a property’s cash flow. With the changes in the lending landscape, Cisek believes that investors now have to provide at least a 30 percent down payment, though he noted they could be as high as 50 percent depending on one’s income and cash flow.

By Region

As with every market cycle, some areas are faring better than others. Fitch Ratings predicted that properties in regions with high unemployment and foreclosure rates would perform the poorest until the market hints at a recovery. The agency had specific performance concerns about properties in five states where the foreclosure and unemployment rates were almost 20 percent higher than national averages. They include California, Nevada, Arizona, Michigan and Florida. These states also comprise one-quarter of the United States’ office, retail and multifamily CMBS transactions.

Phoenix’s retail and office markets have experienced particularly high delinquency rates, as has Miami’s retail market and Orlando’s and Tampa’s hotel markets. Investors hoping to maneuver within these markets and product types aren’t likely to find sympathetic lenders anytime soon. They’re better off waiting until the recovery is well underway, which could be as late as 2011.

While California was identified as a vulnerable zone for commercial properties, Fitch’s analysis noted that there are some areas with low rates of CMBS delinquencies. They include the Inland Empire’s office and multifamily markets, and San Diego’s hotel market. Despite this good news, many lenders remain skittish, partly because California’s housing and employment sectors are flailing, and partly because the market has yet to bottom out, meaning that there’s still time for more delinquencies to occur.

Cisek noted, however, that it’s no surprise that certain sectors in California are stable because “big money people like the East Coast, West Coast and Chicago.” Cisek also believed that investors would have a better time getting a loan in cities with a population above 25,000, with a few exceptions. “If you had a property in Detroit right now that you wanted, you’d have a long list of lenders to call before you’d get one that would even consider the loan,” he said. “The same goes for Cleveland, Ohio.”

Other cities where the CMBS market is performing well, despite a large exposure, include New York City’s office, retail and hotel markets, Washington, D.C.’s retail, office and multifamily markets and Chicago’s hotel market.

By Product Type

Fitch Ratings noted that the retail sector was the chief culprit behind CMBS’s recent 13-point increase. In fact, 46 more retail loans went delinquent in February, totaling $227 million. After consumer confidence dipped, the holiday shopping season went bust and loans came due, many retailers found themselves unable to steady their sales or pay for their spaces. If 2008’s retail landscape has taught us anything, it’s that the current slowdown has not discriminated against a retailer’s age, line of product or size. You can be sure, then, that lenders won’t discriminate when it comes to retail loans. Most are likely to turn anyone and everyone down.

Another product type that is not faring well in general is the hotel industry. In California, transaction volume dropped by 45 percent, according to Atlas Hospitality Group’s 2008 California Hotel Sales Survey. Hotels and resorts attached to casinos, particularly those in Las Vegas, have also performed poorly. Moody's and Standard & Poor’s recently lowered their credit ratings for MGM Mirage, the second largest hotel and casino operator on the Strip, because of a drop in liquidity and some recent renegotiated agreements to repay billions to its lenders to avoid defaults. MGM Mirage’s financial woes highlight a trend that is causing many banks major problems. “Big banks own a lot of hotels, and about one-third of all hotels in the United States are underwater right now,” Cisek said. “Because they were underperforming, had high vacancies and eventually went bankrupt.” Cisek noted that,
Southern California Apartment
Apartment complex in Southern California
like retail, hotels of all sizes are struggling, though the larger chains may be able to stall the foreclosure process longer than boutiques or other smaller operations. “Many hotels are not making a dime right now and, because of this, their owners can’t make their mortgage payments,” he added. “They haven’t been foreclosed upon because the companies behind them are strong enough to pull money from their profit-making hotels to pay for the ones underwater.”

Cisek believed that the multifamily market, particularly apartments and student housing, would remain a solid product type for lenders. He noted that investors must take into account where these projects are located, however, before assuming that a lender may be interested. Savvy investors may want to research cities where foreclosure rates are high, as many former homeowners now have to rent.