The CMBS Market Crash And Its Ramifications – Dr. Peter Linneman

BRUCE KIRSCH: What does it mean when people say the CMBS market crashed? Is that the same thing as saying that the overall real estate market crashed?

PETER LINNEMAN: No. I mean, they’re related, but it’s not the same thing. I think normally what people mean is CMBS went from, in 1990, probably doing a billion a year of issuing mortgages. It got up to $50 billion a year in mortgages by around 2000. And by 2004, 2005, 2006, and 2007, there were $120 billion, $160 billion, $200 billion, and $280 billion, respectively, being done in mortgages. This is a market that had really kind of slowly grown, had a little plateau, and then exploded.

2007 is about $270 billion in new mortgages being written that are then put into CMBS and sold in a structure. By 2008, 2009, you’re back down to $4 billion. And that’s the crash. That is, it just didn’t issue anything.

The old ones were out there, but it didn’t issue anything new. And the reason it didn’t issue anything new is the credit crisis had created a complete lack of confidence in the underwriting of CMBS issuers. There were skyrocketing delinquency rates and default rates that went from essentially zero to 10% in a matter of a year or so.

So instead of having half a percent of the loans in some type of special situation, within a year or two you had 10%. And people just lost all confidence. The financial crisis made things very uncertain, in general. No one wanted to make commitments. And the interest rate scenario was very volatile.

And all that just said that you couldn’t issue mortgages and put them together in a CMBS because there was nobody to buy them. If there was nobody to buy them, there was nobody willing to make those loans. And since there was nobody willing to make those loans, you lost the $270 billion source of financing.

You can imagine you were expecting to be financed in 2008 or 2009 or 2010 as part of a $200 to $300 billion sector that did zero, for all intents and purposes. That put tremendous pressure on refinancings. It put tremendous pressure on pricing of real estate, because people who thought they would be easily able to get loans suddenly couldn’t get loans.

They were scrambling for equity. They were scrambling in every way. Pricing pressure came on, which increased the delinquency and default rates. So in that sense, they were symbiotically related.

By 2012, year end, the market had gotten back to where about $45 billion in the US of new issued CMBS. So you were back to the level that you were in the late ’90s or very early 2000s, but you were nowhere near this peak. And I think most people believe 2013 will come in at somewhere between $45 and $60 billion. It’s a sector that’s still rebuilding confidence among the investor pool. And that’s going to take some time. Trust lost is not so quickly trust regained.

BRUCE KIRSCH: On that note, are there more restrictions, more requirements for transparency this time around for documentation and making things clear and easy to understand for potential investors?

PETER LINNEMAN: There’s a lot of subtle tweaking, legal tweaking of the documents that have occurred. The more substantive thing that’s occurred in 2011 and 2012 is a return to sort of old school underwriting of a mortgage. Income that’s not in place, I’m not going to give you credit for. If it occurs, great. It’s cushion for the lender. But what I see as income is all I’m going to treat.

I’m only going to treat income from credit tenants, in some cases, as income. Even if you’ve got income from other people, if it’s not from credit tenants at a shopping center, I’m not going to count it I’m not going to do 1.1 interest coverage. I’m going to insist on 1.3 times interest coverage– bigger cushion.

I’m not going to rely on appraisals to tell me what a mortgage worth. I’m only going to give a mortgage if it’s a new purchase, and therefore, it’s a real transaction. Or I’m not going to include mortgages where you’re refinancing an existing mortgage, but taking more than the original mortgage out. That is, no refinancings that allow the borrower to take away proceeds.

There have to be reserves for tenant improvements. There have to be reserves for capital expenditures. Or else, I’m not going to make the mortgage. So it’s kind of a return to old school underwriting.

And as markets get more competitive and people start chasing loans, both the underwriting and the technical stuff, the legal stuff, gets chipped away at it– always does in every market. CMBS is no different in good times. We’re still in not such great economic times, so still pretty decent in that regard.

BRUCE KIRSCH: No.