Navigating the Capital Markets Chaos

by francine Hardaway on May 13, 2009

I’m listening to Dan Adkinson, managing director of NewStar Finance in Boston. I heard him speak in late 2007, when he predicted the capital market problems that brought down real estate. I came to hear him two years later to see what he thinks now.

He is telling the commercial real estate audience and the Urban Land Institute meeting about what happens when your commercial mortgage-backed securitized loan goes bad or matures without takeout financing and you have to talk to a “special servicer.” It doesn’t sound that different from what is happening to me with my Half Moon Bay House.

Adkinson thoughtfully points out that the world has gotten to be a much worse place since last he was in Arizona. Capital markets were the problem then. Now it is fundamental real estate demand.

Commercial mortgage-backed securities are somewhat new, although I was reminded tonight that a former client of mine, a home builder, invented the MBS in the 80s, when interest rates were 15% and no one could buy houses.

Mortgage backed securities in the commercial market are much larger pools than in residential mortgages, and totally the province of Wall Street. You start with a pool of loans. The cash flow on these loans pays a sequence of bonds, according to risk appetite from AAA to B to unrated (junk). Now that these loans, too, are going bad, Adkinson says it’s fortunate that your lender is public and the agreement is available for you to read (it’s called a pooling services agreement).

On these pools of loans, the servicer is charged with recovering as much principal and interest as possible for the bondholders. Only trouble is that not all the bondholders have the same interests.

If your loan matures and you have no takeout financing, you are assigned to a Special Servicer, who can reduce, forbear and extend the maturity date of your loan. There’s a pretty low bar to encourage the Special Servicer to play ball with you. However,some certificate holders benefit from foreclosure( AAA), while others benefit from extension.(unrated). Extensions are the natural line of least resistance for the Special Servicers, but that wipes out the AAA bondholders. Lawsuits will be coming when these decisions start hitting.

Right now, there are over a billion dollars in post-mature commercial mortage backed loans. We are going to need $50 billion over the next 4 years to refinance them all, and as of now, there’s no capital to re-fi all these loans. This is a weight on the bond market.

The credit underwriting mismatch is enormous in the short term. 2/3 of existing loans will not qualify for the new 70% loan to value standard. Long term it is no better.70% of office and multifamily loans will not qualify.

Why not? Because the capital markets problem of 2007-8 is now the fundamental real estate demand problem of 2008-2012. There will be recession, negative absorption , and falling net operating income until 2012.

The real estate market doesn’t recover until we get rid of the toxic assets. Does this sound familiar? It’s the housing crisis, only with bigger numbers. How do we make progress from here? We work through it, making individual decisions on each loan and each property. We walk from some, extend others. The new normal is less leverage at higher rates.

The economy starts to look better at the end of this year, but the real estate economy doesn’t bottom out in 2012. Does it come back like before. Doubtful. Depends on when the Baby Boomers can afford to retire. When that happens, it’s the end for the office market, because the Echo Boomers aren’t that large a population, and they work differently. And it’s already the end for retail, as all the malls become “lifestyle centers” selling movies and dinner. Everything else moves online.

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