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A Dose of Fear in 2008: The Commercial Real Estate Capital Markets

NAIOP Chicago September 4, 2008 Dr. Mark Eppli Professor of Finance and Robert B. Bell, Sr., Chair in Real Estate Marquette University. A Dose of Fear in 2008: The Commercial Real Estate Capital Markets. Overview. Review the Subprime Debacle Impact of subprime loans

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A Dose of Fear in 2008: The Commercial Real Estate Capital Markets

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  1. NAIOP Chicago September 4, 2008Dr. Mark EppliProfessor of Finance and Robert B. Bell, Sr., Chair in Real Estate Marquette University A Dose of Fear in 2008: The Commercial Real Estate Capital Markets

  2. Overview • Review the Subprime Debacle • Impact of subprime loans • Commercial Real Estate Capital and Space Markets • The return of discipline • Wide risk spreads • Some commercial real estate metrics • Macroeconomic indicators flashing moderate warnings • Closing Thoughts

  3. Definition of subprime: • Old School definition, Adj.: Credit with higher risk characteristics • Hip hop definition, Verb: to have performed poorly, i.e. I subprimed that exam. American Dialect Society, Word of the Year for 2007

  4. Subprime and alt-A loans played a significant role in increased homeownership rates . . . . Source – HUD and Marquette University

  5. . . . . current levels of home ownership rates are not sustainable . . . . • 67.8% • Current homeownership rate (2008Q1) • 69.3% • Peak homeownership rate in 2004 • 70% • Proportion of the recent rise in homeownership due to new types of mortgages

  6. . . . .the number of missed mortgage payments is growing . . . . Source – Wall Street Journal June 6, 2008, Page A5

  7. . . . .should lenders/borrowers have known better? . . . . Source – Wall Street Journal 12/7/07 Page A14

  8. . . . .we are at the tail-end of the first subprime interest-rate resets . . . . Source – Wall Street Journal 9/25/07 Page C1

  9. . . . . implications of the subprime mortgage delinquencies reported through 2008:Q1 . . . . The “biggest losers” Sources: Varied.

  10. . . . . how have these investments titans lost so much money? . . . . Source – Wall Street Journal 12/1/07-12/2/07 Page A10

  11. . . . . and a dashed glimmer of hope . . . . Source: Markit.

  12. . . . . the subprime mortgage problems are changing underwriting standards . . . . Source: The Federal Reserve.

  13. . . . . and reducing mortgage volume. Source: The Federal Reserve.

  14. So, what have we learned from the subprime market? • If subprime and alt-A mortgage products disappear without replacement; • Homeownership rates will fall to about 66%, • There will be approximately 2.0 million unit reduction in new demand for housing creating a two year supply of single family homes. • We will be digging out of the sub-prime problem through 2009!

  15. Who’s to blame for the subprime mess? • Who was asleep at the wheel? • Originators – side stepped underwriting standards • Borrowers – willing participants in underwriting misstatements • Rating Agencies – failed to appropriately assess risks • Investment Community – packaged/repackaged debt (CDOs) • Federal Regulators – do not regulate non-banks mortgage companies • Does this sound like the CMBS market?

  16. The Commercial Real Estate Capital Markets:The Return of Disicipline (too much discipline?)

  17. CMBS Issuance is off 90%, -- issuance of $12.1 billion through 2008:Q2. . . .

  18. . . . . demand for bank loans is off . . . . Source: The Federal Reserve.

  19. . . . . with tighter bank lending standards . . . . Source: The Federal Reserve .

  20. . . . . making borrowing difficult across major commercial lenders. . . . Source: Federal Reserve and Marquette University

  21. . . . . prompting a steep decline in the flow of debt capital into real estate. Quarterly Net Flow of Funds into Commercial Real Estate Source: Mortgage Bankers Association and the Federal Reserve

  22. The Commercial Real Estate Capital Markets:Risk Spreads Widen (too wide?)

  23. While Treasury interest rates are low, if not very low . . . . 10-Year U.S. Treasury Rate, September 3, 2008, 3.70%.

  24. . . . . risk spreads soaring across all CMBS investment ratings . . . . Source: Morgan Stanley.

  25. . . . . with CMBS risk spreads widening, both in absolute term and relative to corporate debt. . . . AAA CMBS* vs. AAA Corporate Industrial Spreads to Swaps (bps) Source: Morgan Stanley, Bloomberg *Super-Senior AAA CMBS Spreads to UST Through January 16, 2008 Source: Morgan Stanley.

  26. . . . . and with even greater widening of spreads to for more subordinate CMBS tranches. . . . BBB CMBS vs. BBB Corporate Industrial Spreads to Swaps (bps) Source: Morgan Stanley, Bloomberg Through January 16, 2008 Source: Morgan Stanley.

  27. . . . . with tremendous CMBS spread volatility. . . . Source: Morgan Stanley, Bloomberg Through January 16, 2008 Source: Markit.com

  28. . . . . let’s take a look at November 2006, CMBS pricing. . . . Source: Morgan Stanley.

  29. . . . . let’s take a look at August 27th, 2008, CMBS pricing. . . . Source: Morgan Stanley.

  30. . . . . and higher bank spreads. Source: The Federal Reserve .

  31. However, is the jump in risk premiums justified? . . . .

  32. . . . . delinquency by CMBS vintage . . . . Source: Morgan Stanley.

  33. . . . . similar to CMBS, banks have a low but rising number of problem loans . . . .

  34. . . . . and continued record low life insurance delinquency rates . . . .

  35. March 1965 – June 2005 Percent Delinquent . . . . all time delinquency rate lows . . . Life Insurance Company Delinquency Rates, 1965-2005Q2 52 26 22 42 7.53% 0.17% 2Q92 1Q65 4Q69 2Q76 2Q05 4Q81 Source: ACLI and Morgan Stanley

  36. . . . . historical delinquency rate ranges and latest delinquency rates, range since 1996. Source: Mortgage Bankers Association, 2008:Q1.

  37. The Commercial Real Estate Capital Markets:Some Real Estate Return Metrics

  38. Comparative stock and equity real estate risk/return levels are no longer favorable for real estate . . . . Source: ULI.

  39. . . . . real estate yields relative to U.S. bonds are also not favorable to real estate . . . . Source: ULI.

  40. . . . . with cap rates beginning to rise . . . . Source: Mortgage Bankers Association.

  41. . . . . and a dramatic slowing in commercial property transactions. Source: Mortgage Bankers Association.

  42. The Commercial Real Estate Space Markets are Putting on the Brakes (or at least tapping the brakes)

  43. Property vacancy rates are ticking up. . . . Vacancy Rates by Property Type Source: PPR and Mortgage Bankers Association

  44. . . . . with increases in space availability across all property types. . . . Net Completions less Absorbed Space (in 000) Source: PPR and Mortgage Bankers Association.

  45. . . . . with weak national payroll employment hurting office space absorption . . . .

  46. . . . . and with consumer sentiment numbers near all-time lows, retail absorption continues to wane . . . .

  47. . . . . cash-out refinancing is less of an option to fund retail sales growth . . . . Source: Freddie Mac and Marquette University.

  48. . . . . however, the industrial/warehouse markets reveal some potential. . . . Source: Morgan Stanley and PPR

  49. . . . . however, durable goods orders are weak. . . .

  50. . . . . and a weak single-family market bodes well for multifamily.

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