Cap Rate News

Is a Subprime Commercial Mortgage Meltdown Next
by Warren K. Hoppke, SRPA
     Member Appraisal Institute

Turmoil in the commercial mortgage backed securities (CMBS) market is increasing. As more lenders implode several of the largest credit rating agencies like Fitch have issued warnings about credit quality.

Commercial foreclosures - when will they begin. Costar reported CBRE Realty Finance Inc. took a net loss on two foreclosed assets and halted making new investments. As a result, Wachovia wants an increase of 26.7 million in CBRE's warehouse line of credit. The company may have to pledge some of its assets to meet the request. The two properties in question are a 434-unit condo conversion in Bethesda, MD and a 508-unit condo conversion project in Towson, MD. 

Last months report by Banc of America Securities warned of a "broader fallout from Subprime mortgage deterioration" when homeowners with about $515 billion in adjustable-rate home loans -- more than 70 percent of whom are Subprime borrowers -- get higher monthly mortgage bills as rates reset before year-end. Another $680 billion worth of mortgages will reset in 2008, the report said.

According to S&P’s Equity Research, apartment vacancy rates in 2Q increased for the second consecutive quarter.  R.E.I.T. analysts warn that rising cap rates could threaten planned projects especially for highly leveraged R.E.I.T.'s. Wall Street Investors are now demanding much higher IRR's because of recent market conditions. NCREIF One-Year Returns ranged from around 6% in 2003 to above 15% for 2007 Q2. NCREIF returns are reported on an unleveraged basis. For highly leveraged properties higher loan costs could drive down effective IRR's if market conditions deteriorate.    

Bloomberg News reported Lone Star Funds would not complete takeover of Accredited Home Lenders Holding, citing “drastic deterioration in the financial and operational condition”.

According to the Wall Street Journal, Goldman Sachs recently liquidated positions in Global Alpha fund as well as its North American Equity Opportunities hedge fund in order to curb its risk profile. Moreover, three French hedge funds put a freeze on redemptions operated by BNP Paribas a Fench bank with about $2.2 billion in assets. According to Rueters News Service they stated "The complete evaporation of liquidity in certain market segments of the U.S. securitization market has made it impossible to value certain assets fairly, regardless of their quality or credit rating,". Moreover,  according to CNBC.com Peter Schiff, president of Euro Pacific Capital said, "I think this is the Hindenburg, we've got all of this bad mortgage paper all around the world and it's going to get worst."

Mortgage spreads have risen sharply up 30 bp to 65 bp as reported in Commercial Mortgage Alert by www.CMAlert.com . As the meltdown increases we expect mortgage spreads to go much higher on CMBS mortgage pools of properties in the $1,000,000 to $10,000,000 range.

Colliers International Real Estate Brokerage reported in its Outlook 2007 cap rates in the 4th quarter of 2006 have spiked upward 20 bp to 35 bp for all asset classes except multi-family residential.

Boulder Net Lease Funds LLC Q2 Net Lease Market Report indicated the industrial segment had the largest increase a 23 bp rise, bringing the mean cap rates to 8%. Next was office with a 20 bp increase to a mean of 7.7%, and finally retail with a 10 bp increase to a mean 7.1% cap rate.

As reported in our last blog, the spill over from the Subprime mess from the residential housing market is now causing a credit crunch in the CMBS mortgage market driving rates higher. As liquidity dries up and rates go higher many properties that were purchased at extremely low cap rates may go into default.

Lenders are now requiring higher mortgage rates to compensate for the perceived risk in the capital markets. As a result, decreasing loan to value ratios and increasing debt service coverage ratios are becoming common place. Many small and medium size commercial property borrowers have 3 to 5 year VIR loans. As these borrowers try to refinance they may be stuck. As cap rates rise and prices decline many of these borrowers may simply walk away if prices fall substantially. You will find a good example of such a scenario in an article in Real Estate Weekly, July 21, 2004, by Marc Weider. 

The real estate market moves much slower than the stock market or any other market. Typically, the commercial real estate market lags the residential market. As a result, we expect cap rates to rise and certain commercial real estate asset class prices to start declining around the 3rd or 4th quarter of 2008. This will be generally limited to specific asset classes and certain regional market sectors starting with retail and price ranges in the $1,000,000 to $10,000,000 range, unless the overall economy begins to deteriorate. 

In addition, some larger highly leveraged deals may end up being purchased at substantial discounts as so called vulture funds buy these properties up. For example, CNNMoney.com reports Blackstones $39 billion real estate buyout of Equity Office Partners (EOP). This large deal only makes sense if markets keep rising i.e. rents and land values. Further, it was reported that Blackstone paid a premium to beat out rival Vornado and take EOP private. CNNMoney.com reports that since the purchase Blackstone has been selling off properties at lightening speed in the most attractive markets.

The question arises does Blackstone know something about the commercial real estate market that we do not know.

The final question is, if cap rates form around the equation Cap Rate = Risk free Rate + Risk Premium + Capital expenditures - expected appreciation, will investors continue to push up the Risk Premium and will Expected Appreciation not materialize in 2008, 2009, 2010 ?

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