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The Difference A Day Makes
Flush with transaction-volume and pent up demand from hedge funds and other investors, the securitized debt market started the spring of 2007 with all eyes on a record summer and a record year. It wasn’t long after Memorial Day however, before the focus shifted from setting records to simply hoping for stability; and by August the wheels had come off the proverbial bus.
With the effects of the sub-prime woes having woven their way into all aspects of the commercial mortgage backed securities (CMBS) and collateralized debt obligation (CDO) markets, the source for a substantial amount of the debt-capital that flowed into the market during the last 5-years began experiencing measurable adjustments (to available terms) in late-May and by August had all but vanished as a source of debt.
The initial concerns stemmed from unfavorable comments in April from one of the rating agencies and by the end of May, all of the rating agencies had adjusted their guidance to be in-line with the more conservative standards. These more conservative standards meant that the end was near for the highly leveraged, interest only, floating rate debt that had dominated the market during the previous 18 months.
Most of the buyers for this debt (considered the b-piece commercial debt) quickly drew a correlation between the difficulties in the sub-prime market and the rapid adjustments being made to the rating of the CMBS/CDO paper; therefore, the buyers of this debt adjusted their pricing accordingly. Originators of this debt found themselves with billions of dollars worth of debt that was priced/originated prior to the rating adjustments but offered up for securitization in a market with the b-piece buyers having adjusted their pricing to post-adjustment parameters. Almost overnight, what had been a market in which every debt structure imaginable was not only available, but available at extremely borrower-friendly terms, turned into a market in which good deals, with conservative loan terms couldn’t get done because lenders had taken themselves out of the market to “stop their bleeding”.
There are two major dynamics produced by this environment that the real estate market must stay tuned into. The first is that just as rapidly as the purchasers of the debt adjusted their pricing, buyers of the real estate (that backed up the debt) adjusted their pricing as well; because the capital structure available to them changed. What did not change immediately were the expectations of sellers. For most sellers, when faced with the notion of reducing sales price because of the purchasers’ capital structure and terms, they were conflicted because nothing had changed about the tangible commodity they were selling; the real estate. Collected rents had not decreased, occupancy had not decreased and expenses remained stable; so why adjust the price of the property downward 10% or more, when the cash flow stream off of which the asset initially was priced remained the same, if not better. This disconnect disrupted many deals and as a result, many of these deals fell out of contract and, to date, have not closed. What we as real estate professionals must stay tuned into is many owners became sellers because of the high prices at which assets were selling, especially during the last 12-months. In many cases, owners were selling ahead of their planned exit-date because values had reached the levels at which owners forecast an exit; but they reached these values 2 – 3 years ahead of their original forecast.
Although pricing is not today what it was at the beginning of the year, it remains an environment in which buyers outnumber sellers so it remains a seller’s market. Now also remains a good time to sell, especially when one considers that a large number of the highly leveraged, interest-only loans will begin to roll over in the next 18-24 months. Values could soften, as many of the properties securing these loans could enter the market with signs of distress, as the loan amounts will be very difficult to replace (in their entirety) and the interest rates and loan constants will not be able to be replaced; the only viable option, to exit at par-value, could be a sale of the asset. This would dilute the value of the cash flow of non-distressed properties, as the supply/demand pendulum will shift to the favor of purchasers.
The second dynamic that we as real estate professionals should recognize is that when market-corrections occur, they often present opportunities along with the disruption. At least within the self-storage sector (where my activity is focused), the debt that was available in early-2007 had surpassed the limit of what most would consider reasonable. Because loan terms and leverage percentages have and are continuing to return to historical norms the bull-run that the real estate market has been in most of the decade will last longer. Rather than using debt to enhance good deals and make owning sound real estate investments even that much more attractive, deals had begun to happen based solely upon debt. Longevity in the growth-trend of asset value is much more sustainable and predictable in a market where the underlying real estate is driving value; not the engineering of the leverage. Measured growth equals sustainable growth which will keep the trajectory of the trend in the right direction.
Unlike the sub-prime debacle, the turmoil within the CMBS and CDO markets came about as a product of the fear of what could happen, not what was happening. The lack of oversight and regulations in all three markets was and is the real problem and that is now self-correcting and soon will probably also have some legislative correction.
The good news for the CMBS and CDO markets is that the concerns manifested themselves early enough that it likely thwarted a much worse correction 18-months from now. It also brought back debt terms to levels that should support stout transaction volume and maintain steady growth in asset-value.
Aaron A. Swerdlin is Managing Partner at Storage Investment Advisors, LLP. Founded in 2006, Storage Investment Advisors manages self-storage property dispositions, acquisitions and capital market executions/financing on behalf of institutional and private capital clients. SIA team members have bought, sold, brokered and financed more than $1.3 billion worth of self-storage real estate, collectively making SIA the industry’s leading real estate services firm based on transaction volume. Headquartered in Houston, SIA also has an office in Los Angeles. For more information, please call 713.838.8000 or email info@siallp.com.
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