Subprime Woes Spill Into Commercial Real Estate

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Investors are hit with tighter credit standards and higher borrowing costsSADDLE BROOK – Delinquencies on subprime mortgage loans are rippling through the debt market in New Jersey, causing lenders to tighten credit standards and ratchet up borrowing costs for commercial real estate investors. Such changes are likely to put a damper on highly leveraged property deals and could drive some players out of the market, say real estate experts.

The impact on commercial real estate was largely unexpected, says Paul Adornato, who covers real estate investment trusts for BMO Capital Markets in New York City. When the subprime fallout began late last year, “it seemed to be limited to aggressive, single-family mortgage lending,” says Adornato. However, “financial markets are linked in ways that are not necessarily obvious,” he adds.

For example, Bear Stearns, one of the largest underwriters for mortgage-backed securities, has suffered heavy losses in two of its hedge funds whose assets were primarily securities backed by subprime mortgages. In June, the New York City-based investment bank said second-quarter net income after non-cash charges fell 10 percent, compared with the year-ago quarter.

While interest rates on the 10-year Treasury bond that serves as the benchmark for rates for many commercial property loans slid a bit last month, they remain higher than they were in May, and the spread (the difference between what money lenders loan and how much they charge) has been widening. Many have shortened the interest-only period for commercial loans to two years from 10 years before repayment of the principal begins.

Jeff Dunne, vice chairman of CB Richard Ellis in Saddle Brook, says the combination of such factors has pushed up borrowing costs for commercial investors who finance at least 70 percent their deals with debt. “If you’re a high-leveraged borrower, your costs have risen considerably,” says Dunne. “If you’re paying the same price, you’re getting less cash flow, because your debt service has gone up.”

Dunne says that if the interest rate on 10-year Treasury bonds was 4.6 percent, and lenders were lending at a spread of 100 basis points, an investor would borrow at a rate of 5.6 percent. On a $1 million loan, the borrower would pay $56,000 in interest per year. If the ten-year Treasuries are now about 4.8 percent and spreads widened to 170 basis points, as many now have done, borrowers would pay 6.5 percent in interest or $65,000 per year. With principal payments kicking in earlier, the borrower would have to put up even more money on top of that.

Highly leveraged buyers will be the hardest hit by increased borrowing costs, says Dunne. Such investors are likely to bid less for a property unless they are willing to accept smaller returns. Brokers and property owners seeking top dollar for a property are thus looking to less-leveraged buyers to engage in deals, he says.

Interest rates aren’t the only troubles afflicting highly leveraged investors. “Even with good commercial real estate in this market, the ability to obtain credit is tightening and tightening in a whole host of ways,” says attorney Leo Leyva at Cole, Schotz, Meisel, Forman & Leonard in Hackensack. In the past, highly-leveraged buyers would obtain multiple rounds of financing for a deal and often put down 5 percent or less of equity. Such investors now find it harder to get financing as lenders scrutinize deals more closely and require more equity.

“We’re in a more volatile market,” says James Calvano, a principal at Palisades Financial, an investment banking and advisory firm in Fort Lee. He says that although commercial activity remains strong in New Jersey, lenders are becoming more selective with the deals they finance, and are lending at higher rates with stricter terms. This will make it harder for developers to complete or even begin new projects. “We can see the problems–we are less aggressive than we were six months ago.”

Lenders, most of whom provide financing for both residential and commercial properties, have seen their residential portfolios take a beating from the rise in mortgage delinquencies and falling home prices, Calvano says. “It’s hard to imagine a lender with a problem in a residential portfolio not tightening on the commercial side as well. They simply have to reduce exposure.”

“They’re looking for the commercial owner, the commercial investor to have more skin in the game and be part of the risk, says Leyva, who has seen a rise in the number of investors struggling to repay loans. “We’re starting to see more and more workouts, more and more renegotiations, restructurings and modifications,” he says.

In many cases, he adds, lenders are willing to renegotiate some terms in exchange for additional collateral or guarantees..

While experts expect many highly leveraged investors to leave the real estate market in search of other opportunities, Levya says such departures won’t necessarily mean a drop-off in real estate activity, says Leyva. On the contrary, he says, those leaving the market create “opportunities for other potential buyers to come in and do deals.”

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