NO SUCH THING AS Normal [Mortgage Banking]

For the commercial real estate and multifamily finance markets, the term "normal" doesn't really apply. Each new cycle brings its own dynamics.

A s the commercial/multifamily real estate finance market climbs out of the depths of the Great Recession, some wonder what the "new nor~ maP' will look like. But for there to be a new normal would imply that there was an old normal. * With continuous changes in the supply of capital, demand for capital, space needs, construction and many other key market drivers, it seems fair to say there is no such thing as normal when it comes to commercial/multifamily real estate finance.

Background

At the beginning of the 1980s, the 10-year Treasury stood at 10.3 percent, the homeownership rate was 65.5 percent and the commercial mortgage-backed securities (CMBS) market as we know it had not yet been established.

At the beginning of the 1990s, the 10-year Treasury stood at 7.9 percent, the homeownership rate was 64.1 percent and the CMBS market accounted for less than 1 percent of the Federal Reserve Board's estimate of commercial and multifamily mortgage debt outstanding.

At the beginning of the 2000s, the 10-year Treasury stood at 5.1 percent, the homeownership rate was 67.1 percent and the CMBS market accounted for 13 percent of the Fed's estimate of commercial and multifamily mortgage debt outstanding.

In 2007, the 10-year Treasury stood at 4.8 percent, the homeownership rate was 68.5 percent and the CMBS market accounted for 22 percent of the Fed's estimate of commercial and multifamily mortgage debt outstanding.

And as of the third quarter of 2011, the 10-year Treasury stood at 1.9 percent, the homeownership rate was 66.1 percent and the CMBS market accounted for 20 percent of the Fed's estimate of commercial and multifamily mortgage debt outstanding.

Sometimes, the more things change . . . well, the more things change.

Commercial real estate finance market conditions are set by a swirl of different factors. Local economic and commercial real estate market conditions form a base upon which is layered the broader capital markets that establish investor yield expectations and capital availability for a range of different risk/reward propositions.

There is a wide range of conditions for each one of these factors, and the various permutations of all of them together present a near limitless set of states for commercial real estate finance markets.

Factor: The economy

The U.S. economy, as measured by the real gross domestic product (GDP) figures released by the Bureau of Economic Analysis, ended the third quarter of 201 1 producing goods and services at a rate (slightly) higher than prior to the Great Recession. During the third quarter, the U.S. economy produced goods and services at a seasonally adjusted annual rate of $13.338 trillion (in chained 2005 dollars), compared with a pre-recession high of $13.326 trillion at the end of 2007.

Retail sales, likewise, have risen to levels higher than those seen pre-recession. The $397.7 billion seasonally adjusted monthly rate of (nominal) retail sales seen in October 2011 was 5 percent higher than the $378.4 billion level of November 2007.

Employment, on the other hand, remains well below levels seen before the recession. From the non-farm employment peak of 138 million jobs in January 2008 to the trough of 129 million jobs in February 2010, the U.S. economy lost 8.8 million jobs. By October 2011, only 2.3 million jobs had been regained.

But it is not really accurate to say that the lost jobs have been regained. On an aggregate basis, the United States never stopped adding private jobs in education and health care, while the count of construction jobs declined by 2.2 million from peak to trough and has climbed back by only 56,000 jobs. There are 37,000 more jobs in mining and logging than there were pre-recession, and 720,000 fewer in professional and business services.

Within retail sales, October 2011 sales at general merchandise stores were 4 percent higher than their prerecession high, while sales at furniture and home-furnishing stores were 22 percent lower.

Within real GDP, personal consumption expenditure ended the third quarter 1.4 percent higher than prerecession levels while investment in residential structures - driven by single-family home construction - was 58 percent lower.

Even while the headline figures for GDP, retail sales and employment figures all change, even greater changes are taking place within those segments.

The state of housing choice has similarly been going through transformations. Data from the Census Bureau show that from 1995 to 2005 the United States added 12 million households (see Figure 1). Because of the move to homeownership, all that growth resulted in increased demand for ownership housing, while demand for rental housing remained flat.

With the drop in the homeownership rate since 2005, the tide has turned and the 3.3 million in overall household growth has resulted in an increase of 4.1 million renter households and a net decline of 810,000 ownerhouseholds.

Looking forward, a stable homeownership rate would mean that two-thirds of new household growth accrues to demand for owner-occupied units and one-third to renter-occupied units.

Any continued decreases in the homeownership rate would tip the balance toward more rental demand and less ownership demand; any increases in the homeownership rate - such as the one seen in the third quarter - would increase the relative demand for ownership units and decrease that for renter units.

Factor: Commercial real estate supply and demand

Commercial real estate is well understood to operate in a cycle. New space is built when markets tighten, eventually creating vacancies that grow and persist until new development drops below new demand, causing vacancies to diminish and starting the cycle over.

While the cycles persist, no two cycles are exactly the same. In the early 1990s, the real estate cycle was precipitated by a large increase in the supply of new commercial real estate space. In the late 2000s, the cycle was driven by a large pullback in demand for commercial real estate space.

Even within the downturn of the 2000s, different property types have experienced very different turns, as the economy has rebounded in different ways for different sectors and regions, and the cycle has taken on different shapes.

Apartments have come out of the recent downturn quickly and strong. Weakness in the homeownership market has translated into strength for rental markets. Data from REIS, New York, show third-quarter 2011 apartment vacancy rates down to 5.6 percent, compared with 7.1 percent in the third quarter of 2010 and 7.9 percent in the third quarter of 2009 (see Figure 2). Average apartment asking rents have risen 2 percent over the year.

Office vacancy rates are also down from their highs, but just barely. The vacancy rate in the third quarter was 17.4 percent, compared with the cycle high of 17.6 percent during last year's third quarter. Average asking rents rose 1 percent over the year.

The return of employment growth has brought stability to the office sector, but the slow pace of growth means excess supply is being burned through slowly.

Despite the bounce in retail sales, retail space dynamics are also stable but not seeing strong improvement. Third-quarter 2011 retail vacancies matched the cycle high of 1 1 percent and asking rents remained essentially flat compared with a year earlier.

Looking ahead, the weakness in the economy and construction activity means little new space will be coming on line in coming years. Apartment building activity has begun to pick up, with multifamily starts breaking the 200,000 seasonally adjusted annual rate in October 2011, as a result of the improving fortunes of that sector. For the time being, continued weakness in the fundamentals of other property types has kept the value of construction-put-in-place extremely low.

Factor: Investor yields

Nowhere is the flux of changing conditions in commercial real estate finance more evident than in investor yields. Investors and lenders have a range of options available to them to put their money to work. To attract that money, commercial real estate equity and debt investments must present a risk/reward proposition that beats other equity and fixed-income investments, at least to some set of investors. As a result, the constant shifting of investor risk tolerances and economic outlooks flow directly through to real estate pricing and borrowing rates.

During the third quarter of 2011, average capitalization rates for apartment property transactions, as reported by Real Capital Analytics Inc. (RCA), New York, fell to 6.3 percent - a level last seen at the end of the boom (see Figure 3).

Because of the fall in the 10-year Treasury yield, however, the risk premium between the cap rate and the yield on risk-free Treasuries grew to its second-highest level of the decade - 436 basis points. The overall yields investors have been demanding to attract their money to apartment properties has been falling, but not as quickly as the yields investors were demanding to invest in Treasury bonds.

Other property types have also seen cap rates decline from their recession highs, but are also seeing spreads at or near decade highs.

The cap rate for office properties has fallen from 8.9 percent at the end of 2009 to 7.3 percent, but the risk premium to Treasuries has remained flat. The cap rate for retail properties has fallen from 8.2 percent to 7.6 percent, but the risk premium has risen by a point. The cap rate for industrial properties has fallen from 8.7 percent to 7.9 percent, but the risk premium has risen by 75 basis points.

Similar trends can be seen in mortgage pricing. According to the American Council of Life Insurers (ACLI), Washington, D.C., the contract mortgage rate on life companies' commercial mortgage commitments during the third quarter of 2011 was 4.67 percent - the lowest level since at least 1990, and likely earlier than that. But the mortgage spread to similar-length Treasury bonds was higher than it had been for most of the period of 2000 to 2007.

Mortgage rates offered by the CMBS market during the European sovereign debt crisis - which have been viewed as uncompetitive when compared with rates currently offered by many other types of lenders - would in other market conditions be seen as very attractive.

Cap rates and mortgage rates have been extraordinarily low by historical standards. But compared with Treasuries and many other investment yields available in the market, they have been relatively wide.

Factor: Finance markets

Conditions in the commercial real estate finance markets are another component of the continual transformation and change that shapes the industry.

The credit boom of the mid-20oos brought a significant increase in the level of commercial and multifam ily mortgage originations. The Mortgage Bankers Association's (MBA's) Annual Origination Volume Summation reports tracked $345 billion of closed loans in 2005, $406 billion in 2006 and $508 billion in 2007 (see Figure 4).

The subsequent credit crunch and recession brought those levels tumbling down to $181 billion in 2008, $82 billion in 2009 and $ 1 19 billion in 2010.

But even within these broader trends, significant differences and shifts have occurred among different investor groups.

Banks - as a whole - have remained a steady source of capital for income-producing commercial real estate properties. The CMBS sector, which was barely in existence in the early 1990s and drove growth during the 2000s, has been quieted by the broader capital markets tumult.

As they've done in past disruptions, the governmentsponsored enterprises (GSEs) and the Federal Housing Administration (FHA) have stepped into the capital repricing of the credit crunch and dramatically increased their market share.

And life companies - armed with long experience lending on commercial properties and limited options in other fixed-income investments - put out record volumes in commercial mortgages in the second and third quarters of 2011.

Banks

At the end of the second quarter of 2011, banks held one-third of the $2.4 trillion of commercial and multifamily mortgage debt outstanding (see Figure 5). And counter to many of the headlines seen during the recession and credit crunch, banks have remained a steady source of capital to commercial real estate markets.

Banks' $790 billion of commercial and multifamily mortgages is up 10 percent from the beginning of 2007 and down just 3 percent from the peak in 2009. Of 7,445 insured institutions reporting information to the Federal Deposit Insurance Corporation (FDIC) as of the end of the third quarter of 2011, 6,950 held mortgages on income-producing properties.

CMBS

When it comes to size and volume, it seems clear there is no such thing as normal for the CMBS market. The market started in the early 1990s as a means of disposing of loans held by the Resolution Trust Corporation (RTC). Volumes grew steadily over the years as the vehicle was expanded and drew a broader range of both investors and properties.

During the credit boom of the 2000s, the CMBS market was a natural funnel between capital markets investors looking for yield and commercial real estate. Data from Commercial Real Estate Direct show that annual issuance rose from $52 billion in 2000 to $230 billion in 2007 as the market financed an extraordinary volume of portfolio sales and other large transactions.

The onset of the credit crunch and recession squeezed volumes to $12 billion in 2008 and just $5 billion in 2009. Driven by activity in the first half of the year, total annual CMBS issuance in 2011 is expected to be about $30 billion.

Many analysts expect only slightly higher volume next year - well smaller than the $84 billion of CMBS loans that were set to mature in 2011 and $63 billion in 2012. All of this helps explain why the outstanding balance of loans in CMBS fell from $758 billion at the end of 2007 to $617 billion in June 2011.

CSEs and FHA

Fannie Mae, Freddie Mac and FHA all stepped into the credit crunch and recession to provide capital to the multifamily market, and in doing so increased their market shares significantly.

Between the first quarter of 2007 and the second quarter of 2011, Fannie Mae, Freddie Mac and FHA/Ginnie Mae increased the balance of multifamily mortgages they hold or guarantee by $133 billion, or 67 percent, while other investors increased their collective balance of multifamily mortgages by $10 billion, or 2 percent. In doing so, agency and GSE portfolios and mortgagebacked securities moved from a 30 percent share of multifamily mortgage debt outstanding to a 40 percent share - their largest share ever.

Life companies

Life insurance companies have followed a far steadier course in their commercial mortgage investment activities. Volumes have increased and decreased with the market, with life companies' commitment volumes growing from $27 billion in 2001 to $44 billion in 2007.

In 2011, however, with alternate investments providing low relative yields and their commercial mortgage portfolios performing well, Ufe companies stepped up their lending. MBA's commercial/multifamily mortgage bankers origination index for life company loans hit record levels in both the second and third quarters. According to ACLI, life companies' mortgage commitments in the second quarter exceeded $15.7 billion - an all-time high.

Others

A host of other lenders are also driving change in the market. Mortgage real estate investment trusts (REITs), hedge funds, private and government pensions and others all play a part in the market - stepping in with their own sources of capital and risk/reward requirements.

Given the shifts constantly occurring, it's likely impossible to identify any one state as normal in terms of which groups commit what levels of capital to commercial and multifamily mortgages in any given year.

Factor: Loan performance

Commercial/multifamily loan performance is another place where the term "normal" doesn't really fit.

Different loans perform differently. Most of the differences are attributable to the different investment objectives of the different lender segments, the types of properties and borrowers courted and served by each, and the time periods during which loans are made and are outstanding.

Life companies, banks and CMBS investors all have different time horizons and risk/reward tolerances. Commercial and multifamily mortgage lenders understand this well - which explains why life companies approach lending in a different way than the GSEs, which themselves differ from banks, and so on.

It also helps explain why loans made by life insurance companies perform differently than those made by banks and thrifts, which perform differently than those made for the CMBS market.

For life companies and the GSEs, delinquency rates appear little affected by the Great Recession, particularly when compared with the impact of the last significant real estate downturn of the early 1990s. The 60-plus-day delinquency rate for life company loans rose to 0.31 percent in the first quarter of 2010; in 1992 the rate had reached 7.53 percent.

The 60-plus-day delinquency rates for Fannie Mae and Freddie Mac loans rose to 0.80 percent and 0.36 percent, respectively, during this downturn; in 1992 the rates had climbed to 3.62 percent and 6.81 percent, respectively.

Banks and thrifts saw 90-plus-day delinquency rates rise - to 4.40 percent - during the most recent recession, but not to the 6.58 percent level seen in the early 1990s.

The CMBS market, which grew out of the last downturn, experienced higher delinquency rates during this downturn than at any previous time, with the creditboom vintages facing the steepest difficulties in terms of lost equity and unfulfilled growth expectations.

Each sector, in each period, has seen its loans perform differently. Looking forward, changes in underwriting, loss models, capital and regulatory requirements will likely mean that any future performance will differ still further from the current experience.

The outlook

The economy is going through a rash of fundamental changes. National governments are struggling with their spending and debt levels. Businesses and households are balancing uncertainty with a need and desire to spend. Interest rates are at incredibly low levels.

Commercial and multifamily real estate and mortgage markets are part and parcel of this change. But rather than thinking that the markets - whether in terms of originations, or cap rates, or delinquency rates or some other measure - will "return" to what was seen in 1990 or 2003 or 2007, it is probably best to recognize that today's and tomorrow's commercial real estate markets continue to tread new ground each quarter.

There are myriad lessons to take from past experiences. Yet, for commercial real estate finance markets as a whole - as has always been the case - it's probably best if we concede there is no such thing as normal.

WEAKNESS IN THE HOMEOWNERSHIP MARKET HAS TRANSLATED INTO STRENGTH FOR RENTAL MARKETS.

NOWHERE IS THE FLUX OF CHANGING CONDITIONS IN COMMERCIAL REAL ESTATE FINANCE MORE EVIDENT THAN IN INVESTOR YIELDS.

WHEN IT COMES TO SIZE AND VOLUME, IT SEEMS CLEAR THERE IS NO SUCH THING AS NORMAL FOR THE CMBS MARKET.

IT IS PROBABLY BEST TO RECOGNIZE THAT TODAY'S AND TOMORROW'S COMMERCIAL REAL ESTATE MARKETS CONTINUE TO TREAD NEW GROUND EACH QUARTER.

Jamie Woodwell is vice president of commercial real estate research for the Mortgage Bankers Association (MBA) in Washington, D.C. He can be reached at [email protected].