Commercial real estate had a banner year in 2015, and the fundamentals of high demand and low vacancies are still driving rents higher. There is, however, a catch that could cool the market quickly, at least when it comes to financing. Investors are insisting on high yield, and the bonds backing commercial mortgages are not giving them that, so they are moving on to other products, leaving a big crack in commercial financing. "I think cracks is a little bit of an understatement for where the market has been for January and February, where, for all practical purposes, the market was frozen," said Willy Walker, chairman and CEO of Walker & Dunlop, a real estate finance firm.

Commercial real estate, which includes apartments, shopping malls, offices and warehouses, are backed by nearly $3 trillion in mortgages, according to the Mortgage Bankers Association (MBA). The lenders include big banks, which are the largest, insurance companies and commercial mortgage backed securities (CMBS), which are bonds sold to investors. That last one is where the problem lies. It is the second-largest source of commercial real estate debt, and during the last boom, back in 2005, CMBS was very popular.

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CMBS tends to have a 10-year life span, at which point the debt matures and real estate owners have to refinance the loans. These maturities are expected to surpass $400 billion annually this year and in 2017, according to CBRE, a real estate services firm. That is $100 billion more than last year. CBRE "conservatively" estimates that 18 percent of loans this year and 29 percent of loans next year could have problems refinancing, due to lack of investor demand for the bonds. This translates into about $43 billion in potentially troubled loans over these two years.

"We think some of these are going to be remonetized through asset sales, but some will certainly hit the foreclosure list and end up on the special services list of loans to be worked out," said Brian Stoffers, who oversees the debt and structured finance practice at CBRE.

Stoffers doesn't see commercial real estate overall cooling at this point, with a still large influx of foreign capital coming in and the U.S. still considered a safe haven for investment. If the financing situation, however, worsens, even just in CMBS, it could spread to other investors and weaken appetites for real estate.

"The real refinancing wave doesn't kick in until June, but starting in June there's about $10 billion a month that needs to be refinanced, so unless the CMBS market finds its level and starts to price and transact again, we're going to have more than cracks," said Walker.





How did this happen? It's happening across all capital markets, not just commercial real estate debt in the public markets, but high-yield debt. The spreads are widening, which is happening because investors are demanding more to invest in those bonds.

"So with some of the pricing changes in CMBS, with there being a little bit less liquidity there, a lot of loans are coming due and there might be a little less availability of capital to refinance those loans," said Jamie Woodwell, vice president in the research and economics group at the MBA. "At the end of the day for investors in CMBS is when they look at the range of investment options out there, there returns or the yields being paid by other options are higher and so to attract them to invest in CMBS you have to offer them higher yields as well. In order to get a higher yield for that investor, that means paying a higher rate by the borrower."

The vast majority of CMBS borrowers today are owners of commercial real estate in secondary and tertiary markets, like suburban strip malls or office parks, but some are owners of large urban office buildings. Banks may step in to pick up the slack in these refinances, but banks have been increasingly skittish due to a slew of new regulations starting this year, particularly involving high volatility commercial real estate and rate terms which impact development lending. Other regulations involve requirements that banks hold a percentage of the loans on their books.

"There are other rules coming out on general debt that are going to impacting appetite for banks, from the CMBS market and from others to provide capital that could affect availability, it could affect pricing some of those loans," added Woodwell.



