For the last couple of months now, there has been talk in the commercial real estate industry that life insurance companies were or would be stepping in to fill the financing void left by the cessation of CMBS market activity.

In fact, just two weeks ago, on 4 April 2008, we posted a Blog about this possibility, in stark contrast to the doomsday predictions of the CMBX Index, in an article entitled: Commercial Real Estate Financing — Alive or Dead?

• Fitch found that a remarkable ninety-nine (99) percent of recently matured U.S. CMBS loans have been successfully refinanced.
• Broken down further, a total of 3,354 U.S. CMBS fixed rate loans with a balance of $21.4 billion have been refinanced successfully since the credit crunch began in August.
• The lenders were mostly insurance companies and regional banks. Lenders continue to finance assets like this because they produce reliable monthly income, not consume it.  

In a highly insightful article by CoStar Groups Mark Heschmeyer, entitled Will Life Insurers Come to the Rescue?, he cogently provides compelling facts and argues to the contrary:   While there are signs that life insurers are becoming more active, the talk may prove to be more wishful thinking than reality.

Here is the historical time-line relevant to this discussion: 

1.      The commercial mortgage-backed securities (CMBS) industry overtook life insurance companies as a commercial real estate financing source in 2001.

2.      Since then, CMBS issuance increased exponentially, while the life insurers either held steady or retreated.

3.      Then came August 2007 when capital markets froze in their tracks due to the burgeoning problems in the subprime markets and the complete aversion to real estate risk. CMBS issuance stopped almost entirely.

4.      The constriction in capital flow has continued through the first quarter of this year (2008) and the outlook for commercial real estate has weakened due to softening tenant demand for space and the slowdown in property acquisitions.  

Heschmeyer correctly concludes that it is a classic Catch 22 situation: Without financing, leases and acquisitions are not getting done. But leases and acquisitions need to get done in order to encourage financing.

Hence, the industry has been waiting to see what life insurance companies would do, hoping that they would come charging to the rescue.  It is now looking more and more like life insurers, which have plodded conservatively along during the bull market and run up of real estate property values, will continue along that same path.  

According to CoStar Groups Heschmeyer, the buzz in the industry is that life insurers have significantly more deals to choose from than they have dollars they are willing to allocate to real estate. So to no ones surprise, they are cherry picking the very best deals.   So yes, deals are getting done, but here are four (4) stark facts as to why, specifically, it is unlikely that Insurance companies will be the one-and-only savor any time soon, for the demise of the Commercial Mortgage Backed Securities (CMBS):
 
Fact #1 >> Annual life company lending volume has been $45 billion to $50 billion per year, versus more than $200 billion for CMBS lenders. That is a huge shortfall that just can not be overcome.  

Fact #2 >> Given that life companies maintain disciplined asset allocation/portfolio diversification, they simply will not increase their lending activity to make up for the loss of CMBS debt capital, despite the relatively attractive current ‘lender’s market.’ 

 Fact #3 >> Given that life companies generally shy away from Class B and C properties, small markets, thinly capitalized borrowers, and transitional properties, they are not making up for the loss of CMBS capital in these sectors.

Fact #4 >> Because of the likelihood of rising cap rates and falling values, life companies are generally lending not more than 60% to 65% [loan-to-value], and are focusing on the highest quality properties.

These realities are something with which the commercial real estate industry is starting to come to grips. These are facts that are not only today’s reality, but illustrate well the seductiveness of the CMBS and why they were domed for failure. Nevertheless, commercial mortgages represent an important component of U.S. life insurance company investment portfolios. Credit rating agency Fitch estimates that: 

• Aggregate investment exposure to commercial mortgages for U.S. life insurers accounts for approximately 19% of general account invested assets.
• Fitch estimates that the industry’s exposure to investments backed by subprime or Alt-A residential mortgages equates to 5% of general account invested assets.
• Fitch also noted that most U.S. life insurers reduced their overall exposure to credit risk in the narrow credit spread environment of 2005-2006 and are positioned to increase credit risk should commercial real estate become an attractive investment again.
• Fitch reported that it believes that many insurers will view the turbulence in credit markets as an opportunity to invest new money at much more attractive spreads, thereby enabling them to offer more attractive products and potentially earn greater levels of investment income.

So is the glass half full or half empty? I guess it depends on how you look at it.Clearly we can see how commercial deals will be funded by insurance companies, strongly, in the days to come.

However, given the volumes seen in recent years, using the aggressive CBMS instruments, there is clearly going to be a short fall. The pieces are finally starting to come together. Stay tuned …

Tags: CMBS, CMBX, Insurance Companies

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