Real Estate Forum - April 2012

NEWS FRONT
High Court’s Obamacare Ruling Won’t Affect CRE

WASHINGTON, DC—In late March, the US Supreme Court began hearings on arguments over whether or not the health-care law passed in 2010 is constitutional. The three-day marathon of arguments and counter arguments will then be followed by the Supreme Court’s decision, expected sometime in June.

That could go a number of ways. It could affirm the law and its constitutionality. Or, it could decide that the mandate for individuals to buy health insurance— the heart of this very complex piece of legislation—is unconstitutional and strike that down, leaving the rest of the legislation intact. But there’s a third choice as well: the Court could find that the individual mandate is unconstitutional and, because it’s so closely linked to the rest of the legislation, strike it all down.

It’s an open question whether or not the Court will strike down the individual mandate. But even if it does, one participant in the space says it doesn’t matter—at least in terms of healthcare real estate investment.

“Economics drives the shape of health-
care real estate now, not this legislation,”
says Jeffrey H. Cooper, executive managing
director of Savills US and an attorney spe-
cializing in medical office property invest-
ment. “And that won’t be impacted, no
matter what the Supreme Court decides.”
Granted, a period of uncertainty
(depending on how significant any
changes are made by the Court) will no
doubt follow the decision. But the road-
map in the larger picture is clear: reim-
bursement with or without the mandate is
on the decline, and that will continue
whether or not individuals are required to
buy health insurance, Cooper says. “For
healthcare real estate, that means a growth
in outpatient or ambulatory facilities.”
He isn’t alone in this conclusion. Todd
Lillibridge, president and CEO of
Lillibridge Healthcare Services, and Rasesh
Thakkar, senior managing director of the
Tavistock Group, both predicted the health-
care industry would be investing more in
outpatient services.

Cooper points in particular to the tremendous downward pressure on reimbursement levels in both private-sector insurance and by the government as the main driver. “If a procedure can be done on an outpatient basis, it will be,” he says.

By the same token, if the individual
mandate is upheld, Cooper doesn’t think
it would lead to an even greater demand
for medical office buildings or outpa-
tient facilities. “Look to Massachusetts
and Mitt Romney’s healthcare plan,”
says Cooper. “Providers there will tell
you that an individual mandate has made
no difference in terms of forcing provid-
ers to offer more healthcare. What it has
done is change the reimbursement
structure.”—Erika Morphy

CMBS: 10-Year Cycle, Seven-Year Memories?

Some have been surprised at how quickly the US CMBS market has rebounded from virtually no issuance in 2009 to over $40 billion last year. Others have been left questioning whether the lessons from the credit crisis have been learned, and everyone is wondering where the market is headed.

CMBS is still evolving, and whether it’s referred to as version 1.0, 2.0 or 3.0, there is still work to be done. That said, current transactions and the loans within them are substantially improved from their later-vintage pre-crisis brethren. However, a question that has been asked repeatedly is how new loans will be underwritten over time.

Before we look at this latest version of CMBS, let’s recap the performance of CMBS 1.0. Default rates range from 5.6% in 2003 to 18.3% in 2007. There aren’t any surprises, except for perhaps the relatively high default rates for the 2000 and 2001 vintages, which are 14.4% and 13.7%, respectively. This is due to the fact that these vintages were impacted by the recession following the dot-com bust as well as the 2008 credit crisis.

However, deals that came to market in 2006 to 2008 are still only halfway through their lifecycle. So while term defaults may be declining with an improving economy and adverse selection,

there is still a potential impact from maturity defaults. Fitch believes the ultimate default rate for these vintages originated at the height of the property boom could reach 30%.

Losses are more difficult to study, at least right now. This is simply because not enough have occurred due to the slow process to liquidate loans or because the loans have been modified and any potential losses perhaps merely postponed.

So, have the lessons that should have been learned from CMBS 1.0 been put into effect in this latest round of CMBS? A common witticism pertaining to commercial real estate is that it operates on “a 10-year cycle with seven-year memories.” So, even if the lessons are currently being acted on, how long will this last? Two areas that bear close watch this year with respect to new CMBS deals are underwriting standards and potential conflicts of interest among special servicers.

Since the first deals of 2010, underwriting standards have declined slowly. However, they are still more conservative than those employed during the pre-reces-sion boom. The real question is not whether they will continue to slip, but rather, if they do continue to slip, what will the response of the market be?

Elsewhere, several special servicer workouts of late are heightening investor concerns that some special servicers have agreed to loan resolutions for their own interest and not those of bondholders. Loan workouts and resolutions are subjective. What Fitch would encourage is total transparency on any ancillary fees charged to the borrower. Investors may not agree with the charges but they would be out in the open. When they are hidden and only emerge slowly, they raise questions about what else is going on.

By Huxley Somerville

Huxley Somerville is a managing director and head of US CMBS for Fitch Ratings in New York City. He may be contacted at huxley.somerville@fitchratings.com. The views expressed here are the author’s own.