Market Data

Maturing CMBS Market Adjusts to External and Internal Factors

After a fairly steady rise in issuance for seven years, it appears that the commercial mortgage-backed securities market will have a second consecutive year of declining issuance.

By midyear, issuance was down more than 30 percent compared with the same time last year. While this could pick up in the next few months as some conduits build enough product to securitize, it seems unlikely that this year's issuance will come close to last year's total of nearly $68 billion. Estimated issuance could total around $48 billion, but that number could fluctuate by $5 billion to $10 billion either way by year-end.

However, rather than viewing this decline as a sign of gloom and doom, it can be seen as another example of the cyclical nature of the commercial real estate industry.

Contributing Factors
The relationship between CMBS issuance and interest rates is one obvious reason for the decline in issuance. Since January, CMBS spreads to Treasuries have increased dramatically. Triple-A spreads had compressed to about 124 basis points over 10-year Treasuries at the end of 1999. By midyear, these spreads were back up to 165 basis points, similar to their pre-2000 high point of 159 basis points last September. In contrast, spreads were around 65 to 78 basis points over 10-year Treasuries in 1997.

As spreads widen, lenders that wish to securitize their product have to increase their rate, sometimes above 9 percent, which causes significant resistance to borrowing. This creates a shortage of securitized product - and ultimately slows down issuance.

Swap-spread premiums, the amount charged to exchange a floating-rate obligation for a fixed-rate obligation or vice versa, have emerged as a new benchmark in the industry. At least one conduit quotes its mortgage rates in two parts: one part based on loan spread over Treasuries and one part based on swap spreads. This system has the effect of transferring swap-spread risk to the borrowers, something many borrowers should be aware of. CMBS issuers must take into account swap spreads when pricing mortgages and this cost of doing business inevitably will be passed on to the borrowers. How long this market condition will last is anyone's guess. In a different interest-rate environment, such as one where long-term fixed rates and short-term floating rates are more closely aligned, swap spreads may become less important.

Another aspect of the market that has slowed down issuance is the consolidation of B-piece buyers. While a large market still is interested in buying the investment-grade tranches of a securitization, the scarcity of buyers for below-investment-grade B-piece tranches creates a market condition that issuers should consider. For understandable reasons, underwriters want to be sure that an issue can be sold in its entirety. The small number of buyers for B pieces induces caution into the decision to underwrite an issuance. At least one issuance was cancelled as a result of litigation pending between an issuer and B-piece buyer because the reduced number of interested parties brought prices to an unacceptable level for the issuer.

The consolidated market also has allowed these buyers to exert more influence in structuring their part of the investment pie. Reduced interest for servicers, higher yields, and more control over portfolio composition all have been consequences of the shrinking B-piece buyer market.

A Changing Market Several trends in the CMBS market indicate that a changing of the guard is occurring. Some industry leaders, most notably at Lehman Brothers and Goldman Sachs, have assumed positions outside of the CMBS market and their subordinates have assumed leadership of CMBS management functions.

The Commercial Mortgage Securities Association - the CMBS trade group - also has increased its size and influence in the industry by attracting new members and creating standards. The association's growth has caused the industry's traditional conference leader, the Fabozzi conference, to change its conference dates to avoid competing with the CMSA's annual meeting.

Another change in the CMBS market is the growth of foreign participation. The more than $5 billion in upcoming foreign CMBS issuance clearly indicates a growing international acceptance of CMBS product. Canada, the United Kingdom, and Asia all have established CMBS markets. Further, Italy and Spain just recently have passed legislation enabling CMBS transactions.

Securitization of Japanese nonperforming commercial real estate loans finally is beginning to occur, which parallels the beginning of the U.S. CMBS market. Whether the Japanese will be as successful as the United States in resolving their bad loan problem remains to be seen, but the process has begun.

The use of collateralized bond obligations to resecuritize unsecured debt and preferred stock may herald further resecuritization of CMBS transactions. CBOs create securities based on secondary securities such as CMBS, unsecured debt, or preferred stock.

The use of CBOs possibly could increase the size of the CMBS market by opening it up to buyers who are not ordinarily involved in commercial real estate or CMBS.

Claude Werner

Claude Werner is the national director of real estate research at Deloitte & Touche LLP in Atlanta. Contact him at (404) 220-1733 or cwerner@dttus.com.

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