Vital signs are dangerously low in the commercial mortgage-backed securities market. A threefold dilemma of slashed bond prices, weakening mortgage performance and non-existent loan origination has pummeled portfolio values and left borrowers without a critical source of commercial real estate financing. At the same time, fear of further losses has kept investors from administering the proper dose of transactions that would breathe life into the sector again.

“The machinery of CMBS is so broken that no one is interested in buying CMBS bonds,” says Clay Sublett, national production manager at KeyBank Real Estate Capital and former CMBS director for the Cleveland-based lender. “Even if new loans were originated at market rates today, there wouldn't be anyone to buy the resulting bonds.”

Borrowers will exercise options to extend virtually all of the $33.3 billion in floating-rate CMBS loans due to mature this year, putting off their need for new financing for three to five years, analysts say. More problematic are the $36.6 billion and $48.45 billion in fixed-rate maturities in 2009 and 2010, respectively. Add in non-CMBS loans, and the demand for mortgage financing may exceed $400 billion this year when credit has grown exceedingly scarce.

“We do not have a functioning mortgage market in commercial real estate today,” says Wayne Brandt, managing director of lending and equity investment at Newport Beach, Calif.-based Buchanan Street Partners. “Whether it's CMBS or commercial banks or life insurance companies, the traditional sources of mortgage financing are in a dormant state and dealing with their own balance- sheet issues.”

A functioning CMBS market, if it can be revived, may head off an approaching wave of defaults and foreclosures. What the industry needs is renewed trading in existing CMBS bonds, which would help to establish realistic pricing and get the sector moving again.

Path to recovery

But buying and selling won't return until investors feel confident that the bonds they purchase will at least retain their value without incurring further loses, according to Bill Collins of Cassidy & Pinkard Colliers.

“It's the falling knife,” says Collins, managing director of the capital markets group at the Washington, D.C.-based commercial real estate services firm. “People who bought CMBS in 2008 realize in January 2009 that they could have bought cheaper. They don't want to buy too early.”

What will it take to restore investor confidence in CMBS? Transparency and data, says Trevor Murray, director of CMBS research at UBS Securities. It will probably take at least 10 months for investors to get a feel for how well loans issued at the height of aggressive lending in 2006 and 2007 will perform in the face of recession-driven real estate fundamentals.

“The only way investors will get comfortable with increasing their allocation to CMBS is by monitoring performance,” Murray says. “There is going to be an incredible buying opportunity, but the market will be reluctant to act until it understands what commercial real estate is going to do over the next few months. Several investors were burned in 2008 by moving too early.”

Investors watching for the opportune time to jump back into CMBS will gain a clearer understanding by examining the sector's behavior through three different lenses, according to Jamie Woodwell, vice president of commercial/multifamily research at the Mortgage Bankers Association (MBA). Those areas are pricing, performance and issuance.

1. Pricing meltdown

Fearful investors have touched off an unprecedented surge in CMBS spreads, essentially the basis points added to a benchmark rate to compensate bond holders for risk. In early November, the spread on AAA-rated CMBS was 549 basis points higher than a year earlier and 650 basis points over swaps, then shot up to an incredible 1,400 basis points in the week before Thanksgiving. Swaps are a premium investors pay when trading floating- for fixed-interest streams, and provide a base rate for some CMBS bonds.

In mid-January, the AAA spread was down to 975 basis points — still a nosebleed level compared with the 83 basis points for the same bonds at the beginning of 2008. Based on those average rates, the price of a bond purchased a year ago offered the buyer a 5.9% annual return.

To sell the same bond today, the seller would have to cut the price in half in order to give the buyer the 12.45% return dictated by current spreads. “A lot of the sellers won't be willing to part with their bonds at the pricing the market seems to be indicating,” Woodwell says.

Pricing has pulled potential buyers out of the market as well as sellers. Due to mark-to-market accounting, plummeting CMBS prices have withered portfolio values and soured investors' taste for the securities, says KeyBank's Sublett. “Institutions and groups that have bought bonds over the last two years have been so badly burned by the deterioration in their value that they have no appetite to buy new issuance.”

What's more, analysts say spreads overstate the likelihood of investor losses. Super senior CMBS bonds offer 30% credit enhancement, notes Murray of UBS Securities. That means those CMBS deals would have to suffer cumulative losses in excess of 30% from loan failures before AAA bondholders lose principal. Even if CMBS losses reach a more feasible 7% to 8%, which is two to three times the historical average, bonds as junior as AA would emerge unscathed.

“Right now everything is priced to a complete and utter meltdown,” Murray says. “Commercial real estate fundamentals are in for a rough time, but at no other time in my career have there been such investment opportunities in CMBS as there are now.”

2. Performance anxiety

CMBS loans are beginning to falter, and at an accelerating pace. The CMBS delinquency rate climbed to 0.88% in December and is projected to reach 2% by the end of 2009, according to Fitch Ratings. That is sure to fuel investor anxiety that has already paralyzed the market.

Even with December's increase in delinquency, more than 99% of CMBS loans remain current on payments. Unfortunately, current performance isn't the problem. “It's the concern of an impending increase in defaults and losses that creates this fear that overhangs the market right now,” Sublett says.

Commercial real estate fundamentals are weakening and will be affected by the depth and length of the recession, according to Edward Padilla, CEO of Bloomington, Minn.-based financial intermediary NorthMarq Capital. For now, it's too early to say how much cash flows and property values will suffer from the decreasing demand for space, or how many CMBS borrowers will default on their mortgages as a result.

That uncertainty makes investors unlikely to buy bonds, which they believe could still lose value before fundamentals improve. “We'll see a deteriorating commercial real estate market over the next year,” Padilla says. “That will make it increasingly difficult to float new CMBS.”

Investor fears of losses due to poor credit quality in CMBS pools have been heightened by a handful of massive conduit loans that recently moved into special servicing to avoid default. The first, a $225 million loan backed by the Riverton apartment complex in Harlem, N.Y., set off a downward spiral in investor sentiment and widening spreads when the borrower failed to come up with a September loan payment. Originated in 2007 using rent growth projections that didn't materialize, the loan stoked fears that a wave of defaults related to weak underwriting was beginning among CMBS loans.

Then in November, two of the largest loans securitized in 2008 CMBS transactions went to special servicing. Those loans included a $209 million loan for two Westin hotels in Tucson, Ariz. and Hilton Head, S.C.; and a $125.2 million loan for the Promenade Shops at Dos Lagos, a shopping center in Corona, Calif. In both cases, borrowers cited market deterioration as their reason for falling behind on payments.

Investors should expect some delinquencies in a recession, says Woodwell of the MBA, but put that knowledge in perspective. The rate is still well below its peak of 2.72%, set at the end of 2003. “In some ways, that's what the bond structure was designed to deal with,” Woodwell says of delinquent loans. “The high-rated tranches [of CMBS], even when we run them through severe recession scenarios, are still looking good.”

3. Issuance issues

The third problem for the CMBS market is issuance, or the lack thereof. The market is at a seven-month standstill that capped issuance at $12.1 billion in 2008, down more than 90% from the $230 billion that the sector issued in 2007. Don't expect new CMBS transactions in 2009 either, says Sublett of KeyBank. “Probably the earliest we would see any kind of meaningful origination would be in 2011.”

That deprives the commercial real estate market of a much-needed source of leverage. CMBS lenders had become the chief source of commercial real estate financing in recent years — accounting for about one-third of all activity — so shutting off that source of leverage creates a severe undersupply of credit.

Other loan providers, including pension funds, life insurers and banks, may be reluctant to take on new borrowers when much of their capital will be required to finance the maturing loans of their existing customers.

The issuance problem won't be resolved before bond prices recover some of their lost ground, analysts say, because today's CMBS spreads virtually preclude the creation of new loans.

Lenders would have to charge interest rates in the teens to support current bond yield requirements, according to Lisa Pendergast, managing director at RBS Real Estate Finance. That wouldn't leave enough loan proceeds for most borrowers to pay off their maturing loans.

Confident strides

The CMBS market can begin to recover when investors believe the commercial real estate sector has reached the bottom of its cycle, experts say. The signals that will bring about new bond purchases will be a general feeling that property values have bottomed out, that tenants have completed any layoffs and downsizing, and that the economy has stopped shrinking.

Confidence will help buyers and sellers reign in risk spreads to a point that is still attractive to investors, yet low enough to draw in borrowers with cost-effective lending rates.

The confidence of lenders and investors will take months, perhaps years, to be restored, however. In the meantime, industry advocates are working to speed things along. Last fall, the Commercial Mortgage Securities Association, the MBA and 10 other trade groups began lobbying for federal assistance to encourage investment in CMBS.

Specifically, the groups want the sector included in the new Term Asset-Backed Securities Loan Facility (TALF), created in November 2008 and structured to lend up to $200 billion of Federal Reserve money to buyers of AAA-rated securities.

For now, TALF is limited to securities backed by student loans, auto loans, credit card debt and small business loans, and will use $20 billion from the Troubled Asset Relief Program (TARP) to provide credit protection for the loans.

Commercial real estate industry leaders would like the Treasury to use an additional $20 billion of TARP money to back a separate lending facility just for CMBS buyers, according to Brendan Reilly, senior vice president of government relations at the Commercial Mortgage Securities Association.

With TALF promising to cover up to $20 billion in total losses on the loans, the proposed program would fuel bond purchases and spur CMBS lenders to make new loans. “That would help address the pricing and valuation issues that most of these markets are having as a result of illiquidity,” Reilly says.

Pendergast of RBS believes opening TALF lending for commercial real estate securities investments may help revitalize the sector. “We would very much like some form of government support for the CMBS marketplace,” she says. “If you can get lending kick-started at some point during 2009, it would alleviate some of the pressures on the commercial real estate sector.”

With billions of dollars in commercial mortgages maturing in the next two years and insufficient leverage in the marketplace, the government has good reason to loan money to lenders who are attempting to shore up their balance sheets so they can make new loans, says Brandt of Buchanan Street Partners. “There needs to be government intervention in this process.”

While it waits for a response from Washington, the MBA is instructing investors about the market forces weighing on the CMBS sector, and why buying those securities is still a smart choice. According to Jan Sternin, senior vice president of commercial/multifamily research at the association, teaching investors about transparency and the data available on CMBS will ultimately bring about new loan originations and bond trading.

“We do believe education is what will bring the investment community back,” Sternin says, “coupled with a little jump-start from TALF.”

Matt Hudgins is an Austin-based writer.

CMBS loan extensions are painful, but possible

The credit crunch has put borrowers with maturing conduit loans in a tough spot. Borrowers whose loans aren't securitized may be able to convince their existing lenders to provide new financing if they are unable to obtain a loan from another provider.

That's not an option for the conduit borrower because CMBS deals have a finite term that depends on the ultimate repayment of all loans in the pool, rather than a perpetual series of loan placements.

“CMBS servicers are going to take a much more legalistic approach than a commercial bank or life insurance company and are not going to have the same flexibility on restructuring a loan,” says Wayne Brandt, managing director of Buchanan Street Partners, a real estate investment management firm based in Newport Beach, Calif.

That's not to say that a borrower who is unable to find a new loan is doomed to foreclosure. A special servicer, which takes over from the master servicer when a borrower can't keep up with payments, can adjust or extend a mature conduit loan, according to John B. Levy, principal of real estate investment banking firm John B. Levy & Co. “Special servicers are extending and modifying loans depending on the specific circumstances,” Levy says. “That is starting to happen.”

Bondholders continue to receive regular interest payments when a conduit loan is extended, although the extension delays the return of principal. Alternatively, the special servicer may agree to reduce the amount of principal due on a loan, if doing so will avoid a larger loss to bondholders.

Levy offers the example of a borrower that is unable to pay the $10 million balance of principal owed on a loan at maturity. Depending on the quality of the collateral, the special servicer may agree to take $7 million as a discounted payoff. “If your anchor tenant just went dark, they might be delighted just to get $7 million,” Levy says.

It's important for borrowers to make an earnest effort to obtain financing on their own, starting as early as six months before their existing loans mature, says Stacey Berger, executive vice president at Midland Loan Services, a master and special servicer based in Bethesda, Md. A special servicer will be more willing to grant an extension to a borrower who can show a paper trail documenting attempts to secure a new loan.

If the special servicer agrees to extend the loan, the borrower should expect onerous terms such as increased reserve requirements, recourse provisions or a higher interest rate.

Those terms are designed to make the borrower uncomfortable, Berger says. “We want to make sure we are viewed as the lender of last resort for refinancing, and not the borrower's first choice.”
— Matt Hudgins