While the production of commercial mortgage-backed securities (CMBS) continues to outpace last year's volume, at least one expert is pointing to a possible slowdown in issuance later this year.

In the Mortgage Bankers Association's latest Quarterly Data Book, covering the first quarter of 2006, MBA reports that $46.99 billion in CMBS instruments were issued. That's a whopping 43% gain over the first quarter of 2005, but a 19% drop from the fourth quarter of 2005.

A fourth-quarter blowout, followed by a first-quarter slowdown, isn't unusual, although the pattern was broken last year. CMBS volume dropped in the first quarter from the previous quarter each year from 2001 through 2004. “The first quarter is traditionally when originators recover from the flood of year-end activity and build the foundation for the year ahead,” says Douglas G. Duncan, the MBA's chief economist.

But in 2005 — when annual CMBS volume hit an all-time high of $169 billion — issuance in the first quarter totaled $32.96 billion, nearly 18% ahead of the last quarter of 2004.

While Duncan says CMBS could hit another record in 2006, other researchers say CMBS issuance likely reached its peak in 2005 and is already flattening as rising interest rates restrain demand for new commercial mortgages.

“CMBS in 2006 will be down to flat versus last year,” predicts Brian Lancaster, head of structured products research at Wachovia. “You can already see in the number of loans originated that the pace of transactions has slowed.”

The number of CMBS originations may be down, but overall volume is up due to the high-dollar nature of those transactions. Domestic CMBS volume hit $95.1 billion year-to-date through July 20 compared with $73.1 billion at the same point last year, according to Commercial Mortgage Alert. And Lancaster is quick to point out that a slower pace of CMBS issuance will still amount to high volume because the market is only coming down from an all-time record year.

Why is Lancaster forecasting reduced CMBS issuance? Reasons include slower price appreciation on commercial properties and rising capitalization rates. Those factors stem from rising interest rates, which increase the cost of capital and lower the price buyers are able to pay for new acquisitions.

Interestingly, as climbing interest rates have reduced the loan amount borrowers will provide on a first mortgage, lenders have offered to replace much of that lost leverage through complex financial structures that incorporate mezzanine lending, preferred equity investments and other short-term instruments.

That has boosted demand as a means to finance those new instruments, resulting in a boom in issuance of collateralized debt obligations. CDO issuance at mid-year totaled $12.9 billion — 40% ahead of last year's volume for the same period, according to Wachovia.

Lenders like the flexibility of managed CDOs, which enable the issuer to use short-term instruments as collateral and then replace them with new collateral when those assets are paid off by borrowers. The CDO offers a more innovative structure than a CMBS transaction, in which the asset pool is static.

Lancaster doesn't expect CDOs to replace the CMBS market, but he does expect CDOs to take the spotlight for rapid growth.

“On the CMBS side, we will see a slowdown in the second half of the year,” he says. “In contrast … The real estate CDO market is on fire.”