Subordinate investors steer CMBS' market future What happened to the Commercial Mortgage Backed Securities market, and when will it fully recover? These questions do not have clear answers. However, it is clear that the CMBS market was brought to a grinding halt after having achieved a record volume of $55 billion through August 1998. The B-piece investors who purchased securities rated below investment grade continue to evaluate recent market conditions. Their assessment and future actions will have a major influence on the direction of commercial real estate financing.

How did we get where we are now? In August, high-yield investors became nervous and backed away from the table. Events that triggered the retreat seemed to be primarily tied to international economic concerns. Japan's ability to recover from its worst recession since World War II was more doubtful, and Russia's failure to perform on debt obligations surprised the market. The reaction by investors was to seek shelter in preparation for a potential global recession and depressed corporate earnings. Investors began their flight-to-quality by exiting high-yield bonds. Liquidity in the CMBS market dried up immediately and spreads widened to levels that had not been seen since 1994. With commercial real estate loan delinquencies still low, occupancies at their highest levels in years and new construction not yet a major threat, it is clear that the underlying fundamentals did not trigger this drastic reaction. What we finally learned is the extent to which real estate financing is now linked to the capital markets.

Conduit lenders aggregating whole loans for securitization were left holding the proverbial hot potato. Some $20 billion to $30 billion in commercial real estate loans is now being warehoused with far less securitization value than projected. Executing the securitization now could mean taking a 2% to 4% loss on the aggregated principal balance. Two major lenders, Capital America and Credit Suisse First Boston have reportedly ceased all lending activity until their current portfolios are reduced and markets stabilize. Capital America was one of the largest lenders generating over $1 billion a month in loans, and its parent company, Nomura Securities, announced in October a $1 billion loss attributed to its emerging markets and real estate lending operation.

Spread widening and the treasury rally caused severe damage to CMBS investors. Losses added up for those who had hedged their portfolio by shorting treasuries and needed to cover the short positions. Furthermore, many bond investors traditionally financed their investments and were facing collateral calls. As the value of bonds dropped, loan terms required that collateral be increased or surrendered to the lender. One of the largest subordinate CMBS investors, CRIIMIE Mae, found it necessary to seek bankruptcy protection to prevent the surrender of a large portion of its bond portfolio. A number of highly leveraged hedge funds and mortgage REITs have been negotiating quiet extension agreements with lenders or surrendering collateral.

Borrowers who had been chased by lenders suddenly faced a credit crunch with very few capital providers to be found. Lenders were examining the fine print to determine if outs legally existed to withdraw commitments. Subsequently, new lending has begun on a very selective basis and borrowers have found they are no longer in the driver's seat. The lenders who stayed in the market are capturing higher quality loans with stronger borrowers, and interest rate floors have been established to ensure that bond investors are attracted.

It's a good time to take a breath! Markets have recovered nicely over the last five years, giving borrowers a healthy increase in equity. Some of the lowest mortgage rates in history coupled with a competitive lending environment presented borrowers with once-in-a-lifetime opportunities. Since debt service coverage ratios were not much of a hurdle with the low constants available in the market, loan-to-value ratios were the only real obstacle in the borrower's ability to maximize proceeds. But lofty values were easily supported by the aggressive prices being paid by the once acquisition-hungry REITs.

By mid-1998, conduit lending was under extreme competitive pressure. Volume and pace were key ingredients to the success of a conduit. New origination offices were opening across the country to achieve increased production levels, and competition was fierce for product. Loans were being provided for properties in transition or under construction, and so-called Credit Tenant Loans were originated at 1.0 DSCR and 100% LTV for tenants with non-investment grade credit. In refinancings, large cash-out dollars were becoming all too common, and prudent lending safeguards were being waived. Nursing homes, day care centers and franchises were being disguised as real estate loans.

Subordinate CMBS investors were also under severe pressure. New capital was rapidly entering the growing market and yields were under attack. As the market enlarged and liquidity improved, mortgage REITs and large money managers became more active. To maximize their diversification scoring with the rating agencies and satisfy the appetite of investors, issuers assembled larger loan pools. Some rating agencies were convinced that these large pools provided investors diversification and awarded issuers extremely skinny subordination levels. Bids for bonds were being requested on transactions where half of the loans were still being assembled and hadn't yet even been identified. Too much capital in the market was beginning to impair proper investment rationale, and investors began to question the shrinking risk-adjusted yields.

Time to shore up CMBS Subordinate investors provide about 13% of the total securitization proceeds. However, their role in scrutinizing the underwriting and collateral is key. Their purchase of the high-risk portion of the transaction has always been an essential ingredient to executing a successful transaction. Their comfort with the risk profile of future securitized transactions will have a major influence on liquidity and on the long-term viability of this market. We are all facing a real estate market that has fully recovered and is now more susceptible to a downward cycle. Because the CMBS industry is enjoying low delinquencies today should not provide a firm sense of security. Non-recourse borrowers will dig deeper in their pockets to nurse a troubled property if they believe a healthy equity position exists.

Lending in this environment requires prudence, and investing in it requires discipline. Lenders who provide quality underwriting will achieve the coveted brand identification and will survive the consolidation under way in the industry. Standards could be developed in concert with subordinate investors. Discussions are already occurring where issuers will bring subordinate investors into the initial screening process as loans are aggregated. That way concerns can be addressed up-front.

Realizing that the liquidity crisis in the market was initiated by events unrelated to the collateral, new investors have entered the market. Interest by new players with long-term capital, vs. some of the former participants could provide the stability and liquidity the CMBS market needs. If those capital sources are disappointed in the underlying loan product, quick exits will follow. If standards are maintained, they will consider this market a viable alternative. Soon, the CMBS market will be running fast, and prudent lending and disciplined investing will ensure that the run becomes a marathon.