Despite narrower spreads and a string of potent hurricanes, investor demand for commercial mortgage-backed securities (CMBS) appears unscathed for now. The numbers tell the story: total CMBS issuance for 2005 should exceed $160 billion — or nearly double the $94 billion in CMBS that were issued last year, reports Fitch Ratings Service.

But ripple effects from higher interest rates and rising energy costs could dampen investor demand for CMBS in the next few years, especially in the niche condo conversion market and retail property arena. And that, in turn, could make it hard for the CMBS market to build on its record year.

The good news is that investors aren’t expected to pull back at once, which lessens the chances that issuance will dry up considerably in 2006. “Despite widely expected increases in interest rates, capitalization rates are likely to remain relatively low as capital continues to flow into the sector,” says Mary MacNeill, managing director at Manhattan-based Fitch Ratings.

For that matter, Fitch Ratings projects that 2006 CMBS issuance will be consistent with 2005 levels though some obvious culprits could make it difficult to exceed 2005’s record volume. One chief concern: higher operating costs driven by steep energy prices and inflation could put pressure on existing loans. And, owing to that pressure, Fitch believes that many landlords will increasingly try to pass higher costs onto tenants — or risk taking a hit to their net operating income.

“Another metric to watch is whether upfront capital improvement reserves are adequate to effectuate a repositioning plan,” adds MacNeill. With more loans secured by ongoing condominium conversions in places like South Florida and Las Vegas, these reserves become even more critical because they are only repaid after the conversion has been completed. Yet rising material and labor costs — plus longer than expected construction lead times — could thin out existing reserves. That, in turn, could increase the number of delinquencies on these loans.

Beyond the condo conversion niche, which many investors and industry watchers already view as suspect, Fitch expects most property types to improve in 2006. The one exception is retail, where rising interest rates and steep fuel costs stand to dampen retail sales. Also, consolidation among department stores may lead to under-performing mall anchor stores that could close their doors soon after the 2005 holiday season.

“Anchor closings are detrimental to malls in the short term, especially with limited product available to fill vacant spaces,” says MacNeill. MacNeill is also keeping a close watch over Wal-Mart’s impact on grocery-anchored retail centers. “We’ve been concerned about retail for the past four years, but the consumer just hasn’t stopped spending,” says MacNeill. “It now looks like they will be spending less money at the malls in 2006, however.”

Aside from consumer spending and its effect on retail properties, a steady flow of investor capital should give the overall CMBS market some needed buoyancy through 2006. Yet Fitch isn't calling for issuance to exceed 2005's record level since higher interest rates should soften investor demand for CMBS while added operating costs take their toll at the property level.