The commercial mortgage-backed securities (CMBS) market is beginning to defrost—faster than many had expected, but definitely slower than anyone had hoped. But, it’s much too early to say that a robust CMBS market is reemerging, simply because new CMBS issuances have been unimpressive.

Since June 2008, there have been only a handful of new-issue CMBS deals, and all but one were single-borrower deals that closed during the fourth quarter 2009. Last month, The Royal Bank of Scotland Group (RBS) created some buzz by bringing the first multi-borrower deal to market, but it was relatively small at $309.7 million.

“These deals were welcomed because we hadn’t seen anything for months,” says Lisa Pendergast, managing director of CMBS strategy and risk for New York City-based Jeffries & Co. Inc. “But they didn’t make you think it was the beginning of something big.... Still, these are positive steps. Unlike first half of 2009 when you didn’t have folks willing to lend, now they’re willing to lend, if only for the very best properties.”

That’s a marked change from CMBS’ rock and roll years when even marginal borrowers were able to finagle conduit financing because bond investors were so ravenous they were willing to take on plenty of risk. At the same time, conduit lenders were able to attract institutional quality borrowers and assets because their pricing was more competitive than portfolio lenders.

“During the heyday, CMBS was cheaper and got the best assets,” says Gerry Mason, executive managing director of New York City-based Savills Granite. “Now CMBS is getting the stuff that portfolio lenders don’t want.”

Mason isn’t referring only to sponsorship or asset quality, but also to loan size. While portfolio lenders are active in the market, they have allocations and diversification requirements. Large loans might exceed those requirements.

Mason points to the recent CMBS deals done with Ramco-Gershenson Properties Trust as an example of a borrower with a class-B retail portfolio that would not appeal to a portfolio lender. The REIT recently closed on a $31.3 million CMBS loan with J.P. Morgan, securing a loan at 60 percent LTV for two retail properties at a ten-year term at a fixed rate of 6.5 percent.

Similarly, Glimcher Realty Trust closed a $55 million CMBS loan with Goldman Sachs Commercial Mortgage Capital, L.P. for The Mall at Johnson City in Johnson City, Tenn. The 10-year loan has a fixed interest rate of 6.76 percent. The REIT also obtained a $46 million CMBS loan through Bank of America, N.A. for Polaris Towne Center in Columbus, Ohio. The 10-year loan also has a fixed interest rate of 6.76 percent.

Interestingly, retail assets have emerged as one of the most attractive property types for both CMBS originators and investors, despite ongoing concerns with consumer confidence and retail spending.

There was a time when lenders ranked retail properties alongside hotel assets as something to stay away from because of uncertainty within the sector. Today, retail is seen as far more attractive than hotels and marginally more attractive than multifamily. It stands shoulder to shoulder with office and industrial, according to experts.

Like retail property investors, lenders consider grocery-anchored retail centers attractive given their recession-resilient qualities. Power centers are less attractive because of the number of closures in the big-box segment. However, power centers with market dominant boxes still look good to conduit lenders, particularly those in well-established markets.

In contrast, malls and lifestyle centers are pretty much out of favor, Mason notes. He explains that there are very few fortress malls to finance; instead, the majority of mall inventory is class-B assets that are located in secondary or tertiary markets.

Meanwhile, lifestyle centers were overbuilt during the most recent construction boom, and lifestyle tenants have suffered mightily during the downturn. Moreover, leases are likely above-market and are not sustainable in today’s environment.

Retail properties that were built around new housing developments are the least attractive of all retail assets. These properties are the most vulnerable to vacancy and re-leasing risk, experts note.

“I think that there is a very good case that well-located, anchored retail with a strong sponsor is a viable product,” says Mark Doris, national business development director for San Francisco-based Wells Fargo’s commercial mortgage origination group. “When you get away from that, every deal has to stand on its own. There are good retail assets out there; the whole asset class isn’t tainted.”

Dipping a toe

Industry players have nicknamed this new world of conduit lending CMBS 2.0, but the moniker is more a clever turn of phrase rather than representing a new kind of lending. In fact, it seems more like a step backward rather than a step forward. The way lenders are acting today is to try and get back to the kinds of conduit loans originated between 2000 and 2004. During that period, banks embraced CMBS as a way to make money, but were judicious in the amount of leverage they provided and still practiced quality underwriting.

Today, healthier banks and life companies are cautiously providing term sheets for conduit loans and pooling loans for securitization. But, many banks that were major CMBS players are still suffering with underwater assets across their lending business, not just in commercial real estate.

It’s important to note that the banks that have originated and issued CMBS recently have closed the pools and priced the bonds in short order so they don’t have to “warehouse” the loans on their balance sheets.

“There has been so much balance sheet damage that a lot of people are saying that there is no chance they can go to their boss and tell him they want to build a pool of commercial real estate loans to hold on balance sheet,” says Manus Clancy, a senior managing director at New York City-based Trepp LLC. “Fortunately, there has been some healing where there is modest latitude to lend again.”

For 2010, Trepp predicts $25 billion to $30 billion of new-issuance CMBS, a relatively disappointing number compared to 2007 when deal flow reached $207 billion, but certainly a big improvement over the $2.2 billion issued in 2009 and $8.9 issued in 2008.

“I think the industry will rev up because I have clients who were not in the market for making real estate loans for securitization last year, and now they are in the market,” says Michael Gambro, co-chairman of the capital markets department at global law firm Cadwalader. He has been involved with nearly every new issuance CMBS deal that has come to market in the past eight months. “I would expect at least a couple of my clients to come out with deals, so we’ll see volume pick up toward the end of the year,” he says.

This still-developing market for new CMBS is awkwardly juxtaposed with growing defaults and delinquencies from vintage CMBS, particularly loans originated during 2006 and 2007. Even the most confident fixed-income investors have been shaken by increasingly dire reports that suggest CMBS defaults are increasing daily.

For example, Jeffries & Co. anticipates the fixed CMBS delinquency rate will top out at 12 percent to 13 percent during this down cycle, with the 2010 year-end delinquency rate at 11.6 percent. By far, hotels are in the worst shape, followed by multifamily. Office, retail and industrial have delinquency rates ranging from 4.39 percent to 5.27 percent.

Simple structures

The thawing of the CMBS market began with very simple issuances—single-borrower deals, which are just a small subset of the CMBS world overall. Traditional multi-borrower conduit deals that made up the majority of the market prior to the credit crisis have been slower to emerge.

The Federal Reserve and U.S. Treasury introduced Term Asset-Backed Securities Loan Facility (TALF) in March 2009 to help the Asset-Backed Securities (ABS) market including CMBS. By providing equity and debt capital, these programs supported lenders by making collateralized securities more valuable to investors, according to a recent report by UBS Capital. TALF for legacy CMBS expired in March, and TALF for new-issuance CMBS is scheduled to end in June.

TALF restarted the ABS market by offering liquidity. After the initiation of the TALF loan facility, ABS issuance averaged $ 14 billion per month compared to $1.6 billion in the six months prior.

From March 2009 to October 2009, there were eight ABS subscriptions worth nearly $86 billion of TALF-eligible issues. Of that amount, $49 billion worth of securities were purchased with TALF loans. Since the peak of the credit crisis, spreads for eligible assets have declined by more than 60 percent.

TALF succeeded in revitalizing ABS, but it had less of an effect on CMBS, experts note. TALF provided loans to purchase $4.1 billion in legacy CMBS (issued before January 1, 2009), but there was only one new issuance CMBS deal expedited by TALF—a $400 million deal with Columbus, Ohio-based shopping center REIT Developers Diversified Realty Corp. However, even the DDR transaction saw minimal participation through TALF, with only $72.2 million or 22 percent of the DDR AAA tranches pledged to TALF, according to Jeffries & Co.

“By the time the DDR deal came to market, there was enough pent up demand for low-leverage high quality real estate paper that TALF wasn’t necessary,” Gambro says.

Yet single-borrower deals like DDR’s set the stage for CMBS to come back faster than many expected, Doris says. “Those deals made it very clear that there was pent-up investor demand,” he says.

Subsequent single-borrower deals with Flagler Development Group ($360 million) and Inland Western Retail Real Estate Trust Inc. ($500 million) were also well-subscribed, likely because investors were able to dig deeper into the borrower’s credit and asset level performance to complete their own underwriting without relying on ratings from credit agencies, says Sam Richardson, a partner with global law firm Goodwin Procter LLP.

The Flagler deal saw $350 million AAA certificates with 23.9 percent credit enhancement priced at swaps plus 225 basis points, while the AA, A, and BBB- classes priced at swaps plus 400, 450, and 627 basis points, respectively.

The Inland deal, brought to market roughly 30 days later, saw AAA $58.4 million A-1class priced at swaps plus 150 basis points and the $330.6 million A-2 class at swaps plus 205. The AA and A classes priced at swaps plus 360 and swaps plus 420 respectively, while the BBB- class priced to yield 9 percent.

That’s not to say that CMBS loans are not competitive. Mason says he’s been talking with conduit lenders for a couple of deals and has been “surprised” at how close CMBS rates were to what insurance companies are offering. CMBS originators are willing to go to 70 percent leverage on a 10-year fixed rate in the 6.50 to 6.75 percent range with 30-year amortization. Life companies are making similar loans, with slight differences in leverage and rates.

The RBS deal, initially planned as $500 million issuance, was sold as a multi-borrower securitization with many properties, but it actually only had six borrowers. “The RBS CMBS deal was slightly illusory because of the number of borrowers—an investor can get a very good idea about borrower quality,” says Tom Muller, a partner in the real estate and land use group at Manatt, Phelps & Phillips.

The smaller pool size was not caused by lack of investor interest, according to experts. In fact, the deal received strong demand and pushed pricing tighter than initial expectations to 4.5 percent yield or S+500 basis points.

Instead, banks are tentative about originating a large CMBS—both volume and the number of loans—that will have to sit on their books until they can sell it off to investors. The RBS deal reportedly closed, securitized, priced and sold to investors all on the same day, eliminating the need for warehousing.

Many banks are still recovering from the billions of dollars of CMBS they still had warehoused when investor demand dried up in late 2007. Many of those loans are underwater, which is why those with long memories are less likely to be on the leading edge of originating new conduit loans that have to sit on the balance sheet for an extended period.

Yet, the banks on the leading edge of CMBS 2.0 are demonstrating a rare creativity and courage, experts contend. “They’re thinking this is an opportunity to make some money on the deals, but it’s also an opportunity to make a splash and paint themselves as creative enough to revive the market,” Muller says.

Wells Fargo, for example, has expanded its commercial lending platform to include CMBS. Last year, the bank wrote “a fair amount” of new commercial real estate loans in 2009 that it held on its books, Doris notes. He expects the bank’s initial CMBS offerings will include 20 to 30 borrowers and that the bank will hold the loans and “take the warehouse risk” until they are able to pool them for securitization.

Strong investor appetite

As demonstrated with recent CMBS deals, investor demand has returned with surprising force, experts note. In 2008, however, fixed-income investors, from pension funds to life insurance companies, turned their backs on both residential mortgage-backed securities and CMBS. They were worried about the underlying quality of the collateral, as well as the attention to underwriting. They also had lost confidence in the credit ratings agencies.

“When it was clear that the CMBS underwriting was not of the quality that people expected, there was a dramatic loss of confidence in the market,” Richardson says.“Investors have had to regain that confidence and trust the product, so the first few deals that have come out have been simple structures with stabilized assets and conservatively underwritten.”

It’s hard to say whether investors have bought CMBS because they feel more confident about the recent deals that have closed or if they are just dissatisfied with other fixed-income investments. Yields on 10-year Treasuries, for example, have been pushed down to anemic levels of 3.88 percent.

Banks that have brought CMBS to market recently have reportedly had a series of meetings with large fixed-income investors to determine exactly what kind of deals investors want to see come to market and what they’re willing to buy. Previously, originators were less worried about what investors were willing to buy because investors’ risk tolerance was considerably higher than it is today.

“Issuers are listening to some of the concerns and trying to structure transactions so they’re attractive to the investors,” says Barbara Duka, managing director of structured finance for S&P. “They’re going out to people who would hold the B piece and asking investors what they want a deal to look like. All the things that issuers know investors don’t want to see—interest-only, high LTV—they’re not doing it. They’re being very careful to close on collateral to make the deals as attractive as possible.”

These recent meetings between originators and fixed-income investors have resulted in quasi “made-to-order” CMBS. Investors are not only determining what they’re craving but also the menu options. Investors want strong borrowers with high-quality, stabilized properties with strong in-place cash flow. Fixed-income investors find anything else—marginal borrowers or so-so properties—undesirable, and therefore, undeserving of loans, from the lender’s perspective.

Of equal importance is the strict underwriting and conservative terms. Fixed-income investors got their fill of CMBS collateralized with interest-only loans with 85 percent LTVs. Today, they’re looking for fully amortized loans with conservative LTVs—70 percent is pushing it, experts note.

Doris says current CMBS originations are more conservative transactions with far fewer moving parts. “You’re making determinations on more predictable cash flow,” he explains. “Previously, there was a lot of anticipatory cash flow analysis where today expectations are much more pragmatic.”

Again, lenders know there is investor demand for this type of loan product, so they’re willing to offer it to borrowers. Borrowers who don’t fall into the rigidly and clearly defined box that investors have outlined are out of luck.

Savills’ Mason says conduit lenders aren’t interested in borrowers with less than class-B quality assets. “But, we’re probably only six months away from the conduits being fine with that too,” he says.

In fact, the biggest obstacle for CMBS 2.0 may be timing. “There are a lot of people who want to borrow, and there are a lot of lenders who want to make loans, but it takes some time to warehouse the conduit loans,” says Malay Bansal, head of portfolio management & advisory services for commercial real estate and CMBS at NewOak Capital LLC in New York City. “Between the time it takes to make the loan and the time the bonds are priced, you could take a loss if the market moves in another direction. Lenders used to be able to hedge, but there’s no real way to do that right now given the limited activity.”