While the commercial mortgage-backed securities marketplace has been on a record-breaking tear for several years, CMBS investors have become quite a skittish bunch of late. Though issuance surpassed the $200 billion mark for the first time in 2006, three recent events may put much-needed discipline back into the market.

First came the residential subprime mortgage bubble, which burst in February and affected a broad swath of the lending community as residential mortgage defaults escalated. Though the residential and commercial mortgage securitization markets are fundamentally separate, many investors paint both with the same broad brush.

Most market analysts now agree that the inevitable spillover effect into the commercial sector has occurred, but the full extent of its impact on commercial CMBS is unclear. What is clear is how spreads tied to 10-year Treasuries have widened as a result of the subprime fallout.

Spreads on BBB and BBB- securitized loans were near all-time lows just prior to the subprime debacle in mid-February, then widened considerably over the next month as investors demanded a bit more credit surety in increasingly turbulent times. According to a Morgan Stanley study, spreads on BBB- loans increased 38% from 136 basis points to 219 over Treasuries from Feb. 21 to March 28.

Next came the mid-April bombshell report by New York-based Moody's Investors Service, co-authored by Jim Duca and Tad Philipp, group managing director and managing director, respectively. In it, the duo warned that lending underwriting standards had slipped to the point that Moody's would begin raising subordination levels on loans it deemed in need of credit enhancement. (Subordination involves structuring a security into classes, in which the risk of credit loss is disproportionately distributed. The higher the subordiantion level, the bigger the cushion for the holder of triple-A rated securities.)

Rounding out the trio of events, investment-grade and noninvestment-grade investors alike balked at the underwriting on several loans in the recent $4.2 billion CMBS deal dubbed GE Commercial Mortgage Trust, 2007-C1.

As a result, dealers pulled five loans from the collateral pool totaling $226.7 million and reduced the senior portion of another loan by $50 million. Those loans will be included in another CMBS issue, or sold on the whole-loan market at reduced rates.

GE's diversified pool mirrors the present-day genre, including mortgages on office, multifamily, retail, hotel, industrial, self-storage and mixed-use properties, the largest being a $249 million loan originated by Bank of America on 666 Fifth Avenue in New York City.

Deal pipeline is loaded

Despite these early-2007 warning bells, the CMBS juggernaut has run nearly unabated, with lenders issuing $61.2 billion in domestic CMBS loans in the first quarter of 2007, compared with $46.5 in the first quarter of 2006, a 24% increase.

On the surface, much of the news is good. Underlying supply and demand fundamentals across all commercial property types remain robust after years of steady growth. Plus, default and delinquency rates on commercial mortgages remain at all-time lows. As recently as January 2007, Standard & Poor's noted that CMBS upgrades outpaced downgrades by nearly an 8 to 1 ratio in 2006.

The good times have led to increased leverage on loans, but many observers view the trend as a natural extension of healthy markets. “There is a lot more tolerance of allowing greater leverage because of the strong performance of real estate,” says Thomas MacManus, executive vice president of Cushman & Wakefield's debt and equity finance practice. “There is a lot of capital out there to provide the leverage, so borrowers not only can get cheaper money, but they also can borrow more.”

Because it takes several months to bring CMBS issues to market, the pipeline of CMBS deals is now bursting at the seams. But the warnings persist and are growing louder. For example, in early April, New York-based Fitch Ratings predicted that about 15% more defaults would occur over the 10-year term of loans originated in 2007, due mainly to over-reliance on escalating property values and aggressive underwriting.

“In many ways the credit curve and what could be accomplished in the CMBS space got pushed to a whole new level, and I don't know that it will ever be pushed like that again,” says Boyd Fellows, managing director for Calabasas, Calif-based Countrywide Commercial, a division of Countrywide Financial Corp. “We saw the aggressiveness of the lending community take a pretty big step forward, and I don't think everyone is comfortable with where we got to.”

Moody's sends lenders a message

With its April 10 report, Moody's drew a line in the sand for lenders. In particular, it cited high leverage as a primary reason for raising its subordination levels on future issues it deems need credit enhancement. Moody's will also look more closely at local market conditions in rating specific loans.

“Because we are forward looking, we reached a point where we felt the CMBS capital structures could not withstand a further decline in loan underwriting credit quality, and something had to give,” says Philipp. “The action we took was a bit of a rallying point for the market that people needed something to focus on.”

Dennis Schuh, executive director of JPMorgan Chase Commercial Mortgage Securities Corp., admits that the Moody's report only reinforced what was widely known. “We all knew we had to reverse course here, that it was a matter of when and not if,” says Schuh. “We were due for a pullback, and we were just waiting as an industry for someone to really step up and push back.”

While waiting, however, JPMorgan issued the largest CMBS deals in both 2005 and 2006. Most notably, the $4.8 billion securitization that closed in December 2006 briefly held the record for the largest CMBS deal ever, including a pool of 241 loans on office, mixed-use, hotel and unanchored retail properties. That record was quickly eclipsed by Wachovia Corp.'s $7.9 billion securitization in April 2007.

Annemarie DiCola, president of New York-based Trepp LLC, which provides research and data to the CMBS industry, echoes the market's sentiment concerning the Moody's report. “If what the rating agencies have done is help people be a little more conservative going forward right now, that's not such a bad thing.”

B-piece buyers flex muscle

Further discipline has arrived in the form of investors who are relied upon to buy the non-investment grade bonds in CMBS pools, otherwise known as “B-piece” buyers. These investors are buying bonds at the lowest end of the subordination chain and incur the greatest risk for loss, if the loan collateral underperforms.

The number of B-piece buyers has fluctuated over the years, and while there are some 200 potential buyers, analysts note that less than a dozen are extremely active. That small pool gives the group more clout.

Given the relative small size of the group, Lisa Pendergast, managing director of CMBS research at RBS Greenwich Capital in New York, notes that B-piece buyers are likely to wield more power than in recent years.

“I would not be surprised if we return to a period where five years ago a B-piece buyer had the prerogative to kick out 10% of the deal,” says Pendergast. “The more clout that these guys acquire, the better it is for all concerned.”

Investors are also availing themselves of new analytical tools to gauge credit levels. For example, New York-based research firm Reis launched a new program called “CMBS Deal Analyst” to help investors monitor both large and small loans in CMBS pools, many on properties located in secondary and tertiary markets.

“There is a lot of great information out there about the deals themselves, especially the largest loans, but some of the most significant risks of issues that come to market are just below the observable threshold of the largest 10 loans,” says Sam Chandan, chief economist and senior vice president at Reis.

Schuh refers to B-piece buyers as the ultimate “gatekeepers” with respect to CMBS. “If they push back, the market reacts. There is going to be short-term pain, but long term everyone thinks this is a good thing because we needed to reverse course here.”

Second half lending slowdown?

Most analysts are forecasting at least a short-term cooling in origination volume as the markets adjust to the new realities. “Our expectation is that as we move into the next few quarters and the next phase of the commercial real estate cycle where asset price appreciation will be slower, the rate of delinquencies and defaults will necessarily rise from its historic lows,” says Chandan.

In the securitization business, changing course is akin to steering a cargo freighter on a dime, so at least in the short term the rating agencies will have their hands full.

“I actually think things are going to get worse before they get better,” says Philipp, referring to the credit quality in upcoming issuances. “Unfortunately we expect more declines because there are a lot of loans on issuers' books still made aggressively that are going to filter their way through.”

Longer term, lenders will choose one of two paths. Some have already signaled a change in their underwriting practices, while others say they will stay the course but charge more spread over Treasuries. “Some of the changes the lending community is making won't play out until the second half of the year,” says Schuh.

But already Pendergast notes that the CMBS and loan origination teams within RBS Greenwich Capital are working more closely to underwrite deals that will stand the new market tests. “You can't be giving leverage on loans that don't pencil out on assets that you're not particularly fond of. We're seeing it, and I know we're widening on spreads as is everyone else,” says Pendergast.

Whatever path lenders choose, many analysts are looking at potential worries over the next five to 10 years, including overbuilding. “I can't tell you that I see a dark cloud looming 12 months away and it's not like there are cranes on every street corner,” says Philipp. “But that doesn't mean you can indefinitely keep raising leverage.”

Also precipitating a second half slowdown is the potential cooling in the volume of public-to-private REIT merger and acquisition activity. “At some point, that is not going to continue at the pace and the volume it's been,” says Pendergast. “In 2007 we will continue to enjoy a lot of the financings that result from such M&A activity. I just don't think it's sustainable long term.”

In the meantime, the “EOP effect” that has resulted from the securitization of numerous loans associated with the $39 billion privatization of Chicago-based Equity Office Properties Trust by New York-based Blackstone Group will take some time to wind its way through the securitization process.

Ultimately, CMBS lenders and investors alike have a stake in mitigating wildly swinging boom and bust cycles, and this time around more signs point to heeded warnings. “What's great is that adjustments are being made in advance of a downturn rather than reacting to a downturn,” says Philipp. “There is definitely a refocusing on credit at the appropriate time to do so.”

Ben Johnson is a Dallas-based writer.

CMBS industry is ramping up globally

As lenders and investors alike scramble to find the next hot growth opportunity, the commercial mortgage-backed securities (CMBS) industry increasingly is finding an inviting home in overseas markets.

Indeed, European CMBS issuance reached $120 billion in 2006, a 39% increase over 2005 volume, while the number of transactions increased from 64 to 80, according to Standard & Poor's. Barclays Capital in London predicts European CMBS issuance could reach $136 billion in 2007.

“When you think about the next type of [Equity Office/Blackstone] deal, it could well be a pan-European one or some combination of international properties,” says Annemarie DiCola, president of Trepp LLC, which provides research to the CMBS industry. “We have to remember not to think of this as just the U.S. domestic market.”

Trepp has been providing research on European CMBS deals, largely based on client demand, for the last two years through its London office. “Our investor base in the U.S. is huge, and we have a growing investor base in Europe, but our U.K. investor base is looking globally,” says DiCola.

“We wanted to be responsive to what our clients needed and wanted to look at potential deals everywhere.” Trepp also has entered the Asian CMBS market with an office in Shanghai, China.

Jumping over the numerous structural hurdles in foreign markets, though, will take some time. “The international growth has been phenomenal, but there is a lot of complexity in those markets with currency, legal and tax issues,” says Dennis Schuh, executive director of JPMorgan Chase Commercial Mortgage Securities Corp. “It's early days and everyone is looking for growth.”

DiCola agrees. “We're finding that the European market has some hurdles that need to be addressed to allow for more issuance and to provide more data and information to the investor base. The European market is grappling with some of the same issues that our market grappled with in the mid-1990s.”

The explosive growth of the domestic CMBS market has helped fuel investor interest overseas. “Opportunities are harder to find from a risk/reward perspective here in the U.S., and they think there are some interesting opportunities over there,” says Schuh.

Investors in European CMBS deals, for example, often see diversified pools of properties from multiple countries, which mitigates the risk. Spreads on European CMBS deals continue to tighten as a result of strong investor demand, with AAA spreads reaching a record low 16 basis points in April.

Tad Philipp, managing director of CMBS at Moody's Investors Service, cautions that even though real estate is now “sitting at the adult table of asset classes” on a global scale, that status carries both pluses and minuses just as with other investments.

“The good news is there is abundant liquidity, and the bad news is the liquidity is now a little more volatile,” says Philipp. “I think people started to get an inkling of that in 1998 when Russia defaulted and CMBS spreads widened.”

In this age of the global capital markets, volatility is to be expected, adds Philipp. “Money is constantly shifting from country to country, sector to sector, looking for the most favorable risk-adjusted returns. Some money is stable, and some is hot or trading money.”
Ben Johnson