Investors show little appetite for commercial mortgage-backed securities (CMBS) these days despite some enticing deals on the menu. With only $9.9 billion in U.S. CMBS issued in January through April this year, volume is a fraction of the $78.5 billion in bonds that sold during the first four months of 2007, according to the industry newsletter Commercial Mortgage Alert.

Experts say the market won't show significant signs of recovery until late summer at the earliest, and will more likely be spring 2009. A determining factor will be the point at which investors believe CMBS bond prices have stabilized, and for now those prices remain volatile.

CMBS problems came to a head last fall when investors demanded greater returns on real estate bonds to offset perceived higher risk, sending CMBS spreads through the roof. Spreads peaked in March and are narrowing sporadically, and even occasionally reversing course as the market searches for a bottom.

Based on returns alone, it seems remarkable that investors aren't lining up to buy CMBS bonds while spreads are still elevated. On April 16, for example, BBB-rated bonds carried a spread of 1,571 basis points over the 10-year Treasury rate of 3.96%.

That's an incredible return for a bond class that previously peaked at 350 basis points over Treasuries during the Russian ruble crisis of 1998, says Beth Lambert-Saul, director of Archon Group, a Dallas-based subsidiary of Goldman Sachs. “Someone buying that bond was getting more than an 18% return,” she says. “Something wasn't right.”

Fear of paper loses

What wasn't right — and still isn't right for some investors — is mark-to-market risk. Public companies and other large institutions that report to investors typically value their portfolios quarterly based on market rates. That means a CMBS bond that generates a return of 1,800 basis points is considered less valuable if similar bonds down the road are priced to pay 2,000 basis points.

That's a real possibility because CMBS spreads have widened and contracted a few times during their overall narrowing course this year. Volatility in CMBS has investors worried that a return to wider spreads will transform their high-yielding purchase into a paper loss.

The risk of a paper loss is the chief reason investors have shied away from CMBS bonds this year, according to Dan Smith, managing director at RBC Capital Markets, a commercial lender. “It's not a case of investors worrying about defaults on the bonds,” says Smith, who manages RBC's real estate capital division. “It's more the mark-to-market risk.”

In fact, CMBS fundamentals are quite healthy. The CMBS delinquency rate climbed two basis points in April to a still miniscule 0.35%, reports Fitch Ratings. That small increase is tied to a single condo loan that is expected to be cured.

Spread volatility causes problems for lenders and loan syndicators, too, because fluctuations in what the market will pay for CMBS bonds make it difficult to set interest rates on the new conduit loans that go into a CMBS pool. The reluctance of CMBS originators to make new loans is one reason Lambert-Saul expects a sharp decline in issuance to $40 billion by year's end. That compares with 2007's record $230.2 billion in U.S. CMBS volume.

A tough alternative

Life insurance companies are filling some of the credit vacuum created by the stalled CMBS market but with less attractive loan terms, says real estate attorney Doug Buck, a partner at Foley & Lardner LLP in Madison, Wis. Those new terms include debt-service coverage ratios of 1.15 or higher, loan-to-value ratios at 70% and prohibitions against adding mezzanine loans to the debt.

More alarming is a frequent demand from life company lenders for personal guarantees that often require the borrower to repay 25% to 50% of the property's value in the event of a default. Conversely, CMBS loans are usually non-recourse, so unless criminal conduct is involved, a borrower who is unable to keep up with a mortgage can simply turn over the asset to the lender. Buck has one client reconsidering plans to refinance its property due to onerous guarantee requirements by the refinancing bank. “The interest rate would be lower, but they would have a lot more risk,” Buck says.

Borrowers with limited equity and those seeking to finance properties outside the realm of institutional assets may find it difficult to qualify for life company loans under terms previously available through CMBS, says Jeff Friedman, co-chief executive officer at Mesa West Capital, a Los Angeles-based lender.

Some of those property owners and investors are turning to lenders like Mesa West Capital for floating-rate debt that they plan to replace with fixed-rate financing once the CMBS market recovers. “Because the CMBS market's not open, they're coming to us for bridge financing,” he says.

CMBS loan originators won't begin to ramp up significantly on loan originations until spreads stabilize, experts say. Without consistent spreads, issuers can't be sure how to price bonds and originators won't have the necessary data to set interest rates on new loans.

When CMBS settles, expect spreads in the range of 40 to 50 basis points for AAA bonds, spreads typical early in this decade, according to Tom MacManus, executive vice president of Cushman & Wakefield's debt and equity finance practice. Don't expect a return to the ridiculously low spreads of early 2007, he says, which dropped to as low as 23 basis points.

The market may see further spread tightening in the coming weeks followed by a few more weeks for the markets to realize that spreads have indeed returned to a more normal rate. That leaves little hope for a CMBS recovery to begin until this fall, according to Smith of RBC Capital Markets. Until then, lenders and loan syndicators will be looking for evidence of improved investor appetite for CMBS while they monitor spreads.

Getting a good read on spreads will prove challenging in a year when loan origination is down. As Smith puts it, “Frankly, we need to see more transactions in the market to get a good feel for what the spreads are.”