The commercial mortgage market faces one of its toughest credit climates in more than a decade. The most complex corners of the securitized mortgage market are getting hammered. Products that flew off shelves 12 months ago now are piling up: As of mid-September, investment banks were having a tough time bringing to market roughly $21 billion in commercial mortgage-backed securities that have been issued but not yet sold to investors.

While the Federal Reserve's half-percentage point interest rate cut on Sept. 17 lured some reticent buyers back into the CMBS market, the same cannot be said for commercial real estate collateralized debt obligations (CDOs). As of mid-September, issuers weren't packaging any commercial real estate CDOs because investors have been showing no interest.

Charlotte, N.C.-based investment bank Wachovia expects monthly fixed-rate conduit origination volume to fall 75% during the second half of 2007 due to tighter lending standards. Even worse, as of mid-September more economists were upping the odds of a recession.

Given the complexity of these securitized debt instruments amid the backdrop of choppy economic conditions, NREI asked three real estate finance veterans to educate readers on the different ways that these structured finance products are created and sold to investors as bonds.

The experts include Brian Lancaster, senior analyst at Wachovia Capital Markets and Darrell Wheeler, CMBS analyst at Manhattan-based Citigroup. Both investment banks are active players in the commercial real estate debt market. Wachovia issued $20.5 billion in CMBS during the first half of 2007, up from $9.7 billion over the same period in 2006.

Citigroup nearly doubled its CMBS issuance to $8.8 billion over the same period of time. The third expert, Jamie Woodwell, who serves as senior director of commercial and multifamily research at the Mortgage Bankers Association, a trade group based in Washington, D.C.

The following answers were compiled based on responses from these experts.

Q: What types of buyers have historically bought CMBS and commercial real estate CDOs? Are these mutually exclusive groups, or do both markets draw similar buyers?

A: The two markets do share some clients. Sophisticated investors such as life insurance companies and pension funds have gravitated toward CMBS in recent years. These institutional investors historically chased the top of the CMBS capital stack, despite lower yields. Both CMBS and commercial real estate CDOs share similar structures whereby the highest-rated tranches are AAA through AAA-, followed by BBB on down.

While these buyers have dabbled in the commercial real estate CDO market, foreign investors were far more active leading up to the recent downturn. Leveraged players, such as hedge funds and private equity firms, were also enthusiastic buyers of commercial real estate CDOs. In fact, foreign investors — the majority of them European — bought roughly 45% of all commercial real estate CDOs in 2006, according to Wachovia.

Q: What types of loans back CMBS and commercial real estate CDOs?

A: Two key differences center on the fixed- and floating-rate nature of the collateral. Commercial real estate CDOs are typically backed by floating-rate loans whereas CMBS collateral is backed by first-mortgage loans. A commercial real estate CDO can be backed by all sorts of collateral. CMBS, preferred equity and construction loans are commonly held by commercial real estate CDOs. REIT bonds and various other types of exotic debt such as second-lien loans and unsecured debt can get lumped into these pools.

Q: How have the returns varied between CMBS and commercial real estate CDOs?

A: Before the securitized debt market ground to a halt this summer, commercial real estate CDOs were consistently generating higher yields for investors. Active buyers, such as hedge funds, achieved returns approaching 20% from the market in recent years. These buyers were snapping up highly leveraged pieces of commercial real estate CDOs.

The now-defunct strategy, which centered on borrowing the funds to secure stakes in these bonds, or buying on margin, allowed these investors to amplify returns. But rising debt costs have made that approach less lucrative. At the same time, debt issuers were forced to push up yields in an attempt to drum up buyer interest. CMBS spreads over the 10-year Treasury rate jumped from roughly 25 basis points in February to 87 basis points in mid-September, reports Citigroup.

Q: What led to the formation of the first commercial real estate CDO in 1999?

A: Commercial real estate CDOs were a major innovation in part driven by the need to diversify risk after the 1998 Russian financial crisis sparked a global liquidity crunch. Unlike CMBS, which adhere to strict rules on the type and quality of collateral, the commercial real estate CDO market allowed lenders and investors to introduce a debt vehicle with more flexibility. What this means is that commercial real estate CDO managers can swap collateral out of the pool, making these highly managed pools of debt.

Q: The subprime debacle has affected both the CMBS and commercial real estate CDO market. Which segment has sustained the most damage so far?

A: The commercial real estate CDO market has undoubtedly been hit hardest by the market turmoil. One reason that demand for commercial real estate CDOs has dried up faster is leverage. Commercial real estate CDOs are backed by the riskiest types of commercial real estate debt, leaving them more vulnerable to wild swings in the debt markets.

Not only are short-term financing tools such as construction loans and mezzanine debt exposed to rising interest rates, but the very buyers of these commercial real estate CDOs were using debt to finance their stakes in this market. CMBS, which are typically backed by longer-term debt and bought with cash, aren't as sensitive to increased financing costs. So, the volatile debt markets have undermined both the collateral quality and buyers' appetite for commercial real estate CDOs.

CMBS are more transparent than commercial real estate CDOs, too, which likely makes rattled investors more comfortable about buying these bonds. Commercial real estate CDOs often contain so many different types of risky debt that quantifying the value and risk of the entire pool is challenging. The ratings agencies began rating commercial real estate CDOs in 2004, but they often note that the instruments are highly complex.

Q: Given the challenges that the commercial real estate CDO market is now facing, how likely is it that another similar investment vehicle will emerge in coming years? Will the commercial real estate CDO structure be modified?

A: This credit crisis could easily inspire Wall Street to devise some new investment vehicle backed by commercial mortgage debt. If commercial real estate CDOs were partly born out of the 1998 credit downturn, then such an evolution would seem likely. Undoubtedly, both the CMBS and commercial real estate CDO markets will continue to adapt to changing market conditions and standards.

Q: What is the connection between the residential mortgage-backed securities (RMBS) market and CMBS market?

A: RMBS predates CMBS by roughly four years and was born out of the multi-billion dollar savings and loan crisis of the 1980s. After roughly $150 billion in home mortgages defaulted, liquidity dried up for thousands of thinly-capitalized banks. The securitization of these home loans helped bring needed liquidity back to the market over a period of several years. The RMBS template was then adapted for commercial mortgages in the early 1990s during an economic recession.

The mechanisms governing commercial and residential mortgage-backed securities are similar, though each has vastly different underlying collateral. While commercial properties such as office buildings and shopping centers generate income from multiple tenants, single-family homes rely on monthly mortgage payments. RMBS are also more vulnerable to pre-payment risk, when borrowers pay off the entire mortgage before it has fully matured.
Parke M. Chapman is senior editor.

HALLMARKS OF DOMESTIC CMBS vs. CDO'S

While commercial real estate CDOs and commercial mortgage-backed securities share many similarities, they also are distinguished by several key structural differences. Here are a few.

Feature CDO CMBS
Incorporation Offshore (Cayman Island) Domestic (Delaware)
Collateral Secured and unsecured debt Short- or long-term maturity Derivatives Mortgage debt only Short- or long-dated maturity No derivatives
Collateral quality Usually below investment grade Investment grade or lower
Interest-only tranche Rarely Common
Collateral management Collateral can cycle in and out None
Source: Citigroup