High Expectations for CMBS Market

We're hard-pressed to envision the commercial real estate crowd being any happier than it was in 2004. Commercial mortgage originations were up on both the securitized and whole-loan side, with the former up a whopping 19% over last year's record performance. Loan delinquencies were a pretty sight as well, according to Trepp Research LLC, declining from 1.69% at the beginning of the year to 1.18% at year's end. Combine those two events with a 10-year Treasury yield which showed incredible volatility — a swing of 120 basis points from high to low — and you've got enough events to cause a run on the stock of rose-colored glasses at Neiman Marcus.

Last June, we convened a group of industry experts to forecast issuance volume and triple-A spreads for the second half of the year. They turned out to be a conservative lot, a trait generally not found in real estate folks. On average, our panelists predicted that domestic CMBS issuance volume would total $82 billion — a whopping $21 billion less than the final tally. Derrick Wulf, senior vice president of Dwight Asset Management, wasn't swayed by his colleagues, and his forecast of $99 billion was only slightly off the mark. He also won last June and his attempt to three-peat is shown on the attached table.

On the spread side, the gang was much more pessimistic than actual events, projecting that spreads would be at 36 basis points over the 10-year interest rate swaps as opposed to the actual of 26. However, Marc Peterson, investment director with Principal Global Investors, came close with his projection of 28 basis points.

Our new forecasters, evenly divided between buyers and sellers of commercial mortgage-backed securities, are expecting the trends to continue with a projected first-half issuance volume of $51 billion, just slightly ahead of the same period last year. This is in spite of the fact that our panelists are expecting the yield on the 10-year Treasury to increase an average of 40 basis points. The group expects super senior triple-A spreads to stay close to their current level, and is forecasting an average spread of 25 basis points.

At least two major themes appeared in 2004, and they appeared somewhat related. Lenders and CMBS buyers complained bitterly during the year about the deterioration in underwriting standards. When “money chases deals” underwriting always suffers, and last year was no exception. Perhaps the most visible evidence of the deterioration was the striking increase in the number of interest-only loans.

Heretofore, most commercial loans amortized over a 25- to 30-year period, with an interest-only loan only reserved for an unusual circumstance. As recently as 2002, only 10% of the loans had an interest-only portion, according to Citigroup. But that skyrocketed in 2004 to more than 39%. To be sure, interest-only loans are fine as long as real estate values stay firm or increase. But institutional lenders argue that increases in interest-only loans added more leverage to an already highly leveraged industry.

Subordination levels — the percentage of bonds rated below triple-A — declined simultaneously. In 2004, only 14% of the average securitization was rated below triple-A, down dramatically from 20% in 2002, according to Morgan Stanley. Some securitization buyers balked at the combination of higher leverage loans and lower subordination levels, which prompted Credit Suisse First Boston to come out with a new super senior triple-A tranche in October replete with a 20% subordination level. Crossover buyers, who were unable to find an adequate number of corporate bonds due to a sharp decline in their issuance, flocked in to buy up the new super senior tranche.

John B. Levy is president of John B. Levy & Co. Inc. in Richmond, Va. © Dow Jones & Co. Inc., 2004.

THE SPREADS AHEAD