What's next for the CMBS market?

By Kemba J. Dunham

As the saying goes, what goes up must come down. That certainly rings true for the commercial mortgage-backed securities (CMBS) market, which after more than 15 years of riding a positive investment wave, swiftly crashed in late 2007. Currently, a recovery has yet to get under way.

CMBS, pools of loans that are sliced up and sold to investors as bonds, were one of the factors that drove valuations and transaction volumes in the commercial real estate industry over the past few years. Since the early 1990s, banks utilized CMBS as a way to reduce the risk on their books and to lend with lower rates and relaxed terms. This allowed private equity firms to purchase large property portfolios—and even whole REITs—using significant leverage. In fact, The Blackstone Group made its record-breaking purchase of Equity Office Properties Trust at the height of the CMBS frenzy in early 2007.

However, during the second half of 2007, CMBS issuance began to subside, thanks to a number of developments. In April of last year, Moody's Investors Service announced in a report titled, "Challenging Times for the U.S. Subprime Mortgage Market," that underwriting standards had become too lax during the real estate frenzy. Many analysts began worrying that the problems affecting residential real estate would spillover to the commercial side. Those warnings caused bankers to tighten lending standards and raise interest rates, which forced borrowers to place more equity into deals. Additionally, unable to continue securitizing loans and remove debt from their balance sheets, banks became less willing to lend.

Industry Standoff

For the past six months, the CMBS market has all but shut down. Lenders, primarily investment banks, are sitting on several loans that are worth far less than their face amount as the value of the collateral has declined. Spreads have widened to record levels, and with huge loan inventories, CMBS issuers are reluctant to make new loans. Many large banks, which had issued short-term loans to finance property acquisitions with plans to sell them later, have been forced to return an estimated $55 billion to $60 billion in fixed- and floating-rate loans on their books, according to J.P. Morgan Chase & Co.

"The main issue is a standoff in the CMBS industry. Issuers don't want to make new loans unless they can sell the resulting bonds to investors, but investors don't want to buy bonds until the spreads have settled down," says Tad Philipp, managing director at Moody's. "More people are sitting on the sidelines and taking a wait-and-see-attitude."

However, it's not just lenders with a backlog of loans for securitizing that are jammed. Even banks that have cleared out their balance sheets and are in a position to issue new CMBS have been impacted by the overhang problem. That's because new loans are priced on the basis of recent CMBS issuance, but because no CMBS are being issued, the valuation of new paper and the potential yield in which it would trade remains uncertain.

"Loan officers who are making new paper don't have the ability to tell borrowers and brokers that they will be able to hold the spread that they are quoting," says Scott A. Singer, the executive vice president of the Singer & Bassuk Organization, a real estate finance and brokerage company. "Borrowers and brokers are reluctant to accept financing from a lending source that isn't sure what the cost of capital is going to be at the time of closing."

So far this year, CMBS issuance has been nonexistent. That's surprising, considering the trend of the past few years, when CMBS issuance in the United States jumped from $77.8 billion in 2003 to $230.2 billion in 2007, according to industry newsletter Commercial Mortgage Alert. Many predict that CMBS issuance will drop by more than 50 percent in 2008.

The Waiting Game

Commercial property sales have dropped in the past year as a result of the shutdown in the CMBS market. During the fourth quarter of 2007, property sales declined 40 percent compared to the same period a year earlier, according to Dan Fasulo, a managing director at Real Capital Analytics. That's due to a disconnect between buyers and sellers over price. However, the trend is largely linked to more expensive debt costs caused by the disappearance of the CMBS market.

"CMBS became a plentiful, attractive source of capital for real estate investors in 2007, representing an estimated 25 percent to 30 percent of the market. When that percentage of the lending market disappears overnight, obviously it will impact debt costs," Fasulo says. He adds that buyers and sellers are now "playing a game of chicken." Buyers are asking sellers to lower their prices because their debt costs have gone up, but sellers are refusing to do so because their occupancy rates are high and rent growth is strong.

Some industry watchers are anxiously awaiting the outcome of several large buyouts to determine where the CMBS market is headed this year. Blackstone is reportedly planning a $9 billion CMBS offering backed by Hilton Hotels in the first quarter of 2008, which will be the largest issuance ever if it goes through. Additionally, nursing home-operator Manor Care Inc. was acquired last year by private equity firm The Carlyle Group for $6.3 billion, a transaction still expected to be financed, in part, through CMBS.

Damage Count

There have already been some companies that may have lost their footing this year as a result of the CMBS market's disruption. Centro Properties Group (ASX: CNP) of Australia, one of the largest owners of shopping centers in the United States, recently found itself struggling to refinance $3.4 billion in short-term debt used to fund its acquisition of New Plan Excel Realty Trust in 2007. Centro is trying to convince its lenders to give it time to restructure its balance sheet. However, since these travails began, the company's former CEO, Andrew Scott, has stepped down, and the company has announced a number of restructuring possibilities.

Another example is the predicament of Harry Macklowe, the New York real estate mogul who bought seven Manhattan office buildings at the top of the commercial real estate market last year in a highly levered deal. After the credit crunch hit, Macklowe struggled to refinance the debt that was due early this year. At press time, Macklowe had reached a tentative deal with Deutsche Bank AG, his primary lender from whom he borrowed $5.8 billion, to turn over effective control of the buildings.

"In the current environment of tighter lending standards, constrained bank balance sheets and more limited securitization exit options, we are likely to see this situation replay itself throughout 2008," says Alan Todd, executive director and head of CMBS research for JP Morgan Securities, a unit of J.P. Morgan Chase & Co.

Investors aren't the only ones taking losses. A number of banks, including Credit Suisse Group and Wachovia Corp., have announced CMBS-related writedowns. Mike Kirby, director of research at Green Street Advisors, says those announcements are just scratching the surface.

"The puny number of writedowns the banks have taken to date on CMBS inventory suggests the banks have yet to fess up to the problem," Kirby says. "However, with regulators, shareholders and a variety of other constituencies breathing down their necks, the banks will not be able to keep this problem under cover forever."

Cloudy Forecast

Goldman Sachs analysts recently estimated that banks could book $23 billion of commercial real estate-related losses in 2008, consisting of writedowns on commercial mortgage-backed securities and collateralized debt obligations (CDOs). CDOs are a complex financing tool that combines various slices of debt, which are subsequently sold to investors.

Where Non-U.S. CMBS are Issued $ Billions
UK	15.9
Other Europe	43.9
Japan	14.7
Canada	2.9
Australia	1.2
Other	0.9
TOTAL	79.5
Source: Commercial Mortgage Alert

Other sources are predicting losses as well. According to Fitch Ratings' latest U.S. CMBS loan delinquency index, U.S. CMBS delinquencies were a low 0.28 percent in December 2007. That number is expected to double, or even triple, by the end of 2008, according to the Fitch report. "Additional economic stress to property cash flows, declining defeasance volume, balloon defaults and the decrease in new origination volume is likely to contribute to the increase," says Fitch Director Michelle Bayard.

The commercial real estate CDO market appears to be in worse shape. Fitch Ratings recently reported that delinquencies on commercial real estate CDOs rose to 0.7 percent in January from 0.64 percent a month earlier. This rate is measured by any loans more than 60 days past due. Commercial real estate CDO delinquencies appear to be much higher than CMBS delinquencies at this point. Fitch has placed approximately $928 million worth of commercial real estate CDO tranches on its "Rating Watch Negative" surveillance review.

Additionally, the disruption of the structured investment vehicles (SIVs) market is a concern to those trying to gauge a CMBS comeback. SIVs are off-balance sheet entities set up by banks to sell short-term debt, some backed by mortgage debt, to fund higher-yielding investments. SIVs have historically purchased as much as 30 percent to 40 percent of the senior tranches of floating-rate CMBS transactions, according to J.P. Morgan's Todd.

The risk associated with SIVs has prompted some banks to move them onto their balance sheets, but those managed by hedge funds have largely been left to fail. Todd believes that because of SIVs' "extremely limited options" at this point, it's unlikely that they will re-enter the market to buy bonds in the near future.

Silver Lining

Yet, some lenders have found a way around the CMBS stalemate. Peter Hauspurg, chairman of real estate investment services firm Eastern Consolidated, says a number of banks are teaming up to divide large loans into slices with each bank then putting the slice of the loan on their balance sheet. "Most banks are reluctant to take any large loan on their balance sheets, but this is a way to get around the CMBS situation," he says. "They'll use them for the duration of the loan, or until the CMBS market recovers."

Those taking advantage of the current downturn in the CMBS market are institutional investors, foreign investors and REITs. These groups, according to Real Capital's Fasulo, which traditionally use more cash to fund their acquisitions, were shut out of the market by the private equity players that utilized a lot of leverage. Since debt has become more expensive, the more cash-oriented investors are finding opportunities in a number of in-demand U.S. cities like New York and San Francisco.

"Eventually, probably sooner rather than later, the banks will need to blow out this paper into a market that smells blood in the water," Kirby says. "The 2007 vintage CMBS product will eventually get sold to bond investors, banks will take big hits and this will lay the stage for the market to resurrect someday. However, the sure-to-be weak pricing of the paper that does get sold will likely mean that bids by CMBS lenders will be uncompetitive for the foreseeable future."

Meanwhile, a number of opportunity funds are already starting to take advantage of the current CMBS situation. Some report that tens of billions of dollars are already being raised. "It may take a new class of investors coming in that is willing to be a little patient and that finds the risk-adjusted returns to be attractive to get the market moving again," Philipp says.