Even the most exuberant projections proved to be tame. After a record $90 billion of U.S. commercial-mortgage-backed securities were issued in 2004, market watchers figured CMBS issues would reach $100 billion in 2005 -- $130 billion at the outside. Instead, the total was $169 billion.
“The market has just exploded,” says Jonathan Strain, a 13-year Morgan Stanley veteran who until last month ran the firm’s CMBS distribution and trading desk in New York. Morgan Stanley is the second-largest CMBS player, with $20.8 billion in issuance in 2005, after J.P. Morgan Chase, with $21.9 billion. This summer Strain will join Dillon Read Capital Management, a new alternative-investment group at UBS in New York.
Will this year see another CMBS surge? Many of the same factors that propelled past gains are intact: an active property investment market, an abundance of capital and still-low interest rates. Experts project CMBS issuance to total $230 billion for 2006 -- not quite as dramatic a gain as last year’s, but still pretty impressive.
Plainly, CMBS appeal to issuers and investors alike, although the securities have been getting riskier lately because of fierce competition among lenders to get in on lucrative commercial mortgages.
CMBS issues now account for about 20 percent of the more than $2.5 trillion in commercial real estate mortgage debt; a decade ago the share devoted to CMBS was 5 percent.
Borrowers like the securities because the issues tend to be roughly 25 basis points cheaper than loans from banks or insurers. But with the attractive pricing comes greater scrutiny: The ratings agencies closely review CMBS transactions, as do so-called B-piece buyers that invest in lesser-quality bonds. The buyers have considerable power to disapprove of a suspect loan’s being included in a CMBS pool.
Investor demand has been stoking the CMBS market. “Driving the high issuance is really the amount of institutional capital coming into the real estate market,” says Susan Merrick, a managing director who heads Fitch Ratings’ CMBS credit analysis group in New York. “Pension funds are looking to put money into real estate -- but not necessarily by buying properties. There’s an awful lot of money that’s looking to be invested in real estate in any form.”
CMBS have done well by investors. Estimated returns for triple-A-rated ten-year CMBS are currently running 7.1 percent. Moreover, the securities’ average loan-delinquency rate, at 0.84 percent, is as low as it has been since 1999.
Yet as recently originated mortgage loans mature, they may pose risks for CMBS holders. Competition among lenders to place capital in commercial mortgages has pushed up leverage.
Fitch Ratings reports that the average CMBS transaction in 2003 had a loan-to-value ratio of 80 percent; today it is 95 percent. In addition, notes Roy Chun, a credit analyst and managing director in the structured-finance surveillance group at Standard & Poor’s, CMBS pools include more interest-only loans. The danger of such loans, he says, is that when they mature, the borrowers may not be able to refinance the full amount, given that they did not pay down any principal, as they would have with a normal amortizing loan.
Chun also points out that the commercial property market looks frothy to some observers. “You have some incredible valuations,” he remarks.
Morgan Stanley’s Strain sums up the current dilemma for CMBS investors: “If money continues to pour into the sector and asset values are stable, everyone will be fine. But if rates go up 300 basis points quickly, or if rates go up and real estate doesn’t appreciate, there could be some problems.”
