Investor interest in commercial-mortgage-backed securities, CMBS for short, has run hot and cold since the securities first appeared a dozen years ago. In today’s risk-averse market, they are very much in vogue. Investors appreciate that the asset class sports one very attractive feature: a relatively low rate of default and delinquency, at a time when corporate bankruptcies and defaults are near record highs.
According to Standard & Poor’s, CMBS delinquencies were running at 2.1 percent at the end of November, down from 3.8 percent at the end of the fourth quarter of 2001, although higher than the 1 percent average that prevailed at the end of 2000. CMBS defaults rose from 1.02 percent in 2001 to 1.80 percent through August, according to Fitch Ratings -- a more modest jump than might be expected given the weakness of the economy.
Of the roughly $345 billion of CMBS issued since 1990, only 11 offerings became delinquent or went into default. That translates into a cumulative default rate of 0.17 percent: not too shabby, especially since corporate bonds experienced a default rate of 3.77 percent between 1980 and 2001, according to Moody’s Investors Service.
In late October newly issued triple-A CMBS were yielding approximately 5.1 percent, about 85 basis points less than comparable corporate bonds. According to research from Salomon Smith Barney, triple-B CMBS in late November were trading 17 basis points behind like-rated corporate bonds, well inside the one- and three-year averages of 33 and 41, respectively. “CMBS have performed well because delinquencies have been moderate,” says James Stouse, director of CMBS research at Banc of America Securities. “Also, the ratings have been very durable.” CMBS typically have multiple tranches, with most deals offering three-, five-, seven- and ten-year bonds. “Investors can access the asset class in a very highly diversified security format,” says Michael Hoeh, a CMBS portfolio manager at Dreyfus Corp. “It’s a very liquid market.”
An estimated $70 billion in CMBS is expected to be issued this year, up from $50 billion in 2000 and more than triple the $20 billion issued in 1994.
The CMBS sector was born out of the industry excesses of the late 1980s, when developers built properties on spec, resulting in a wave of loan defaults when the real estate could not be sold or rented in the recession of the early 1990s.
As in a single-family residential mortgage-backed security, in a CMBS all of the principal and interest payments on underlying loans are passed through to the bondholders using a sequential payment order. While prepayments can be a big risk for residential mortgage-backed securities, on CMBS the underlying mortgages usually have prepayment lockouts or high prepayment penalties.
A typical CMBS deal comprises 200 loans, each of which has as many as 15 corporations behind it. The loan package is diversified, both geographically and by property type. “It’s rare that you get a concentration of 20 percent or more in one state,” says Darrell Wheeler, director of CMBS research at Salomon Smith Barney.
Investors appreciated this diversification when several major corporate bankruptcies hit the bond markets this year. One example: While Kmart Corp., which filed for bankruptcy protection in early 2002, is the largest retail tenant in CMBS deals, no offering had more than a 1 percent exposure to the retailer, says Roy Chun, an analyst at Standard & Poor’s. “No deals with Kmart exposure had to be downgraded,” he notes.
Can the low rate of defaults and delinquencies last? Analysts and consultants are divided on this critical question. Steven L’Heureux, a Boston-based real estate consultant, expects that the current economic downturn will increase defaults and delinquencies in the coming year. His prediction: a CMBS default rate that rises as high as 3 percent over the next year.
