THE COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS) market has grown so much in the last several years that it is becoming the dominant form of financing for commercial real estate, leaving other lending sources lagging behind.
"The CMBS market is worth about half a trillion dollars today," says John Levy, president of John B. Levy & Co. Inc., Richmond, Virginia, a real estate investment banking group. "Ten years ago, it was worth zero. A decade ago, the life insurance industry was the dominant player. Today, it has about $250 billion [worth of commercial real estate loans in company portfolios]" compared to $240 billion 10 years ago, which indicates that the sector's commercial mortgage business hasn't grown very much, says Levy.
Joseph Hu, managing director, global real estate finance research at Standard & Poor's, New York, estimates that the net increase in commercial mortgage debt for 2003, based on second-quarter 2003 data from the Federal Reserve, will be roughly $182 billion--including multifamily mortgages--which is a record. One-third of the capital going into commercial mortgage debt is for multifamily, he says.
"Life insurance companies only contribute about 3 percent of the funding today for new commercial mortgages," says Hu. Thirty-six percent of commercial mortgages are funded by CMBS and 37 percent by commercial banks, he says.
In 2004, CMBS will be the leading source of commercial mortgage originations, Hu predicts.
"If you only look at holdings, life insurance companies still have a lot of loans, but they're not competing in [the commercial mortgage] market" for new originations, Hu says. "The reason CMBS is taking over is that [originators of loans going into CMBS pools] are offering better deals in terms of rates and terms, and they are making loans faster than insurance companies," he says.
"Life companies are usually more conservative underwriters and they are often interested in a lower leveraged transaction," says Levy. On the plus side for insurance companies, from the borrower's standpoint, he says, "they offer a more personalized approach to servicing."
Even with the decline in commercial mortgage originations by life insurance companies, large life companies are still investing 15 percent to 20 percent of their total invested assets in commercial mortgages today, says Jose Siberon, director of financial services ratings at Standard & Poor's. While that range hasn't changed over the last 10 years, he says, it is a big range and today it is closer to 15 percent than 20 percent. These companies invest another 6 percent to 10 percent in CMBS, and that allocation is growing, says Siberon.
"In the last two years, it has become more competitive [for life companies] to invest in direct commercial loans," says Siberon. The yields are less attractive as more banks and insurance companies compete for this business, he says. As a result, buying CMBS has become more attractive to insurance companies.
"All assets are getting tougher to buy," says Siberon. "Spreads are tightening in corporate bonds, so a lot of companies are looking for alternative asset classes, including CMBS."
CMBS volume down in 2004
Although the popularity of CMBS has grown over the last couple of years, the issuance for 2004 is expected to drop about 10 percent from last year. The reason for this, according to Jeff Mudrick, senior vice president of commercial mortgage research at Lehman Brothers Inc., New York, "is that we think interest rates will be higher by the end of the year. This [development] will push the amount of issuance down, because there will be fewer real estate acquisitions," he says.
For 2004, Lehman is predicting that there will be $70 billion of CMBS issuance in the United States and an additional $22 billion in foreign markets, says Mudrick. This compares with $82 billion in the United States in 2003 and another $20 billion worldwide, he says.
If you can't beat them, join them
If life insurance companies are not making as many whole loans in the commercial real estate arena, they are participating in the CMBS market--not only as buyers but, in some cases, as originators of loans for mortgage pools.
Kevin Riordan, managing director of commercial real estate securities at Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), New York, says that large life insurance companies, such as Prudential Life Insurance, Principal Financial and John Hancock, as well as TIAA-CREF, have been actively originating mortgages for securitization since 1998 or 1999.
Since 2001, TIAA-CREF has had an active program to securitize some of the mortgages the company originates, says Riordan. In 2003 at TIAA-CREF, $600 million in commercial mortgages was committed to a mortgage acquisition/securitization program, he says, "and we sold about 30 percent of those loans, or $150 million worth of commercial mortgages, compared to $120 million in 2002 and $120 million in 2001." TIAA-CREF also originated $3.5 billion worth of mortgages for its own portfolio in 2003, he says.
In the future, says Riordan, TIAA-CREF expects to increase its level of securitization. There are a lot of reasons for life companies to securitize their loans, he says, but at TIAA-CREF securitization is good for profitability, as well as to gain liquidity and to verify pricing.
"If we get a good price, that verifies that we did a good job in originating the loan," says Riordan. Plus, the process makes TIAA-CREF a better investor when the company buys CMBS itself, because "we get to see both sides of the business," he says.
In spite of TIAA-CREF's activity in the CMBS market, "Few large insurance companies originate CMBS loans, because it is not their business," says Siberon. "But because of their expertise in buying commercial loans, they can alleviate some of their risk by packaging more of these loans," he says. "Not a lot of insurance companies originate loans for pools [to create] a profit center."
The small and midsized life companies are more likely to invest directly in CMBS rather than originate loans for conduits themselves, says Siberon.
CMBS a preferred investment
Historically, the CMBS market had been viewed as one of the riskier types of credit investments available, but after this asset turned in a good performance during the recent recession, its status has been elevated to one of a preferred investment, according to Patrick Corcoran, CMBS analyst at JP Morgan Securities Inc., New York.
"There have been few credit problems at the loan level, and that has meant also at the bond level," says Corcoran. "With investment-grade, BBB or higher, there have been almost no defaults," he says.
CMBS versus corporate bonds
The CMBS market has been attracting a broader base of investors in the last couple of years because of what is happening in the corporate bond market, says Kenneth Cohen, managing director at Lehman Brothers. "There are a lot of issues regarding corporate bonds," he says.
"The CMBS market has performed beautifully, and there are no surprises," says Cohen. "A lot of money managers have shifted out of corporates into structured products such as CMBS."
"The performance of the CMBS market over time is better and less volatile than corporates," which are "more volatile in terms of spread movement," says Mudrick.
Not everyone is abandoning the corporate bond market in favor of CMBS, of course. "The point is that we're in a cyclical market," says Levy. "Last year corporates did very well, but because they did well, some people think that is all there is. But investors have to make judgments about the future. It looks like CMBS is a better value today because they have a better yield, so they are less expensive" than some other investments, he says.
"If you look at Lehman Brothers' U.S. Aggregate Index for bonds, the best-performing assets in 2002 were CMBS," says Cohen. That year, the CMBS total return on investment was 15.3 percent, and the so-called excess return over Treasures was 2.1 percent, he says.
Last year, CMBS was second-best to corporates, with a 4.66 percent total return and a 2.01 percent excess return. One of the reasons that returns were so high in 2002 was that there was a cut in interest rates, which causes bond prices to rise.
Although the CMBS market competes with corporate bonds for investor dollars, the corporate market is a lot bigger than the CMBS market, notes Mudrick. The former will issue about $300 billion this year, he says. In comparison, last year--a peak year for CMBS--there was approximately $100 billion in CMBS issuance, he says.
In the Lehman Brothers' U.S. Aggregate Index for bonds, corporate bonds account for between 26 percent and 27 percent of the total, while the CMBS sector accounts for only 2 percent to 3 percent, says Mudrick. CMBS have only been securitized since the mid-1990s, while the corporate market has been around for much longer, he says.
REITs versus CMBS
"CMBS bonds are trading at the tightest spreads in years," says Brian Lancaster, managing director of CMBS and real estate research at Wachovia Securities, Charlotte, North Carolina. "They still look more attractive than REITs [real estate investment trusts]," although with the economy getting better "they may not do as well this year as last, because they've tightened so much already," he says.
One reason CMBS is a better bargain than REIT bonds, says Lancaster, is that while REIT and CMBS are both dependent on commercial real estate fundamentals, which are soft today, REIT debt is more expensive than CMBS.
"Investors compare and contrast REIT bonds, which are unsecured paper, to CMBS, which is secured," says Mudrick. "Most of the REIT bonds are BBB. Lots of investors look at those versus CMBS BBB bonds to see which have more value--which is mostly tied to how tight the spreads are--but those values ebb and flow," he says.
"A BBB REIT [bond] trades like a single-A CMBS bond," says Lancaster. "REIT debt looks rich compared to CMBS."
One reason why many investors prefer the CMBS market to REITs today, says Mudrick, is that when investors buy CMBS, they are picking up a broad exposure, while a lot of the REITs are more concentrated because many specialize in one sector, such as office or retail. In CMBS bonds, there is more diversification, notes Mudrick.
Discipline by CMBS lenders has held up
"Despite the amount of demand we're seeing, lenders have held the line on LTVs [loan-to-values] and debt-service coverage ratios," says Mudrick.
"The fact that the B-piece buyers [who buy below-investment-grade bonds] have continued to play an important role in policing issuers since 1998 has meant that there are no increased credit risks," he says.
"Investors want to see rent rolls and occupancy and leasing rates," says Lisa Pendergast, managing director with RBS Greenwich Capital, Greenwich, Connecticut. "The level of information for AAA buyers is the same as for B-piece buyers today," she says.
Investors have definite opinions about the kinds of collateral they will accept in a loan pool. "Multifamily, followed by office--especially suburban office--are property categories that investors don't want to see in CMBS bonds today," says Pendergast.
What do investors want?
For the longest time, retail has been one of most coveted assets, says Pendergast. "While that is still the case on a macro basis, on a regional level investors are concerned about grocery-anchored centers because of Wal-Mart's impact on smaller regional grocers," she says. "This concern started last year and will continue."
"Single-tenant retail still causes consternation," says Pendergast. "But today, investors are willing to accept the retailer if the dirt is valuable. They don't want a single retail property in the middle of nowhere, but if a single tenant is in a good location, they'll accept it because they've seen things get worked out for troubled retailers," she says.
Investors have gotten used to volatility in retailing, says Pendergast. JC Penney Co. Inc. and Kmart Corporation are also having their problems, she says. Given all the uncertainty in retailing, developers are building less space, thus keeping a lid on retail supply, says Pendergast.
Delinquency rates still low
In spite of softness in some commercial real estate sectors, delinquency rates are still relatively low, according to CMBS Loan Delinquency Rate Ramps Up as Leverage Increases, a Nov. 13, 2003, special report on structured finance issued by Moody's Investors Service, New York.
Using data through second-quarter 2003 gathered by Trepp LLC, a New York-based CMBS data and analytics firm, Moody's found that, out of a pool of 42,888 loans with a total value of $284.7 billion, or approximately 60 percent of the CMBS universe as defined by the Federal Reserve, the delinquency rate as measured by the value of the loans was 1.5 percent, and 1.8 percent as measured by the total number of loans.
Delinquencies are higher among loans with more leverage, according to the Moody's study. But delinquency by loan size follows a classic bell-shaped curve, with midsized loans--those between $3 million and $10 million--having higher delinquency rates than either smaller or large loans.
An analysis of the leverage of loans of various sizes generates a "bowl-shaped" curve, with larger and smaller loans tending toward less leverage while more midsized loans have slightly higher leverage. This finding attests to the correlation between leverage and delinquency, according to the Moody's study.
About half of the loans in the CMBS universe that Moody's studied were less than $3 million, but they represent 12 percent of the value of all CMBS collateral. Therefore, analyzing delinquency only by the number of loans puts a disproportionate emphasis on small loans.
In addition, looking at delinquency from the standpoint of the numbers of loans alone, rather than by their value, will result in certain property types being over-represented, especially multifamily and industrial. The loans associated with these property types tend to be more numerous, but smaller.
One of the best ways to avoid problems, should a loan be delinquent or in default, is to parcel out the risk. "Large loans--those over $50 million--will often be split into junior and senior pieces," says James Stouse, vice president, Bank of America, Charlotte, North Carolina. "The junior portion would be sold to an insurance company, which takes more risk because they are real estate-savvy," he says.
Deals that feature very large single assets in the $100 million range and above are rare today, says Corcoran.
"The World Trade Center bonds were a single-asset deal, but after 9/11 the experience with terrorism insurance and a lot of corporate businesses getting into trouble highlighted single business risk. As a result, more and more larger loans have been combined with smaller loans in what are called fusion deals," he says. But some loans are so big, even putting them into fusion deals doesn't always solve the problem of too much risk lumped in together, says Corcoran.
"Three years ago, in a typical conduit transaction, the top 10 loans accounted for 25 percent of the pool. Today, we're seeing average conduit transactions with 45 percent to 50 percent in the top 10 loans [by size] on average," says Corcoran. "And some have up to 65 percent of loans in the top 10. One of the things the market is grappling with is the lumpiness of what were previously generic conduit deals.
"With larger loans accounting for up to 65 percent [of the pool], there is less diversification," says Corcoran. "In a classic conduit transaction [with as many as 150 small loans], if a couple of $5 million deals go bad in a $1 billion deal," the loss wouldn't be that great, he says. "The investment-grade bonds are protected by below-investment-grade bonds," which have the first loss, which, in the past, may have only amounted to a couple of $5 million loans. "But if you have a couple of large loans of over $100 million, then every one is impacted" if the loans go bad, says Corcoran.
Because fusion pools are more sensitive to the performance of larger loans, "these deals have had more scrutiny from bond buyers," says Corcoran. "If an agency gives an opinion that a large loan had an A rating and then that loan is downgraded, that could apply to the bonds themselves," he says.
"In the past, if you had a huge office property in New York with a $600 million mortgage, you carved out bonds, maybe 70 percent of which were AAA and the rest below AAA," says Corcoran." Sometimes insurance companies liked these deals" because they've done a lot of credit analysis and so they are comfortable with large real estate loans, he says. "But for AAA bond buyers, they have always relied on ratings, says Corcoran. When they weren't buying CMBS, they would buy Treasuries, [interest rate] swaps and [other] AAA bonds," he says.
"Today the market is so skittish about large loans," said Corcoran, "that a $600 million loan would be carved into pieces and put into four or five conduits," and inter-credit agreements are then drawn up that dictate the order of events, if there is a problem with the loan, he said. But these kinds of arrangements only increase the complexity which could lead to other problems, said Corcoran.
While investors in real estate debt are trying to insulate themselves against future catastrophes, vacancies in commercial real estate are approaching 1991 levels, according to Structured Products Research: CMBS and Real Estate--Rates, Real Estate and Real Estate Securities: Outlook 2004--A New Paradigm Emerges, a Wachovia Securities report dated Dec. 23, 2003. Yet "total returns from real estate have outperformed those of the last recession because of strongly property valuations," according to the Wachovia Securities report.
"Superior real estate valuations and lower debt costs have greatly benefited commercial mortgage performance, whether off-balance-sheet; in the CMBS market; or on-balance-sheet at banks and insurance companies, where loan delinquencies remain a fraction of 1990-1993 levels," the Wachovia Securities report states.
Hortense Leon is a freelance writer based in Miami. She is a regular correspondent for the Florida Real Estate Journal. She can be reached at firstname.lastname@example.org.…