Academic journal article The Journal of Real Estate Research

Analysis of Yield Spreads on Commercial Mortgage-Backed Securities

Academic journal article The Journal of Real Estate Research

Analysis of Yield Spreads on Commercial Mortgage-Backed Securities

Article excerpt

Abstract

Yield spreads on commercial mortgage-backed securities (CMBS) are defined as the difference between the yield on CMBS and the yield on comparable-maturity Treasuries. CMBS yield spreads declined dramatically from 1992 until 1997, then increased in 1998 and 1999. The relationship between CMBS yield spreads and other variables is estimated in an effort to explain recent trends. Results identify several variables that are related to yield spreads on both fixed-rate and variable-rate CMBS. However, even after controlling for other observable factors, the yield spread on CMBS still declined from 1992 until 1997, then increased each of the next two years. Possible explanations for this phenomenon are explored.

Introduction

The market for mortgage-backed securities (MBS) has grown rapidly in recent years. Initially, Veterans Administration (VA) and Federal Housing Administration (FHA) single-family mortgages guaranteed or insured against default by the U.S. Government supported most mortgage-backed securities. Only after secondary markets for MBS on FHA and VA loans were well established did the secondary market for MBS supported by conventional residential mortgages develop. In 1970, less than 10% of single-family mortgages had been securitized; by 1992, of the $3.1 trillion of residential mortgages outstanding, nearly half were securitized (Fabozzi and Jacob, 1997). The growth rate of securitization of commercial mortgages during the 1990s is roughly comparable to the pattern of securitization of residential mortgages in the 1980s. As of the end of 1990, 9.5% of multifamily mortgages had been securitized, almost entirely by GNMA, FNMA and FHLMC, and less than 1% of other commercial mortgages had been securitized, all by the private sector. By the end of 1999, 58.8% of multifamily mortgages were securitized. (Calculations based on figures in Mortgage Market Statistical Annual for 2000.) The slower pace of commercial mortgage securitization relative to residential mortgages may be related to the fact that very few commercial mortgages (including multifamily) are insured or guaranteed by the federal government.

As the volume of CMBS increases, an issue of interest to investors is how the yields on such securities compare with yields on alternative investments. In the mid-1990s, the trade press noted a decline in CMBS yield spreads (defined as the difference between yields on CMBS and yields on U.S. Treasury securities of comparable maturity) (see, for example, Fathe-Aazam, 1995; Fabozzi and Jacob, 1997; and Zuckerman, 1998). As shown in Exhibit 1, CMBS AAA yield spreads in 1997 were less than one-half the level of 1992. Beginning in 1998, however, CMBS yield spreads began increasing, and in 1999 AAA yield spreads approached 1993 levels. Similar trends are evident for lower-rated investment-grade CMBS, as shown in Exhibit 2.

Yield spreads on a particular class of securities are expected to respond to a variety of factors, including differences in default risk, call risk, taxability, liquidity and possibly other factors. The purpose of this study is to estimate the relationship between CMBS yield spreads and other variables in an attempt to determine the extent to which recent trends in CMBS yield spreads can be explained by changes in other observable variables.

Development of the CMBS Market

There are several reasons securitization developed later for commercial mortgages than for residential mortgages. Until recent years, commercial mortgage lending was a local market, dominated by banks, thrifts and insurance companies. Moreover, as was true on the residential side prior to the creation of the FHA, commercial mortgages lacked consistent underwriting standards, documentation or agency backing, and as a result, did not easily support securitization. GNMA, FNMA and FHLMC have issued multifamily MBS for a number of years, with an annual average volume of $4.9 billion of multifamily MBS during 1985-1991 (Fabozzi, Ramsey, Ramirez and Marz, 1997). …

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