CMBS Market Splits as Investors Avoid Taking on Risk

Long-Term Outlook Improves but Investors Still Looking for Short-Term Protection

After a promising first half of the year, the CMBS market finds itself back in uncertain territory with the more than $4 billion of new deals currently in the marketplace getting mixed investor interest.

The latest deals all involve public offerings that have been bolstered with extra credit enhancements to appeal to the higher level of class holders. And the appetite for the highest rate portion of those deals (dubbed CMBS 3.0) has been strong.

The downside, though, is that the demand for the lower-rated portions of the deals has been muted, prolonging the expected completion of the full deal.

Not surprisingly, industry analysts are also split over current conditions in the CMBS market and where it goes from here.

"CMBS was in recovery in the spring and it looked like things were on a roll. At the beginning of the year, we thought CMBS volume was going to be $35 billion or maybe $40 billion. We were on the conservative side of that. Right now, its looks like we'll be lucky to cross [the] $30 billion [threshold] for U.S. originations," said John Levy, founder of investment banking firm John B. Levy & Co. in his podcast this week.

"In the spring, things were going so well, we might have thought we could get $50 billion to $55 billion. While $30 billion (for 2011) is certainly less than what we saw in the spring, keep in mind it's triple what we had in 2010, when we only had about $10 billion. We're doing better but we've certainly slowed down; in fact most of the volume this year will be done in the first seven months. Are we as optimistic as we were in April? Nowhere close."

Borrowers looking for a CMBS or insurance loan will find a bifurcated market, Levy said, something that it has "never really seen that before."

"In the spring we could go to the CMBS markets or to insurance or pension fund markets and frankly the deals we would come up with would not be that [different]. CMBS would probably price 25 basis points (bps) or one-quarter of a percent higher than insurance companies, but they were fairly close, they were competitive," Levy said. "Now, we've seen a difference between CMBS and insurance companies of about 150 bps. If you want an insurance company loan, you could get rates in the 4 to 4.5% range. But if you want to go to the CMBS market, it's going to be in 6% range."

"What that has brought about is there are now two classes of borrowers, the haves and have nots. Obviously, to the extent you could access pension fund or insurance capital, why would you go to CMBS? You wouldn't," he said.

Barclays Capital, though, thinks there are some attractive opportunities to be had in the current CMBS market.

Barclays Capital and FundCore Finance Group this week established a new CMBS loan origination and securitization program. Barclays Capital will provide funding to originate conduit loans while FundCore will source loan opportunities. The partnership will look to originate and securitize 5-, 7- and 10-year fixed-rate loans secured by traditional commercial property types in major markets throughout the United States.

"The CMBS business model has dramatically changed and we continue to look at numerous ways to take advantage of this opportunity," said Steve Ball, president of FundCore.

"We have been thoughtful about our expansion into CMBS origination and we believe that the current environment provides us with many opportunities," said Larry Kravetz, head of CMBS Finance at Barclays Capital.

In a global outlook Barclays published this week, the firm noted that investors have shifted to much more bearish positions over the past couple of months, "suggesting to us that parts of the market have sold off sufficiently to warrant some targeted long positions."

Long term, Moody's Investors Service said structured finance transactions such as CMBS deals will perform better than pre-crisis ones as a result of improvements in asset quality and transaction structures, both of which were responses to weaknesses revealed during the crisis.

"Loans included within the current generation of U.S. commercial mortgage-backed securities (CMBS) are considerably less risky than loans originated during the 2006-07 issuance peak," noted Tad Philipp, director - commercial real estate research for Moody's, this week in an extensive report Moody's published on the shifting credit markets post the current credit crisis.

"The financial crisis exposed the consequences of aggressive underwriting by driving CMBS delinquencies to high single-digit levels. The improving risk profile of current originations largely reflects more conservative underwriting applied to bottoming commercial property valuations," Philipp noted. 
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