CMBS Markets More Hardy Than Doomsters Speculated

New Issuances, Active Secondary Market, Increased Modifications Pave the Way for Stronger 2011
January 12, 2011

All things considered, 2010 wasn’t such a bad year for the commercial mortgaged-back securities (CMBS) market. Predictions earlier in the year of a CMBS tsunami of defaults flooding the market largely missed their mark. Delinquencies, which were forecast to hit 12% by 2012, now seem likely to top out at right around 10% this year.

And issuance last year tripled from 2009’s anemic $5 billion to $16.1 billion in 2010, with 40% of the year’s issuance occurring in the last quarter of the year – a much faster recovery than many anticipated, according to Christopher T. Moyer, an associate with Cushman & Wakefield Sonnenblick-Goldman LLC.

“Absent a spike in Treasury rates, our sense is that ‘the Street’ is so anxious to push this product, and investors are sufficiently interested in the yield premiums they’re getting in CRE debt, that issuance will be at the high end of that range, or higher,” Moyer said.

“Three major factors contributing to the stabilization of the CMBS delinquency rate,” David Tobin, principal of Mission Capital Advisors in New York, told CoStar. “New originations have helped reduce overall delinquency. Conduit programs have re-started or started anew because of the pending maturity avalanche that is expected, because secondary market performance of CMBS has been strong following the credit implosion, and because firms perceive CMBS to have less credit and regulatory risk than RMBS [residential mortgage-backed securities].”

Lower interest rates also allowed for flexibility, Tobin added.

“Modifications, new originations and discounted payoffs are all able to be financed by virtue of the even lower rate environment today,” he said. “And resolution rates are accelerating. Modifications, loan sales and foreclosures are all accelerating. By our measure, advisor-led special servicer loan sales increased from 2009 to 2010 from $554 million to $3.01 billion or 543%.”

Special Servicers Speeding Up Loan Resolutions

Xiaojing Li, senior financial analyst in CoStar’s Boston office says, “the bucket of current CMBS delinquent loans is heavily loaded, with $60 billion of unpaid balances. Close to half of that bucket – $26.6 billion – consists of loans in foreclosure or REO. Not surprisingly, most of the bucket contains soured loans originated from 2005 to 2007.”

Going forward, analysts expect two factors will determine the size of the bucket of delinquent loans: the rate at which previously performing loans become delinquent each month (thereby adding to the delinquency balance), and the rate at which special servicers resolve delinquent loans each month via liquidations or modifications.

“While the first driving factor may not moderate in the near term, the second factor has improved dramatically recently,” Li detailed. “As the volume of distressed loans peaked at $89.4 billion by the third quarter of 2010, the average cycle time for the cumulative $28.4 billion of loans resolved by special servicers since 2009 has improved over that time.”

“The declining cycle times suggest that after two years of dealing with a growing volume of bad loans, special servicers are getting more efficient in resolving troubled loans. It also appears they are supplementing their standard toolbox of resolution options (modifications, note sales, liquidations, etc.) with some creative solutions to maximize the return to investors.”

For example, Li noted, one new approach is to put a distressed asset into receivership and allow the receiver to sell the asset directly, with an assurance to potential buyers that the debt is already in place; i.e., the buyer assumes the modified CMBS mortgage loan.

“As property values turn up more broadly in 2011 and loan resolution cycle times decline further, the ratio of newly delinquent loans to resolved loans will continue to fall,” Li said. “As that momentum continues, that ratio will fall below 1.0, and the overall delinquency volume will begin to fall in 2011.”

Li added one caveat, however – it may take longer this year to resolve loans.

“The majority of loans that have defaulted since 2009 haven’t been resolved yet,” she said. “Since better loans get reinstated or resolved more quickly than loans with bigger problems, the average resolution time could increase when more loans eventually get resolved.”

Investor Appetite Returned

Will Sledge, managing director of sales & trading at Mission Capital Advisors, said the use of CMBS loan sales has increased markedly over the past 12 months.

“The willingness of special servicers to utilize the loan sale process versus other workout or liquidation scenarios likely stems from or correlates to the steep influx of assets serviced by the respective special servicers and the human resources required to manage the loans and the speed at which loans can be sold (6 weeks) versus modified or, foreclosed, listed and sold via traditional REO methods (several months),” Sledge said.

Also Sledge added, “the investor communities increasing aggressiveness in terms of pricing (which is likely the result of the sense that the worst is behind us and the market’s floor has been reached) has also sparked loan sales.”

“Investor appetite remains very strong for CMBS debt,” Sledge said. “Generally speaking, investors tend to chase CMBS loans secured by the following (listed in order of preference) multifamily, office, retail, hospitality, mini-storage, industrial, manufactured housing, healthcare, then other).”

The tie in between Treasury rates and investor demand was evident late in the year, though. The aggregate value of commercial real estate (CRE) loans priced by DebtX that collateralize CMBS decreased to 80.3% as of Nov. 30, 2010, from 80.9% as of Oct. 29, 2010. Loan values were 77.7% as of Nov. 30, 2009.

“The decline in the value of commercial real estate loans in November was due primarily to an increase in Treasury rates,” said DebtX CEO Kingsley Greenland. “Rising Treasury yields were partially offset by tighter whole loan spreads for higher quality assets.”

Issuance Volume Likely To Continue Increasing

With momentum in mind, industry veterans are forecasting 2011 CMBS issuance to total anywhere from $35 billion to $50 billion, reported Annaly Capital Management Inc. in its latest monthly commentary. Most expect investment banks to team up with other specialty finance lenders and securitize mortgages as soon as practical

“Structurally, there were some improvements to 2010 CMBS transactions. Credit enhancement went back to 2002 and 2003 levels of 18% to the AAA class, a welcome relief from the aggressive levels for 2006 and 2008 vintages,” Annaly reported. “We anticipate some pressure to subordination levels in 2011 as originators compete for product.”

Annaly estimates that approximately $300 billion of commercial mortgages will mature during 2011. Nearly 70% of that amount is attributable to the banks and thrifts and another 20% to CMBS and the balance to life insurance companies.

Banks’ balance sheets have been mending and as a result they have an increased desire to add commercial real estate loans to their portfolios. That activity, coupled with a resurgent CMBS market and better life company allocations, should result in sufficient funds for those projects which are financeable, although we may see more ‘amend, extend and pretend’ programs for over-levered commercial real estate,” Annaly reported.

Increased CMBS Issuance Leads Moderating Delinquency Percentage

Delinquencies closed out 2010 at 8.23%, though they have moderated in recent months, according to the latest Loan Delinquency Index results from Fitch Ratings.

While U.S. CMBS delinquencies are down from the high of 8.66% reached in September 2010, Fitch projects late-pays to peak at or near 10% within the next year. This is a notable markdown down from Fitch’s original forecast of 12% by 2012. Several factors should work to keep the index near 10% despite continued defaults of highly leveraged loans, according to managing director Mary MacNeill.

“Property market fundamentals are stabilizing and liquidity is returning to the market, allowing special servicers to resolve an increasing number of loans,” MacNeill said.

An increase in new CMBS issuance for 2011 will also help to offset amortization and repayments, keeping the universe size relatively stable. In 2010, the size of Fitch’s rated universe shrank by approximately $36 billion as principal was reduced.

Improved CMBS Market, Not Necessarily Good News for CRE Yet

Trepp LLC, a provider of CMBS and commercial mortgage information, analytics and technology, put the December delinquency rate at 9.2%. If defeased loans were taken out of the equation, December’s overall delinquency rate would be 9.74%, up 26 basis points from November.

“Many have speculated that between the emergence of new CMBS lending, the resolution of many troubled CMBS loans and an uptick in trophy property sales, that the commercial real estate crisis was nearing its final stages,” said Manus Clancy, managing director of Trepp LLC. “The December delinquency rate underscored that there still may be some nasty surprises in store even as the market shows some signs of healing.”

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