CMBS market rebounds

Commercial Mortgage Backed Securities (CMBS) issuance this year is far outpacing other private label securitization markets. Notwithstanding continued high default rates and severity rates reported by Standard & Poor's, the CMBS market is rebounding. Despite the continued poor performance of many of the underlying loans in existing securities, the S&P projects that CMBS issuance may reach $35 billion in 2011, a tenfold increase from the lows of 2009 when financing all but dried up. This is good news for the commercial real estate market. The bulk of financing for commercial property owners and developers over the last decade has come from the capital market. Recovery of this financing tool is essential for stabilization of the overall commercial real estate market. We expect this pick-up in financing to gain speed as the economy continues its slow recovery and, importantly, the Federal Reserve pursues a second round of quantitative easing (QE II). The CMBS market recovery has been unique. Since the financial crisis, residential real estate financing has depended largely on government support with over 90% of residential mortgages requiring financing or guarantees made available through Fannie, Freddie, the FHA or other government programs. With the government focused on the larger and politically more important residential real estate market, the upturn in the CMBS market has been largely private sector driven. After reaching a record of $234 billion in 2007, CMBS issuance fell 95% in 2008 to $11.2 billion, cutting off financing to commercial property owners. As investors lost confidence in the economy and scrambled for liquidity, prices for CMBS collapsed and spreads blew out to over 15% in November of that year. The sell-off began with highly leveraged hedge funds trying to meet margin calls, but after the collapse of Lehman Brothers, panic spread to traditional investors including fixed income managers, insurance companies, and banks. Unlike with the residential loan market, however, the government's hands-off approach to commercial loans allowed the CMBS market to perform its core function of price discovery. With prices approaching 50 cents on the dollar, distressed debt investors swooped in, establishing a floor for prices. With record low new issuance, 2009 was a period of consolidation as investors sorted through the wreckage to determine valuations in the new recessionary economy. While consolidation and price stabilization was largely private sector driven, it was supported by the Federal Reserve's maintenance of a near zero interest rate policy since the fall of 2008. By keeping interest rates low, the Fed's accommodative monetary policy has supported prices, buoyed banks unwilling to sell at the bottom of the market, and spurred loan modifications to keep troubled loans current. As 2009 progressed, it became clear that instead of entering a second great depression, as many had feared the economy began a slow recovery. With renewed confidence that the worst was behind us, investors began to purchase riskier assets. This included CMBS. Continued low interest rates fueled demand for high yielding assets. Demand for the most senior tranches has driven prices up and yields down, leading investors looking for yield to buy mezzanine and junior tranches. In this improving environment, new CMBS issuance has become attractive. In the first quarter of 2010, Hartford Financial Service Group, sold $600 million of commercial mortgage loans, citing improved market conditions. By mid-October, the market had absorbed $4.7 billion of new issuance. In the last week of October and first week of November, JP Morgan Chase and Deutsche Bank announced a $2 billion deal and Goldman Sachs brought to market a $2.7 billion deal. Wells Fargo, Bank of America, Morgan Stanley, and the Federal Deposit Insurance Company reportedly plan additional deals for this year. This flurry of activity compares favorably to the residential market, where since the crisis, there has been only one securities offer without some form of government support. Risk still exists for investors. Low rents and high vacancy rates continue to drive defaults. In addition, close to $1.4 trillion of commercial real estate debt will come due by the end of 2014. Many of these loans were originated in 2006 and 2007, when lending standards were lax. We think, however, that these risks will be manageable as the economy improves over time and the Federal Reserve pushes long-term rates lower through the successful implementation of QE II. The Fed announced on November 3, that it would expand its balance sheet by $600 billion by the end of the second quarter of 2011. The Federal Reserve will accomplish this by purchasing US government notes and bonds through open market operations, which is expected to result in an increase in the monetary base and lower rates on 5 and 10-year U.S. treasuries. Increased money supply and lower rates will be positive for market fundamentals (increased demand, lower vacancy rates and higher rents) as well as for financing. With banks, pension funds, and insurance companies all looking to improve their returns, higher yielding, well-structured CMBS should attract many investors. Adelaide Polsinelli is an associate VP at Marcus & Millichap, New York, N.Y.