Anticipation of Delinquencies Keeps CMBS on Hold

MBA (3/21/2008 ) Murray, Michael
Industry participants continue to express frustration as capital market panic and negative headlines overshadow relatively strong fundamentals in the commercial real estate and commercial mortgage-backed securities market.

In its March CBRE Viewpoint, Debt Market Panic Overstates Risk in Commercial Real Estate Market, CBRE/Torto Wheaton Research, Boston, said Wall Street credit markets are overreacting to a likely increase in commercial real estate mortgage losses, because investors could be overestimating future default rates by three times higher than the likely result.

“The anticipated increase in commercial mortgage losses has caused the credit markets to significantly overestimate the potential for future default rates,” said Jon Southard, director of debt management and valuation for CBRE/Torto Wheaton Research. “The reality is that commercial real estate markets remain sound, with low vacancy levels and construction moderate in all but a few markets. Despite the slowdown in the economy, all major property types are expected to have positive—if lower—rental growth rates this year, and buildings’ net operating income should continue to improve.”

However, the CMBS market’s frustration stems from a “disconnect” in pricing based on concerns about refinance risk of recent CMBS vintages that would connect these commercial mortgage loans to subprime loans, based on lax underwriting guidelines.

Industry analysts say commercial mortgage loans do not perform in the same manner as subprime mortgages, and recent questionable loans will not be a factor for at least seven years.

“Current CMBS valuation implies ‘doomsday’ loss rates in which the highest loss rates ever recorded—160 basis points in 1992 —continue for a number of years, and loss rates would need to jump unprecedentedly this year and be sustained at high levels for several years to justify current CMBS pricing,” the report said.

The report said A-rated or higher tranches in CMBX—a set of derivatives that provides insurance against defaults—are particularly undervalued from a credit performance perspective. “Based on real estate market fundamentals the widening of CMBX/CMBS spreads is unjustified,” Southard said.

"At current wide spread levels, the heightened volatility in the [CMBS] market makes buying protection all the more dangerous, particularly given that ever-widening spreads implies higher and higher anticipated losses, on top of what many already view as anticipated losses that exceed reasonable expectations," said Lisa Pendergast, managing director of CMBS at RBS Greenwich Capital, Greenwich, Conn.

Jan Sternin, senior vice president of commercial/multifamily at MBA, said in a recent MBA Executive Podcast that MBA is on Capitol Hill with its members and government affairs team educating policymakers on the commercial real estate finance market.

“The restoration of investor confidence is the most important thing in bringing back the capital markets and bringing liquidity to the market. We’re aware of it—all of our members are aware of it,” Sternin said. “The fundamentals on the commercial side remain relatively solid and if we look at that, there should be, again, a rise in investor confidence that will bring liquidity back. We just have to focus on the fundamentals.”

In its weekly report, RBS Greenwich Capital said CMBS delinquencies rose to 0.51 percentin February from 0.47 percent the previous month, and CMBS delinquencies are “poised to continue to show modest monthly increases, with a strong likelihood that the rate will return to the October 2003 high of 2.5 percent over the next 18 to 24 months.”

“The increase will come from a rise in newly delinquent loans and the slower pace at which seriously delinquent loans are disposed,” Pendergast said. “In historical terms, 2.5 percent remains well below the all-time high in monthly delinquencies hit in June 1992 at 7.5 percent.”

CBRE/TWR’s March report said it expects the cumulative 10-year loss rate for the entire CMBS conduit market to hit 2.53 percent. While analysts expect vacancy rates across all major property types to inch upward for the next few years—with the peak vacancy level around 2009—they will still be lower than the peak in 2002/2003, the report said.

In its Research DataNote released yesterday, the Mortgage Bankers Association said the commercial and multifamily mortgage market faces limited exposure to refinance risks stemming from the credit crunch and relatively few commercial/multifamily mortgages will mature in the next two years.

Meanwhile, delinquencies from life insurance companies were at their lowest during the fourth quarter of 2007, based on data from the American Council of Life Insurers. ACLI said retail delinquencies were at .02 percent; office properties were .01 percent delinquent; and all commercial properties were .01 percent delinquent, based on $303 billion of the life insurance industry’s 2006 mortgage portfolio.

Sternin said delinquencies will remain at record low levels as properties continue to perform. “It’s a record low by a lot,” she said. “It’s not just a little bit above what you would say is the lowest we’ve ever seen. It’s like next to nothing in delinquency and it continues to hold solid. We’ve been saying record low delinquency levels for awhile now.”