CMBS Tide Turning on Tighter Spreads

MBA (4/25/2008 ) Murray, Michael
Positive sentiment from Wall Street chief executives, synthetic spreads holding tight and a new deal in the commercial mortgage-backed securities (CMBS) market pipeline are giving a reason for some cautious optimism that the CMBS market could be gaining momentum to attract investors.

“If the bulk of asset writedowns may have occurred and the worst is behind us, as was recently indicated by several Wall Street CEOs, it should prove to provide a substantial layer of support for cash and synthetic spreads at the top of the capital structure,” said Alan Todd, head of CMBS research at JP Morgan Securities, New York, adding that there is cautious optimism at the top of the capital structure. “This, in fact, corresponds with our fundamental view that AAA CMBX were trading at spread levels that implied cumulative losses would be three to five times that which we viewed as likely to occur.”

“The spread tightening seen in the CMBS cash markets over the past few weeks is in response to the tightening move in synthetics [as measured by CMBX],” said Lisa Pendergast, managing director of CMBS at RBS Greenwich, Greenwich, Conn.

“This may give some indication that indeed the market fears are beginning to calm and investors are looking to establish a new equilibrium in this context,” Todd said.

He added that it could make sense to "tactically and selectively go long [on] some lower-rated bonds" since cash is trading so much wider than synthetics.

Most industry analysts viewed the CMBS deal from Lehman Brothers and UBS (LBUBS 2008-C1) as the most positive development in weeks—possibly months. The $1.007 billion offer—in the market with 62 loans on 75 properties—included 43.5 percent retail, 23.2 percent office, 13.4 percent hotel and 12.6 percent mixed-use properties.

The properties, in Maryland, Indiana, Alabama, North Carolina and Florida, have a total loan-to-value at nearly 64 percent. The top, AAA-rated class of $48 million priced at nearly 230 basis points over swaps but dropped to 190 bps over swaps, narrowing the gap by 35 bps during the past two weeks.

Informa Global Markets, New York, reported that last week's pricing of the LBUBS 2008-C1 CMBS "showed a level of demand not seen in the market in months."

“Tighter CMBS spreads and reduced volatility are the required elixirs to mend the primary CMBS marketplace,” Pendergast said.

“With the rally at the top of the capital structure fundamentally justified, the significant shift in market sentiment should provide support against any meaningful spread widening and we recommend that investors add AAA cash bond exposure,” Todd said.

Some industry analysts said the Federal Reserve’s assistance in JP Morgan Chase’s purchase of Bear, Stearns & Co. was an “inflection point” that provided corporate investors confidence that the federal government would protect them from a capital markets collapse.

“From a confidence point of view, I thought that it was an extraordinary step,” said Adam Schneider, principal of Deloitte Consulting LLP, New York.

Any celebration, however, could be premature as cap rates and CMBS delinquencies push upward, which could affect commercial property values and market sentiment.

RBS Greenwich expects a “moderate but steady” increase in the CMBS delinquency rate as it reported the fixed CMBS delinquency rate increased two basis points to 0.53 percent in February from 0.51 percent in January and 0.47 percent in February 2007—relatively historical lows.

“Historically, the fixed-rate conduit CMBS delinquency rate has responded to downturns in the U.S. economy, but with a lag,” Pendergast said. “We project the delinquency rate will close out 2008 around the 1 percent mark, still sharply lower than the recent peak in October 2003 of 2.48 percent.”

Moody's Investors Service, New York, said it continues to expect commercial property prices to fall nearly 15-20 percent before bottoming out, but added that the longer average holding time for property sales during the past year contributed to a slowdown in value depreciation.

Industry analysts continue to favor strong commercial real estate fundamentals based on less construction during the recent cycle and a relatively healthy job market. Despite an unemployment rate increase to 5.1 percent last month, U.S. jobless claims fell to their lowest level in two months, down 33,000 to 342,000.

Mary Sullivan Kelley, senior vice president at Meredith & Grew, Boston, said less new construction and overbuilding has helped keep the commercial real estate market, overall, on “firm enough footing.” For the Boston market, she said leasing fundamentals have been strong, particularly in downtown Boston.

“Owners don’t have to sell, and I think they’re comfortable with waiting out whatever uncertainty there is,” Kelley said. “But none of that is translating into a decrease in pricing—although there has certainly been a decrease in volume.”