CMBS Calm Prior to Retail Storm

MBA (5/13/2008 ) Murray, Michael
As volatility begins to subside in commercial mortgage-backed securities (CMBS) spreads, deteriorating fundamentals could be increasing for retail properties.

Some industry analysts said spreads are becoming more competitive since the Federal Reserve provided capital for J.P. Morgan Chase to purchase Bear, Stearns & Co. Inc.

"Despite the positive 'shocks' to the system due to unprecedented actions by the Federal Reserve and other government entities, a fundamental credit problem remains," said Alan Todd, head of CMBS research at JP Morgan Securities, New York. "Aggressive underwriting standards, a weak economy and insufficient subordination at the mezzanine tranche level will ultimately result in losses occurring into the triple-B and triple-B minuses portions of the structure."

"As the CMBS delinquency rate and commercial property fundamentals remain relatively positive, lenders and investors have started to express a sense of cautious optimism. However, whether this translates into a CMBS origination increase is still undecided," said Jere Lucey, managing director of real estate investment banking at Jones Lang LaSalle, Chicago. "One strong obstacle to a true CMBS revival is the ability to effectively hedge fixed rate loans ahead of securitization."

Lisa Pendergast, head of CMBS strategy at RBS Greenwich Capital, Greenwich, Conn., said a standard 10/30 commercial mortgage is 40-50 basis points from becoming competitive with portfolio lender pricing, but the question remains as to whether deal underwriters "will be given the balance sheet to house loans during the aggregation process."

"For now, the answer seems a very likely 'no,'" Pendergast said. "Thus we wait not only for a further tightening move in CMBS spreads, which we don't think will happen to late summer, but also for a period when balance sheets will be in expansion mode, not contraction mode [late 2008]."

Pendergast said the housing crisis combined with job losses, high debt levels and increasing energy costs, negatively affect consumer spending—and retail property. She added that these factors suggest personal consumption would continue to drop and ultimately affect retailers and retail properties.

"What does this mean for CMBS retail loans? Expect heightened volatility in property cash flow and thus greater potential for loan defaults," Pendergast said.

Property & Portfolio Research, Boston, reported that the impact of slow to falling retail sales resulted in rising vacancies, slowing rent growth and more store closings announced during the first quarter. The firm said 3,175 chain store closings were announced in the first quarter, “the most since 2004 when the grocery sector shakeout was peaking."

"At a minimum, we expect the retail delinquency rate to reach the 2 percent level last seen in June 2002, post the last recession," Pendergast said. "However, given that the roots of this recession are declining housing values and the direct negative effect on consumers, we suspect that the retail delinquency rate will surpass that seen in 2002 and climb closer to 2.5 percent to 3 percent."