Reports about the death of CMBS have been exaggerated, it appears. Following a year of inactivity, issuance from three single-borrower CMBS deals has hiked up expectations for the sector heading into 2010.
Market participants anticipate that 2010 will be a transitional year in which new CMBS issuance could rise to $15 billion, after 2009's total of more than $2 billion, pushing issuance back to mid-90's levels.
And in the new and improved CMBS avatar, it is likely that structures will be tweaked to better provide investor protection.
"The next year or two will be a transitional period, from between the last market and maybe a more healthy, normal market a couple of years out," said Tad Philipp, chief risk officer/managing director, CWCapital Investments.
"I think we will still be working off some of the excesses of the last few years," Philipp noted that some classes on the three recent deals - Developers Diversified, Fortress Flagler, and Inland - were actually oversubscribed.
"The view is that we might be at the bottom or very close to it," Philipp said. "And transactions done at the bottom tend to perform well. Investors are now beginning to come out of their defensive posture and assume a little more of a risk profile. The last month or so has been a real turning point."
While this bodes well for the outlook, there still remains a constraint in terms of finding collateral to back deals.
Lisa Pendergast, a CMBS strategy and risk analyst/managing director with Jefferies & Co., said, "While we now know that there is demand for the product, the most difficult and challenging aspect for 2010 will be finding and sourcing the product because there aren't that many loans that can withstand the limited amount of leverage that's afforded on some of these better quality transactions."
Pendergast expects that details relating to structural issues will be a part of the picture.
There is a certain disconnect in the market considering that there is much more potential to do higher loan-to-value deals than the lower LTV deals that have recently passed muster.
However, to do the higher LTV deals, investors in senior classes of CMBS will want more features that favor them, while junior investors will be reluctant to potentially give up the control necessary to clear the senior bonds.
"You can structure anything to be appealing to people, but it only works if it works," Pendergast said. "If it is such a great structure, if you don't have all sorts of investors to buy the bottom and the top, it is a moot point."
She expects that it is going to be a tug of war trying to determine how to get some of the higher leverage deals through, while keeping the structural needs of some of the investment-grade buyers.
The Federal government-backed Term ABS Loan Facility (TALF) has helped offset some of the market tension this year, putting a floor on the potential decline and beneficially impacting CMBS spread stability and levels.
The program demonstrated that there could be an exit strategy via CMBS provided that underwriting was done conservatively, based on cash flow in place on a property, and conservative leverage levels.
So what is likely to be the impact when the program ends next June, as it is slated to?
Daniel Alpert, managing partner, Westwood Capital, doesn't see any significant impact from the program's ending.
While TALF makes it very easy to do fairly low LTV transactions, such as the recent Developers Diversified deal, it doesn't do anything for higher LTV transactions, as he sees it.
"There is very little collateral out there that isn't leveraged beyond its current value. So in order to have new CMBS issuance, as opposed to rollover of existing debt, you need to free up the collateral and create an environment in which financing can take place," Alpert noted.
One positive sign is that two of the recent deals have been done without TALF support, Philipp said.
TALF aside, there are larger issues relating to the refinancing of loans coming due. In many cases, loans will not be eligible for refinancing.
"If you had an IO loan with low leverage, it might be fine, but in many cases amortization was becoming increasingly rare a few years ago," Philipp said.
Alpert expects that banks and CMBS trustees will grant term extensions and reduced interest rates on loans, in an attempt to push the problem down the road.
"But there's a limit to the extent to which you can kick the can. And one of the problems with doing that is that you are postponing the inevitable, which means the losses will be just postponed to later years."
As Alpert sees it, the bubble in values created in commercial real estate is going to be pretty much erased, wiping out between $350 billion and $500 billion of the approximately $3.5 trillion in commercial real estate debt outstanding.
He expects commercial real estate values in this cycle to decline between 35% and 40% from peak values.
CWCapital's Philipp anticipates that property prices will bottom out in 2010 and have to fall another 5% to 10%.
Also casting a shadow are accounting and regulatory issues that could constrain the sector in 2010.
FAS 166 and FAS 167 requirements will kick in for asset securitizations, requiring consolidation of loans on the books of certain issuers and servicers, with retroactive effect.
This could cause issuers' balance sheets to balloon and impede loan making as capital requirements rise.
One positive aspect Pendergast sees is that in the case of the CMBS sector it is likely to be the 'B' piece buyers and special servicers that hold the first loss piece of a securitization, rather than issuers, that are going to have to consolidate these loans.
In addition, there are regulatory changes afoot in the form of the financial services sector reform proposed by the government.
And Pendergast expects that the CMBS default and delinquency situation is going to deteriorate in 2010, with delinquencies going up to 10% easily from the 3Q09 rate of higher than 4%.
"Unfortunately, loss severity will continue to be very significant," Pendergast said. "The big difference between 2009 and 2010 is that in 2010 you are going to actually see more real estate liquidations. That's something you haven't really seen to date."
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