The old adage of one man's junk is another's treasure could be the best way to describe the situation that is creating a schism in CMBS land today.

As the paper's traditional holders brace for more defaults ahead, commercial real estate (CRE) loan portfolios are turning out to be a good investment for buyers attracted to the current appraisals on these assets.

"Basically, if you bought real estate assets at values extracted in 2006 and 2007 and hold them now, you are feeling pain," said Malay Bansal, head of portfolio management and advisory for commercial real estate and CMBS at NewOak Capital.

Buyers looking at sales based on today's lower valuations might be making a good investment, especially given the returns on other asset classes.

Mission Capital Advisors had over $800 million in CRE loans on sale in June. This gave bidders the opportunity to acquire performing, sub- and nonperforming assets throughout the U.S. secured by a variety of collateral types, including multifamily, office, student housing, condominiums, marina, industrial, residential and commercial land, medical office and bank stocks, among others. Many of the loans have recent appraisals.

"The sale is an ideal opportunity for equity buyers looking to enter the market by purchasing one or several of the individual loans," said Stephen Emery, managing director of sales and trading at Mission Capital.

Although the bulk of commercial real estate is still in the doldrums, there is growing demand for a small number of trophy properties.

The current situation now puts buyers at two ends of the market - in the winner's corner are buyers making use of current valuations where great properties can be bought at a discount. On the losing end are the buyers holding on to overvalued paper.

According to PIMCO, the traditional buyers of subordinate CMBS tranches, including mortgage REITs and special servicer affiliates, have disappeared. This creates an opportunity for new investors to acquire discounted subordinate positions and potentially influence the outcomes of CMBS loans.

Additionally, constantly shifting spreads among bond classes create arbitrage opportunities for investors who understand the relative risks between various bond classes and CMBS deals.

The buyers in these portfolio loan sales, Mission Capital said, have mostly been local operators that understand the assets and are willing to take them at a lower basis.

Investing opportunities have also extended to private equity type players as well, which have the experience in workout situations, and also a number of large hedge funds with interest.

"Essentially you may run the gamut of players from your mom-and-pop operations to highly sophisticated investment houses," a source at Mission Capital said.

Indeed, recent commercial real estate sales demonstrate demand for the product.

For instance, there is the acquisition of Corus Bankshare's $4.5 billion real estate portfolio. The deal, which was part of a Federal Deposit Insurance Corp. (FDIC) auction, sold for 60 cents on the dollar to a group of real estate investors and hedge funds. The group of buyers includes Starwood Capital Group, TPG Capital, WLR LeFrak and Perry Capital. The FDIC kept the majority of the portfolio but gave the buyers zero-percent financing.

Centerbridge recently led a consortium that included Paulson & Co. and Blackstone Group to win a bid on the auction for Extended Stay America after 11 rounds of successively higher bids and a marathon bidding session lasting 19 hours, when rival groups including Starwood Capital andTPG decided against another higher bid.

"What seems like the final chapter on Extended Stay for now is interesting to analyze," Bansal said. "The final purchase price was $3.925 billion, which is good for holders of $4.1 billion CMBS bonds, who were looking at a much higher loss last year when Extended Stay's advisors had pegged the value at somewhere between $2.8 to $3.6 billion."

Bansal said that the bid levels indicate that Blackstoneis making a meaningful investment, as they know the assets and the company well, having owned it previously.

"They sold it at $8 billion to the Lightstone Group in 2007 and are buying back in at $3.9 billion," he said. "Also, since Extended Stay owns budget hotels and not trophy properties, the heavy bidding challenges the convenient notion of bifurcated markets with lots of demand for trophy-type properties and lack of demand for others."

Tishman Speyer also announced last month that the firm, and some partners, recapitalized a portfolio of 28 Washington, D.C. office properties. The group invested a total of $700 million, which in part went to retire $600 million of partnership debt. The partnership acquired these buildings, formerly known as the CarrAmerica portfolio, in 2006. The debt that was paid off was partnership debt that had been in default since last July, Bank of America Merrill Lynch analysts said.

Many of the properties the partnership owns are also securitized in CMBS deals, such as the Tishman Speyer DC Portfolio I loan and the Tishman Speyer DC Portfolio II. The loans have remained performing, according to BofA Merrill.


But, Still Trouble Ahead

Despite the positive signs that capital is returning to CRE and high levels of bidding activity in certain sectors have made many observers and participants optimistic, the transactions have generally been limited and capital flows have been concentrated in trophy properties and in properties where below-market agency financing is available.

"This has provided a false sense of clarity on the real level of property values," said John Murray, commercial real estate portfolio manager at PIMCO, in a report on the sector published in June.

Financing issues, for instance, are a long way from being resolved. Banks still have no appetite and paper will be coming due up ahead make for a potentially messy situation. At the moment, what the market is experiencing is demand for only the best-quality credit. Most buildings remain vacant and over-levered as a result of much less demand.

A significant volume of weaker and distressed assets has yet to be liquidated, and this foreshadows further pressure on values.

"There is a dichotomy in commercial real estate at present," Bansal said. "On one hand, there are worries about commercial real estate, with Standard & Poor's downgrading three insurance companies - Principal Financial, National Life and Pacific Life - a week ago citing expected losses on commercial mortgages and CMBS. On the other hand, every property we have looked at has had 30 to 50 offers from possible buyers already. Portfolios of loans, especially better-quality ones, have attracted a lot of buyers too."

According to BofA Merrill analysts, there are $10.9 billion of conduit loans that are scheduled to mature over the rest of 2010. The loans are in 99 different transactions. Analysts estimated that among these deals, at least one-third of them will not be able to successfully pay off as scheduled.

Some of the loans that already matured in the first half of 2010 that did not pay off as scheduled were granted one- or two-month extensions, some are in the process of obtaining longer-term extensions and others will likely have another type of workout.

The macroeconomic situation has also affected spreads. Royal Bank of Scotland (RBS) securitization analysts said that equity market volatility induced by increasing concerns regarding the risk of the debt of European countries, such as Greece, Spain, Portugal and Ireland, and their potential impact on European banks drove CMBS spreads significantly wider, taking back almost all of the gains since March and nearly 50% of the year-to-date gains. CMBS delinquencies and losses also continue to hit new highs.

At the same time, the market is beginning to experience the first signs of a bottoming or stabilization in CRE fundamentals and prices, a development that RBS analysts do not think the European economic situation will alter.

"The CMBS market is currently characterized by a disconnect between volatile spreads and prices on the one hand and changes in the fundamental underlying credit quality of CMBS collateral and the commercial real estate property markets on the other," RBS analysts said.

There is growing sentiment that CRE values may have reached bottom or are nearing a bottom. Financing has started to come back, which is helping to stabilize commercial property prices particular larger, high quality properties in primary cities. "Transaction volumes are still limited, but are starting to pick up," said Brian Lancaster, head of MBS, CMBS and ABS strategies at RBS.

Basic occupancy and performance fundamentals are beginning to come back, bringing more stability down to the asset level of property transaction because with a steady flow of rental income deals will perform better.

"Properties are stabilized and occupancy has reached bottom," said Mike Kent, president of asset and property management at Colliers International. "Based on this, I believe that landlords and investors have a better understanding of tenants and occupancy-related issues,."

Where a year ago tenants were looking to sign short-term leases, Kent sees more tenants looking for longer-term arrangements. This suggests that tenants believe rental rates are likely increasing, he said.

Nonetheless, prices might still trend downward. Lancaster believes prices in some markets still have further to fall and predicts that at the end, prices will have fallen on average around 50% from peak to trough, putting pricing back to 2003 levels before cheap, high leveraged debt was readily available. At the moment, he said prices have already come down by 43%.

While there have been a number of large distressed, sales a number of them behind the scenes, the flood of loans and properties from special servicers and banks that was expected a couple of years ago has not yet materialized.

"There was a lot of money put together looking for distressed commercial real estate assets, but so far the reality is that loan and property sales have been nowhere near the levels seen in the early 1990's," Lancaster said. "Lenders are tending to work with the borrowers modifying the terms, such as extending maturities, particularly with the larger loans and properties."

The trend so far, at least for the Tier 1 property holdings, has been for banks and special servicers to modify and workout the loans. For smaller properties the option is to foreclose and sell the loans.

But the more regular financing levels are returning only for high-quality tenanted properties, move down the property ladder, to the Class B and C properties, and it's an altogether different scenario. Financing is still hard to come by, and vacancies continue to rise in these segment while properties continue to fall in value.

Kent said that the real struggle to generate occupancy has been among Class C properties. Even so, selling loans backed by these lesser quality assets has become more popular with entrepreneurial-type investors who know the assets and local markets inside and out. In most cases these assets won't be significant in size.


CMBS Emerging on the Primary

Demand for each of the four CMBS deals in the last six months and the borrowing costs achieved have encouraged the reentry of a number of commercial real estate securitization programs including JPMorgan Securities, Wells Fargo, Barclays Capital, Deutsche Bank Securities and Goldman Sachs, to name a few.

According to RBS analysts, there might be around $5 billion of loans teed up for CMBS securitizations.

The pricing of JPMorgan Securities' $716 million JPMCC 2010-C1 CMBS was also a step forward for the market.

The bonds reportedly saw good demand. Bansal said that, from an investor's perspective, it is also good to see issuers moving toward lower LTV, higher DSCR and in-place underwriting.

"The control shift based on appraisal reduction also moves the structure back toward what it used to be before the 2006-2007 loosening of standards," Bansal said. "However, pricing spreads were about 50 basis points wider than the RBS deal that priced in April, underscoring the fact that hedging loans while aggregating will be important for any prudent lender trying to close loans before securitization."

Bansal said that this inability to hedge loans while aggregating a pool for securitization is one of the biggest obstacles preventing the restarting of conduit lending for commercial real estate properties.

In the past, the conduit originators were able to hedge loans while they were aggregating a pool big enough to securitize.

By doing so, they were not exposed to risk from changes in interest rates and bond spreads between loan origination and securitization.

The hedging generally involved hedging the interest rate risk by selling interest rate swaps, and hedging the bond spread risk by using Total Return Swaps on Lehman Brothers or BofA CMBS indices, Bansal said.

These indices allowed loan originators to effectively sell their risk to investors who wanted to gain exposure to CMBS in their investment portfolio. They sold the risk when they originated the loan and bought it back when they securitized the loan. The hedge worked because spreads on new CMBS deals moved in parallel with the spreads on existing deals.

"The problem now is that those indices are no longer appropriate for hedging, especially for new origination loans, because of two problems," Bansal said. "One, ratings downgrades have impacted the composition of the indices. Second, and more important, the spreads on new bonds with newly underwritten loans cannot be expected to move in tandem with spreads on old bonds with the old underwriting. This lack of correlation between the two spreads makes the old bonds or indices unusable as a hedge for newly originated better-quality loans."

Bansal explained that to hedge new loans with better underwriting, originators need bonds with better underwritten new loans. "In other words, to originate loans, you need bonds with new underwriting, and to create bonds with better underwritten loans, you need the better underwritten loans," he said."That's the chicken-and-egg type problem of loan aggregation. This is what has prevented loan origination from restarting once the spreads on old bonds widened out."

Nonetheless, BofA Merrill analysts are optimistic that the CMBS market will slowly come back, and the reopening of the securitized markets is a key milestone in the sector's recovery. "We would expect further securitizations (single- and multi-borrower transactions) in the months ahead," analysts said.



Commercial/Multifamily Mortgage Debt Levels Dip

Outstanding commercial/multifamily mortgage debt levels decreased to $3.31 trillion in 1Q10, according to a study of the Federal Reserve Board Flow of Funds data issued by the Mortgage Bankers Association (MBA).

The Federal Reserve figures marked a decrease of $31 billion, or 0.9%. Multifamily mortgage debt outstanding rose $3 billion, or 0.4%, to $852 billion from 4Q09.

The decline was associated with drops in commercial and multifamily mortgages held in CMBS and construction loans held by banks and thrifts.

"Low levels of commercial mortgage borrowing mean that property investors are paying off and paying down more in mortgages than they are taking out," said Jamie Woodwell, MBA's vice president of commercial real estate research.

The Federal Reserve Flow of Funds data summarizes loan holdings or, if the loans have been securitized, the security's form. The MBA highlighted the various securities held by life insurance companies, including mortgage notes held for whole loans, CMBS, CDOs and other ABS for which the issuers of the security and the trustees hold notes.

The largest share of commercial/multifamily mortgages is held by commercial banks, which account for $1.49 trillion (45%) of the total.

The second-largest holders of commercial/multifamily mortgages are CMBS, CDO and other ABS issuers, assuming $679 billion (21%) of the total. Life insurance companies hold $302 billion (9%), and savings institutions account for $184 billion (6%).

Ginnie Mae and other GSEs hold or guarantee the largest share of multifamily mortgages, accounting for $309 billion (36%) of the total multifamily debt outstanding. Commercial banks follow with $210 billion (25%), and CMBS, CDO and other ABS issuers hold $107 billion (13%) of the total. State and local governments are next with $77 billion (9%), and savings institutions hold $60 billion (7%). Last are life insurance companies, with $48 billion (6%) of the total, according to the MBA.

1Q10 marked the largest decrease in commercial banks' holdings of commercial/multifamily mortgage debt, showing a $19 billion (1.3%) drop. CMBS, CDO and other ABS issuers decreased their holdings of commercial/multifamily mortgages by $11 billion (1.6%). Life insurance companies decreased their holdings by $4 billion (1.4%), and the federal government decreased its holdings by $3 billion (3%).

Nonfinancial corporate business experienced a 7% drop in holdings, the largest in percentage terms. Private pension funds saw their holdings increase by 8%.

Multifamily mortgage debt outstanding increased $3 billion (0.4%) between 4Q09 and 4Q10. Agency and GSE portfolios and MBS saw the largest increase, with holdings rising $6 billion (2%). State and local governments increased their holdings by $898 million (1%). There was a 10% increase by private pension funds, which added $272 million in holdings.

- Matthew Silfee

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.