The ducks are lining up nicely for the commercial mortgage sector this year, as a number of factors converge that are strong positives for this asset class. Higher interest and mortgage rates will limit production, thereby increasing demand for current deals, but it will be the prospect of better economic times that will prove to be the biggest factor for CMBS.

Already, the current economic environment is affecting predictions for 2002 supply. As the market emerges from a banner year in terms of issuance volume, CMBS market participants are expecting the numbers to go down in 2002. A higher interest-rate environment - dampening the demand for credit - combined with the worsening performance of CMBS sectors such as retail and selected office markets, may inhibit this year's performance.

But 2001 was a particularly impressive year for CMBS. According to Banc of America Securities, domestic issuance surged by 49.4% in 2001. Last year's domestic volume reached $74.1 billion, a big leap from 2000's $49.6 billion, and last year's figures come close to 1998's record issuance volume of $76.4 billion.

In a report by Salomon Smith Barney, analysts said that they are expecting the pipeline of fixed-rate CMBS transactions to thin coming into 2002.

Although the firm expects the 2002 fixed-rate conduit volumes to exceed levels achieved in 2000, the issuance volume will seem light compared to having two deals a week -- a pace that CMBS players have grown accustomed to during the past year.

SSB is expecting the total for combined domestic and international CMBS issuance to drop this year. From a total of $92,634 billion in 2001 to approximately $82 billion, which is the firm's high estimate for issuance this year.

Effect of Sept. 11

on single-asset deals

There were two events that had a huge impact on the CMBS market during the last year: the implementation of FAS 140 and the terrorist attacks on Sept. 11.

The implementation of FAS 140 drove issuance in March of last year as issuers scrambled to come to market before the rule was enforced, so that their deals were grandfathered under the old rule. Though it impacted the flow of deals during the first half of last year, the issue was eventually resolved as bond market industry participants as well as the Commercial Mortgage Securities Association (CMSA) rallied the accounting board to come to a favorable resolution for CMBS.

Though FAS 140 did not leave any lasting marks on the industry, the events of Sept. 11 may have some graver ramifications as investors live under the spectre of two deals that "blew up": the $563 million GMAC Commercial Securities Inc. Series 2001-WTC and the $383 million Banc of America Large Loan Inc. Series 2001-7WTC.

In his report, SSB CMBS strategist Darrell Wheeler said that since Sept. 11 investors seem to be cautious of large-loan event risk, which will hinder single asset issuance activity in 2002. While issuers have developed a higher credit awareness, which should limit regular fixed-rate conduit loan originations.

"Single-asset transactions that do get sold will likely offer a significant pricing premium in 2002 and will require terrorism insurance solution that provides the ability to ensure the renewal of that insurance," said Wheeler.

Ironically, single-issuer transactions accounted for a large portion of the 2001 issuance increase. According to SSB, the dollar volume of single-issuer deals rose to $12,376 billion last year from $5,239 billion in 2000.

The other major increase took place in the international sector which saw issuance nearly double to reach $22.9 billion in 2001. Wheeler projected that international issuance would continue at strong pace in 2002, as the UK market provides the majority of issuance and has had a government-sponsored terrorism insurance mechanism in place since 1982.

But the future is not all that bleak for single-issuer deals. Some market players said that Wall Street still holds a fair amount of these single-issuer loans so it would just be a matter of the market's appetitite for them.

"It is really measuring the probability of another terrorist attack impacting the single property being securitized," said Marc Peterson, CMBS manager at Principal Capital Real EstateInvestment. "I think there will continue to be a market for these types of deals and buyers out there who understand and can determine when there is relative value. The key is for investors to feel that they are getting overpaid to take on that kind of event risk."

Deal quality

With the events of Sept. 11, market participants are expecting better-underwritten deals going forward, in contrast to the way things were prior to the terrorist attacks.

According to Peterson, 2001 was one of the more challenging years for his firm in terms of trying to identify strong CMBS deals.

"We thought that underwriting was much more aggressive than we've seen in the previous years and subordination levels were tight," said Peterson.

"Putting it together we passed on more deals than we had historically based on pure credit. Our outlook is that deals that were originated in 2001 will have a higher propensity to underperform most of the deals originated prior to them based on credit in a prolonged economic slowdown."

Meanwhile, the outlook for credit performance going forward is not that favorable.

According to a BofA report, the ratios of upgrades to downgrades are going down sharply. BofA said that the number and amount of CMBS on watch for downgrade is at its peak level, consisting of 125 issues amounting to $4.2 billion. This is in direct contrast to the numbers at the end of 2000, where only 68 securities were on watch for downgrade, totaling $1.7 billion.


Lehman Brothers expects delinquency rates to rise in 2002, but credit support in the existing deals is sufficient to head off any meaningful effect for bondholders. And while the terrorism insurance issue continues, all but large trophy-assets will pull through unscathed. The firm expects spreads to tighten once the issue is resolved and puts CMBS as their number-two sector ranking. Specifically, it likes triple-As versus agencies, the better credit protection versus RMBS, and the advantage over corporates on a risk-reward basis.

Keep an eye on inflation, however, since lower levels - Lehman predicts that inflation remains below 2% for the year - will limit capital appreciation. This will put the onus for real estate returns on rental income, which is expected to slow, notes the firm. The mitigating factor will be office space demand, tied primarily to economic recovery.

Morgan Stanley's Howard Esaki touched on these very same issues in the firm's Dec. 14 research, and mirrors the positive outlook for investment grade CMBS. Delinquencies should top at 2.5% in the year and despite slowly deteriorating real estate fundamentals, he believes that commercial spreads will remain stable, trading within the +45-65 basis points to swaps range. Esaki expects domestic issuance to decline to $60 billion from 2001's $72 billion, while Lehman is looking for $64 billion. Bank of America is being even more conservative, predicting $55 billion.

This reduction in issuance is what might save an otherwise vulnerable sector this year. BofA's Michael Youngblood expects the slowdown to increase investor buying in the sector as a means to maintain exposure and recommends an overweight to the sector. Life insurance companies, for one, will lead this trade, while others will inject funds that are currently invested in RMBS in order to head off lengthening durations.

Plus the lowering of risk-based capital weightings for CMBS from 100% to 20% -in line with RMBS levels- starting this year will prompt depository institutions to experience the better yields and more stable cash flows in CMBS versus RMBS. Youngblood expects credit performance to slip in Q1 2002, but improve thereafter as the economy rebounds. If only.

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