More securitizations backed by commercial mortgages are outstanding than ever before. This has caused a surge in the number of CDOs backed by these loans, putting more pressure on rating agency analysts to review the transactions. Issuers and collateral managers alike have been drawn to the sector because of its recent strong performance and its perceived stability compared to residential mortgage loans. Standard and Poor's said delinquencies and defaults among CMBS are at a seven-year low.
In fact, more than 80% of CMBS investors polled last month by Dominion Bond Rating Service thought that the midterm forecast for the market was either "sunny" or "partly cloudy." More than 75% of those investors said they were most interested in the sector because of the value it offers relative to other asset classes, and because they have a lot of money to put to work, according to DBRS.
The volume of CDOs backed by commercial real estate has climbed so high that Fitch Ratings is looking to hire additional staff members to manage the flow of deals. The rating agency last week announced that it has created a separate group devoted to the sector. Commercial real estate CDO issuance is up more than 100% this quarter, and individual deal size is more than twice the size on average, according to Jill Zelter, a managing director at Fitch. But as CRE CDO issuance booms, market participants have noted that credit protection isn't what it used to be, nor are individual deal characteristics.
CMBS performance to date
The percent of outstanding U.S. CMBS delinquencies at the end of 2005 was 0.84% - a 70% decline since December 2003, when the rate peaked at 1.26%, said S&P Director Eric Thompson. As of the end of the first quarter, $2.48 billion worth of CMBS loans were considered delinquent out of a total of $445.7 billion outstanding, for a total delinquency rate of only 0.58%, the lowest level since 1999, the rating agency found.
Similar to the RMBS market, the CMBS market was only lightly affected by Hurricane Katrina. Hurricanes Katrina, Wilma and Rita combined were the reasons behind 7%, or about $4 billion, of CMBS delinquencies in the first quarter.
But according to S&P, the two sectors most sensitive to consumer behavior - multifamily and retail loans - could be at a performance turning point. As short-term borrowing rates rise, consumers' homes won't be as much the cash cow they've been in recent years. That, coupled with a rising cost of fuel, could spur a change in spending habits. "Some adjustments may have already started to spill over into the commercial property markets," said S&P in a recent article on the matter.
While CMBS delinquencies within the multi-family sector have declined, retail borrowers have begun to fall behind on payments within the last two quarters. Multifamily delinquencies have fallen by 17% since a peak of more than $1 billion in September 2005, while retail delinquencies have increased by 22% during the same time period, according to S&P.
Investor sentiment
As demand has worked to liberalize underwriting standards, investors should not only pay attention to historical performance patterns, but also take a look at the often wide divergence among deals in the market today, according to DBRS. "Differentiating between deals in the market is something that may not be happening to the extent possible, as indicated by the largely similar treatment many deals receive in light of their dissimilar credit profiles," DBRS wrote with its survey results. At the triple-A level, for example, conduit credit enhancement levels have averaged between 11% and 13.5% over the past two quarters, despite substantial variances in credit quality, the rating agency said.
Ranking as the top concern among CMBS investors is the presence of large, unstabilized or "transitional" assets - meaning properties that lack rental contracts - which are funded by issuers as if they were stabilized. According to the DBRS survey, more than 80% of investors would not purchase such a deal. The rating agency said a lack of both current and future rental income has "no place in a cash flow used to size fixed-rate long term debt."
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