By Andrea Bryan, Director, Real Estate Finance Group, Standard & Poor's Ratings Services
The 1999 commercial mortgage-backed securities market recovered from the uncertainty that was sparked by the capital market disruption in the summer of 1998.
However, several trends have emerged in the post-disruption genre of CMBS deals. They include less investor tolerance for nontraditional real estate assets in pools, smaller deal sizes, divergence of the investor base, the importance of the swap market, a reemergence of single-borrower and/or single-asset transactions, increased issuance of floating-rate transactions, increased competition from portfolio lenders, insurers, and banks, a more active and vocal group of B-piece buyers, and increased focus on alternative avenues of real estate financing and alternative structures.
We believe that these trends will continue to influence the CMBS market in 2000. In general, we anticipate issuance of approximately $55 billion in 2000, including approximately $18 billion of deals expected in the first quarter of 2000, many of which were pushed off from 1999.
Back to Basics
Last year saw the return of the four basic food groups of real estate: multifamily, retail, office, and industrial assets in well-diversified CMBS conduits.
Gone were the large hotel concentrations, nursing homes, cold storage facilities, "story facilities," and any asset that was viewed as primarily an operating business rather than real estate.
In addition, any conduits with large loan concentrations that were viewed as increasing the risk profile of the pool were shunned by the broader investor base of the CMBS market.
It is obvious that the majority of CMBS investors have decided that they are only willing to "lend" on well-diversified, nonskewed conduits containing the basic asset classes, and we anticipate that conduit pools in 2000 will offer more of the same.
Bifurcation of the Triple-A' CMBS Investor Base
The CMBS investor market became even more tiered in 1999 with the emergence of a two-pronged triple-A' investor class - the traditional buy and hold investors and the relative value players.
As CMBS securities became cheap, they became attractive to non-real estate securities buyers who, on a relative value basis, saw the benefits of swapping out of various asset-backed securities (ABS), such as credit cards and residential MBS, into comparable triple-A' rated CMBS.
These buyers also drove the movement to well-diversified, nonlumpy pools as they demanded the protection of large numbers of uncomplicated real estate loans.
As long as CMBS spreads remain rich and the real estate market and the economy continue to be strong, these "new" investors will become more comfortable with holding real estate securities and will continue to drive the types of deals that are offered to the market.
We believe that their involvement constitutes a fundamental shift in the CMBS investor base and their impact will begin to be felt in the double-A' and single-A' classes of conduit pools. The result will be more focus on liquidity, less tolerance for story pools, and less focus on the real estate characteristics of any specific loan.
Reemergence of Single-Borrower/Single-Asset Deals
One of the offshoots of the back-to-basic movement in conduits has been the increased issuance of single-borrower transactions.
Most popular in the nascent days of the CMBS market, single-asset/single-borrower deals lost favor with the emergence of the fusion and large loan transactions in 1997, which proved to be a more efficient means of securitizing large loan concentrations.
In 1998, fusion deals totaled $33 billion, and large loan transactions totaled $3 billion. In 1999, fusion deals totaled $3 billion, and there were no large loan deals.
In the same year, single-borrower issuance, driven by its exclusion from conduits and the absence of large loan transactions and the continuing need of real estate investment trusts to secure financing, totaled over $6 billion (excluding lease-backed transactions), which nearly triples the $2.2 billion issued in 1998.
However, issuing one-off, single-borrower deals is not the most efficient means of financing these loans. To optimize pricing on large loans, issuers need to be able to gain the diversity benefit of pooling these loans and broaden or develop a new investor base for these types of transactions.
As a result, we expect an increasing number of issuers to continue to tinker with the structures to target traditional real estate investors who have a greater appetite for the equity-type risk of the lower portions of large loans, while offering the less risky senior portions to traditional CMBS buyers.
The Vocal B-Piece Buyers
The past year saw the emergence of a more active and vocal participation of the B-piece buyers in the CMBS market. Their impact has been felt in the market as they increasingly influenced the composition of conduits by successfully excluding loans that they believed heightened the potential for losses to the junior certificates.
Since the investor market for B-pieces remains thin, we expect these buyers to continue to drive pool composition, language in the documents, and overall loan quality.
Alternative Financing Strategies
The year 1999 was abuzz with talk of real estate collateralized bond and debt obligations (CBO, CDO), and other repackaged deals.
However, only three transactions were completed in 1999 and another three may be completed by the first quarter of 2000. Unlike the traditional "re-real estate mortgage investment conduits", repackaging of CMBS securities as a CBO and/or CDO offers more flexibility to add and remove securities over time.
But like re-Remics, investor demand for real estate CBOs is low. While the corporate bond CBO market is a $50-billion-a-year market, the biggest stumbling block for real estate CBOs seems to be finding the right investor base.
We believe that as traditional CBO buyers become comfortable with the inclusion of these assets in corporate pools, their acceptance of 100% pools of repackaged real estate bonds may not be far off.
Real estate securities are already being added to traditional CBO pools, although in small concentrations. 2000 may be the year that CBOs prove to be a new avenue of liquidity for subordinated CMBS securities.