The factors that propelled the CMBS sector to be a top performer in 2000 - lower supply, good credit quality, and a larger investor base - should continue in 2001, with the commercial real estate and CMBS markets well positioned for a possible economic slowdown in 2001.
According to Salomon Smith Barney, CMBS should perform very well relative to other spread products this year, pricing on top of other similar-rated products such as corporates.
"I don't know an unhappy CMBS investor," said Darrell Wheeler, CMBS strategist at Salomon. "I can only describe the CMBS market's performance as awesome."
And that trend is likely to continue. According to Wheeler, the underlying, stable commercial real estate market and the CMBS credit structure will enable CMBS spreads to outperform those of other spread products, and triple-A CMBS spreads should tighten relative to swaps by five to eight basis points in 2001.
Analysts from Merrill Lynch agreed: according to a recent research report, the CMBS sector proved to be more stable than corporates, residential mortgages, ABS and even Agency debentures.
Moreover, 2001 supply is expected to be roughly $49 billion to $61 billion, versus $60.1 billion in 2000 and $67 billion in 1999, according to Salomon Smith Barney's estimates. Also, average issuance size is predicted to improve slightly to $750 million from a little over $500 million as issuers continue to team up.
"The Fall spread widening in corporate bonds limited subordinate CMBS spreads, so it had a single-A CMBS pricing just behind single-A corporate," Wheeler said. "In 2001 we expect the market will continue to recognize the credit benefit of secured assets enabling CMBS spreads to trade on par with similarly rated corporate bonds."
Although an economic slowdown will cause CMBS delinquency rates to increase slightly, there will be no material shift in delinquency rates, Wheeler said, and if the current Treasury rally stays where it is, there will be better pricing on premium bonds. "Even if delinquencies increase from 78 basis points where they are now we don't see anything taking us to the levels we've been pricing CMBS with."
The continued Treasury rally, therefore, means that there will be more premium-priced bonds.
Although the problems in retailing made headlines, diversification prevented spreads from widening, and rating agency upgrades outweighed downgrades. According to Merrill Lynch, the rating action exceptions were in the franchise and credit tenant lease sectors, which experienced an unmistakable rise in credit problems.
However, Salomon notes that CMBS classes are experiencing six rating upgrades for every one downgrade, versus five downgrades for every one upgrade in corporates. On this basis, there is the potential that CMBS credits can command pricing on par with that of corporate bonds in 2001.
Strong First Quarter
The first quarter of 2001 is expected to see a high level of new issuance based on carryover from 2000, as well as the steep drop in mortgage rates in the past month which will spur some origination activity.
Salomon believes the first quarter could see $16 billion; but as the year progresses, new issuance is forecast to slow as there is a shortage of expiring mortgages from the early 1990s. By the end of the year, the total CMBS market should be over $300 billion outstanding.
The continuing growth in the sector, as well as improving technology by CMBS market participants, should continue to improve liquidity within CMBS, said Salomon's Wheeler.
"We think the first quarter will be very strong, but that's mostly because of the decrease in the Treasury," Wheeler noted. "Originations were very low in September and October, but they picked up in December, which creates the supply for the first quarter. But mid-year it will be tough, because there are no mortgages rolling over from the early 90s. It is difficult to predict the actual volume of commercial real estate transactions during the year, since the lower Treasury may cause refinancings to accelerate."
Regardless of how the overall real estate market fares, Salomon believes differing pricing expectations between buyers and sellers will restrict transaction volumes. Sellers still want to realize prices from 1999 levels, while buyers want to buy based on worst-case market assumptions. So transaction volumes in the market may go down, but property yields or cap rates should hold steady, Wheeler said.
ERISA Kicks In
The expanding depth of the CMBS investor base is another trend that is expected to continue into the new year, sources say.
The recent changes in the ERISA rules will surely be a plus for the sector, as a new potential pool of investors will look at CMBS. "Several pension funds have now started looking at lower classes, and will likely look at going down the CMBS credit curve to maximize yields," Wheeler said. "But it's been tough for lower investment-grade CMBS classes to tighten, as they've had a very good year versus corporates. So we expect corporate bonds will continue to act somewhat as a governor on lower-rated investment-grade classes overriding any benefit that has occurred as a result of ERISA change."
Additionally, the growing presence of CMBS in market indexes will lead to more buying by index funds.
Another significant innovation for CMBS was the A/B note structure, which has proven itself acceptable to the market. "It allows dealers to secure larger mortgages and get the benefit of a diverse pool of smaller mortgages," Wheeler noted.
Lehman Brothers pioneered the use of the A/B structure, in which large loans are broken into two pieces, with the senior portion securitized and the junior part sold separately to an investor.
