CMBS default rates have been low historically, but now market troubles are starting to ring through a sector that, previously, was relatively immune.
JPMorgan Securities analysts, in a recent presentation, stated that there are two things simultaneously happening in CMBS: financing constraints persist, while credit fundamentals are taking center stage.
They enumerated several problems currently plaguing the asset class, and curtailing origination activity. For one, they said, many real money investors are currently overweight CMBS, thus making it hard to add risk at any level. Securitization as an exit option is also limited at current spreads, which will in turn bring down origination activity.
These statements are being echoed by other market participants.
"I don't see CMBS origination starting up anytime soon," Susan Merrick, managing director at Fitch Ratings said. "With no liquidity and so much market volatility, no one can figure out where to price and sell loans." She added that with the market being so volatile, loans that are mark-to-market are difficult to originate because "you're potentially taking a loss on these loans as soon as they are closed."
Merrick said that at least in the past, loans that were maturing were able to find refinancing alternatives, which is going to be a problem for deals that are going to be refinancing in the next few months. In the past, alternative sources of financing, such as regional banks and insurance companieswere open, but in the last two weeks, Merrick said that these firms have stopped lending altogether.
She said that two factors are going to come into play: the inability of maturing deals to refinance, and the liquidity crisis will start having a real effect on the economy - increases in unemployment, drops in housing prices, rises in foreclosures.
These, Merrick said, are now having a direct effect on the consumer, which is manifested, for instance, in the fact that business and leisure travel has been down. "We do think that the economic indicators are more bearish in general, although it will take time for them to reflect," Merrick said. "Just because of these economic indicators, it doesn't mean that tomorrow cash flow within properties will dry up. Our view has gone from cautious to more pessimistic in the near-term."
The negative economic manifestations will reflect most immediately in the hotel sector, just because it's an operating business. Room and occupancy rates, Merrick explained, reset everyday, whereas there are underlying leases in office buildings that prevent detrimental effects right away. "Even with fundamentals declining, you are not going to see incomes in these properties decrease immediately. It depends on the underlying lease maturities."
To monitor how these events are affecting CMBS deals and to give investors additional information on potential rating actions, Fitch has begun adding rating outlooks to bonds.
The rating agency started with the 2006 vintage CMBS transactions that it rates, and is also working on 2007. "What we have been doing is developing outlooks to include noticeable trends and then signal rating actions or bonds in the next 18 to 24 months."
Merrick said that the trend that they have seen is 10% of the 2006 deals have negative outlooks although the remainder of the 2006 bonds were stable. It also appears that 2007 vintage transactions will have more of a negative trend relative to 2006 vintage transactions, Merrick said.
The rating agency will also look at older vintage deals as part of their evaluation of CMBS trends.
Things are not looking up for commercial real estate anytime soon. In a recent Merrill Lynch report, analysts said that they continue to be bearish on the outlook for commercial real estate, and increasingly so. "Financing has become extraordinarily difficult to obtain (and more expensive when available)," analysts said. "This, coupled with clear signs of economic distress, leads us to believe there is little chance of a near term recovery for the commercial real estate sector."
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