Into the year, CMBS analysts believe real estate lending has remained reasonably disciplined and safe. However, there are certain sectors that investors should be eyeing for potential trouble.

JPMorgan Securities mentioned two "yellow flags" where caution is warranted: the apartment sector and large loan trophy property deals, usually included in the "top 10" loan concentrations.

In terms of large trophy assets, 2003 saw a considerable number of these types of loans. JPMorgan said that the recent "cheapness" of new issue bonds compared to seasoned paper has been due to the lumpier new issue deals.

Patrick Corcoran, head of mortgage research at JPMorgan explained, "A lot of times in a recovering sector, trophy assets with strong longer-term leases are originated." However, it is significantly less common to have larger loans with broken leases.

These trophy properties are usually not affected by current leasing market weakness, and become very attractive in an improving market. Currently, the bidding for these large trophy properties has been very heated with the market seeming to overprice the difference between trophy type properties with strong leases that are in place compared to those with broken leases.

"We are concerned that the market's overpaying for these properties and, as a result, there would be more vulnerability in a more normal market environment," said Corcoran. "This should be a concern for anyone who is an investor in real estate debt."

This is why Corcoran said that investors should insist on relatively tougher underwriting. One way to do this is to insist on shadow ratings based on which investors can make more informed decisions.

As mentioned, another cause for concern is apartment loans. Corcoran explained that this is a sector where property cashflows have fallen about 13% to 14% nationally since the beginning of the recession. Aside from this, cap rates - which are the gross yields on the property - have fallen by considerably more in the sector. He said that in other major CMBS sectors like retail, office and industrial, cap rates remain in the 8% level. However, in apartments, cap rates have dropped to below 6%. Further, there hasn't been a material downturn in construction during the recession.

Despite these setbacks, JPMorgan's CMBS loan default measure highlights an "extraordinarily strong credit story."

"We think investors should be looking at defaults not delinquencies," said Corcoran. "We think if you look at that, the CMBS credit story becomes simple, how good it is."

JPMorgan has developed and been publishing in the last couple of years its own estimates of trailing three-month CMBS loan defaults for core loans, which include retail, apartment, office and industrial loans

In its outlook piece, JPMorgan explained that the trailing default measure has the advantage of transparently revealing the solid CMBS credit story. In direct contrast, the conventional delinquency measure has risen. The firm said that investors who focused on this measure missed their chance to overweight on CMBS in 2001 to 2002. Researchers said that the difficulty with the measure, which is seen as an index of CMBS credit conditions, is the long lag.

"The difficulty with delinquencies as measure is that it is a bucket filled with old credit problems, so it's a very untimely measure," said Corcoran.

JPMorgan believes that the solid credit story shows that CMBS could serve as an alternative for high-quality liquid assets such as swaps and Agencies. It could also be used as a hedge for credit instruments such as corporates.

Roger Lehman, managing director of mortgage research at Merrill Lynch, believes the CMBS sector has done as well as it has, and will likely continue to do so, because of evolving deal structures. With subordination levels dropping, deal concentration on the rise, and interest shortfalls occurring more frequently, the market is witnessing the emerging strength in structure. Lehman said that it is important that investors be aware of it and value it.

Lehman cites changes in structure due to interest shortfalls as a particularly important issue. "I think that we are going to see more changes after the CMSA [Commercial Mortgage Securities Association] conference in January," said Lehman, adding that changes in structure to cope with the problem of interest shortfalls is going to be a hot topic down in Miami.

Lehman said that their view is that CMBS credit has deteriorated throughout the course of 2003, and continues to deteriorate. However, they are still not overly concerned about the level of credit deterioration.

"We are not even near the breaking point of the CMBS structure," said Lehman, noting that the loss rate on conduit loans in the last year has only been 23 basis points. To put this in perspective, he said that a loss rate 50 basis points above this figure sustained for 10 years barely even begins to eat into the average double-B security issued in 2003. "We still think that there still significant protection before we become worried about credit," stated Lehman. "Credit may continue to deteriorate, but there's ways to go yet before we would raise the red flag. Nevertheless, it remains important to monitor the proper indicators."

Rating agency


Representatives from rating agencies share this optimistic view of the sector - looking at it from a small rise in delinquencies expected in the coming year.

Though delinquencies in CMBS are expected to show a slight uptick going forward, they are expected to eventually fall off as the economic recovery takes hold. In this respect, many market participants view real estate as a lagging indicator, said Moody's Investors Service Managing Director Tad Philipp.

For instance, the leasing structure - particularly in the retail, industrial and office sectors - helps smooth out the downturn in buildings until the tenants' leases expire, at which point they may leave the building or occupy less space than before.

"We actually think that delinquencies can potentially rise a little bit before tapering off as the recovery takes root," said Philipp.

Philipp added that the performance profile will vary by asset class. For example, office might take several years before it gets to a point where there is upward rent pricing momentum, as the national vacancy rate for office is approximately 17%. The key, in this instance, is job creation in the service sector, which seems to be coming back somewhat.

In terms of hotels, this sector appears to be bottoming out, said Philipp. Further, with hotels repricing daily as travel activity picks up, hotel incomes actually have the potential to rise quickly. Philipp also thinks that apartments have neared the bottom where many of those who are able to move into houses due to low interest rates have already done so. "You reach a point where there is a core renter community," said Philipp. "So we think that the downturn in apartments has largely played out."

The retail sector has largely cruised through the downturn unscathed with the exception of those properties affected by tenant defaults. U.S. consumers continued purchasing right through the recession and, because of this, retail has held its own.

"Real estate credit has benefited from a powerful tail wind of falling interest rates," said Philipp. He said that the good news is that many lenders are now getting higher debt service coverage than before. However, if rates return to historic norms, coverage might become tighter. This might potentially lead to balloon risk sometime in the future, but this is not an immediate risk as of yet.

Relative value thoughts...

In terms of relative value, Merrill's Lehman said that after the supply bulge in November and December, the technicals in the sector became very positive. With supply lighter and demand reduced, there was some spread tightening.

"I'm still very positive on CMBS performance in the coming year," said Lehman. "We think it remains attractive on a relative basis."

Though Merrill's chief U.S. strategist is worried about credit spreads in general - and thinks credit across the board, not just in CMBS but in all products, is fully priced - Lehman believes CMBS still looks cheap versus competing spread products such as residential mortgages and even corporate bonds.

Within CMBS, Merrill currently favors moving into triple-As from triple-Bs with the credit curve remaining relatively flat. However, there might not be a dramatic steepening in the credit curve with the triple B-bid from insurance companies and CDOs remaining strong.

Lehman believes the best value throughout the CMBS market is currently in off-the-run bonds. Many of the new investors have been looking for clean, on-the-run, generic paper and they have bid this paper against more of the story bonds - the beaten up sectors with credit problems such as single borrower deals. Though investors still have to do their homework, Lehman believes there is value in some of these securities.

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