The following is an excerpt from a larger report, "CMBS Quarterly Review: Fourth Quarter 2002." The entire report can be found on Standard & Poor's RatingsDirect, or on the Web at

Overall, Standard & Poor's expects a stable year in 2003 for U.S. CMBS. Issuance levels and delinquency performance are unlikely to deviate from those seen in 2002. Here are the forecasts for 2003, made with the realization that all predictions must be qualified by the significant uncertainty in the current economy.

* U.S. CMBS issuance in 2003 is expected to be stable amid a modest rebound in real estate fundamentals and in spite of an expected moderate increase in interest rates. The continuing low interest rate environment will provide impetus for continued strong CMBS issuance, which is currently expected to reach between $55 billion and $65 billion in 2003. Issuance is likely to be most robust in the first half of the year before rates begin edging up in the second half. The pipeline for January is solid, with more first-quarter transactions this year than in years past.

* Fundamentals in the real estate market, which declined in 2002, will see a modest recovery in 2003. This expectation is based on a critical assumption that, barring a war in Iraq or other shocks to the market, the economy will grow between 2.5% and 3.5%, with a mild 2% to 2.5% inflation rate and a modest 50 to 100 basis point increase in interest rates in 2003. There are extraneous factors that could significantly affect real estate property markets that cannot be predicted or controlled. However, the expectation is that if the economy continues to improve this year, real estate fundamentals will also begin to recover.

* With broad and more consistent economic growth, there will be private-sector-job creation and more robust business activity. These will, in turn, improve the occupancy and rental rates of various real estate properties and enhance their cash flows and market values. Apartment and retail properties are likely to show stronger improvement than offices and hotels. Metropolitan areas on the East and West Coasts are likely to perform significantly better than their southern counterparts. As it stands, the delinquency rate of commercial mortgages underlying Standard & Poor's-rated CMBS transactions is expected to hover around a range of 1.5% to 1.7%. However, real estate lags the economy and it is uncertain if the economy can rebound enough to limit the delinquencies.

In light of the weaker real estate fundamentals and the maturing of the CMBS market, Standard & Poor's brought together servicers and investors at the end of 2002 to discuss issues faced by the industry. In addition to polling those present at the seminar, Standard & Poor's also circulated a survey with many of the same questions and issues. Standard & Poor's will report on the results of the survey later this quarter, along with some of the pointed comments. As a teaser, one of the questions asked was "Which industry issue is your greatest and second greatest concern?" The results show that the greatest concern is real estate credit fundamentals, which would be expected in the current economic environment. These are followed by quality of servicing, loan economics (such as LTVs), and level of surveillance.

Delinquency rate - Out

like a lamb in 2002

At the close of 2002, the delinquency rate for Standard & Poor's rated CMBS pool transactions was 1.51%. Compared to the third quarter of 2002, the delinquency rate was flat and lower by 2 basis points for the year. This was the rate's lowest point for the year after it hit a high of 1.64% in the middle of the year. As of Dec. 31, 2002, the total amount delinquent was $2.48 billion, based on $165.6 billion of Standard & Poor's rated CMBS. Although the amount delinquent increased by 1.8% in the fourth quarter, the decline in the delinquency rate is attributed to the net change in total outstanding CMBS (new issuance less securities retired and amounts amortized), which grew faster than the delinquencies (new delinquencies less those that became current or were liquidated) during the quarter.

The performance of CMBS continues to mystify its observers, as the underlying collateral appears to be ignoring the signals of the economy and the property markets. With a slowly recovering economy and weak property markets in many areas, CMBS collateral performed well in 2002.

The dichotomy that exists between property market fundamentals and the performance of CMBS collateral may, however, be on a collision course. Borrower perceptions of the economy and property markets appear to be changing and could influence payment decisions. Landlords that were once giving away concessions as a way to deal with what they believed was a temporary situation, are now lowering rents in many markets for various property types (especially multifamily and office), realizing that market conditions may not improve that quickly. Property cash flows are being strained and borrowers' debt service coverage narrowed.

Beliefs of a rebounding economy, low interest rates, and built-in equity due to property appreciation in the past few years have kept the CMBS borrower steadfast in making principal and interest payments. Higher interest rates or changing perceptions may be the catalyst for delinquency increases. The timing of higher delinquency levels, however, is uncertain, as delinquencies typically lag both the economy and real estate markets. If borrowers can hold out a bit longer and the economy rebounds quickly in 2003, aided by the possible fiscal stimulus being discussed on Capitol Hill, the level of new delinquencies could be muted.

North American CMBS

loans remain resilient

North American CMBS rating actions during the fourth quarter are reflective of the full year's rating activity in 2002, both with respect to the number of rating actions and make up. There were 28 upgrades and 41 downgrades during the fourth quarter, bringing the year-end totals to 132 and 178, respectively. The resulting upgrade-to-downgrade ratio for the quarter was 0.68 to 1.00, and the ratio for the year was 0.74 to 1.00.

Even though the 178 downgrades is triple the 62 initiated in 2001, the resiliency of CMBS loans has been somewhat surprising. While Standard & Poor's predicted at the beginning of 2002 that there would be a record number of downgrades during the year, the strong CMBS delinquency performance was not expected. The delinquency rate remained low and held steady for most of the year.

As was the case in previous quarters, a significant amount of fourth quarter downgrade activity (25 of the 41 downgrades) was attributable to bonds whose ratings are dependent on ratings of other companies or financial institutions. These rating dependencies are typically derived from obligations under lease agreements or other guarantees.

Excluding the dependent transaction-related activity, rating actions for the quarter were more positive than negative, as upgrades surpassed downgrades by a ratio of 1.75 to 1.00. For the year, rating activity (excluding the 102 dependent transaction-related actions) displayed a similar ratio (1.74 to 1.00). While the 1.74 is positive, it is well below the upgrade-to-downgrade ratios of recent years, which exceeded 10 to 1.00 in some years.

Conduit transactions continued to perform well during the fourth quarter and received the majority of upgrades. The collateral diversity and senior sub-structures, as well as the low delinquencies, have protected most investment-grade classes in these transactions from downgrades.

The fourth quarter also saw the first upgrade of a Canadian CMBS transaction, Merrill Lynch Financial Assets Inc.'s series 2001-LBC. The raised ratings on four classes from this transaction reflected the strong loan performance history of the pool and increased credit support, even though the financial information for the borrower was limited due to the small loan nature of the pool. The pool's performance is consistent with other Canadian CMBS transactions. Only one of the 13 conduit Canadian CMBS transactions rated by Standard & Poor's has a delinquency.

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