A strong real estate market and a tightening of loan criteria have brought new optimism, coupled with new conservatism, Stephanie Schwartz-Driver finds

This winter's sub-prime mortgage collapse sent jitters through the financial community, and investors in and issuers of commercial mortgage-backed securities (CMBS) were no exception. However, despite the gloom in the residential sector, CMBS seems, in the short term, to have been spared disaster and even looks set to grow stronger.

The CMBS sector is buoyed up by the fact that the US market is highly liquid. Commercial/multifamily loan originals were up by 10% in 2006, according to the Mortgage Bankers Association I(MBA), with a total volume of $406bn (€302bn). Office was the dominant property type. And CMBS, along with commercial real estate
collateralised debt obligations (CRE CDOs) and other asset-backed securities (ABS), were the largest single investor group for these mortgages. According to the MBA, this segment of the market bought 46% of the closed loan volume, amounting to some $185bn.

In conjunction with this, the US CMBS issuance market was very strong - in 2006 it ran around 20% up on 2005 - although this was nothing on the dramatic growth in issuance in 2005, which was 80% higher than the previous year, according to a report from Fitch Ratings.

Despite market nervousness earlier this year, CMBS issuance is already up on last year. For the first six months of 2007, issuance amounted to $112.7bn, compared with $90.6bn the previous year.

"Real estate equity transactions have helped to drive CMBS volume," says Marc Peterson, director of portfolio management at Principal Financial. Many of this year's big deals, such as equity office properties, have been funded by CMBS, notes Peterson. These deals tended to be highly leveraged - EOP's sale to the Blackstone group included more than 90% leverage, and many of the real estate investment trust privatisations have included 60-70% leverage.

And the deals are continuing, as long as commercial real estate fundamentals remain as strong as they are—although the investment environment has changed, and underwriting requirements are different than they were even just a few months ago.

The fundamentals look good - rents continue to rise and defaults and delinquencies are at low levels. In one way, the sub-prime crisis has even contributed to the strength of the commercial market, notes Brian  Lancaster, managing director and head of structured products research at Wachovia. "The multifamily sector was negatively impacted by people buying homes with sub-prime mortgages," points out Lancaster, as sub-prime mortgages were often made to renters eager to own their own homes. Now that mortgage lenders have tightened their loan criteria for borrowers, more people are remaining as renters, and with rental demand back up, the multifamily sector has strengthened.

However, they are continuing in a slightly different atmosphere. The sub-prime crisis has made many market participants more conservative.

"The sub-prime crisis has been a good wake-up call for CMBS - at least we hope it has been," says Peterson. The sub-prime crisis was driven by aggressive underwriting in combination with a change in fundamentals and also some fraud. While there are no fraud issues in CMBS and the fundamentals remain sound, underwriting was also getting far more aggressive, Peterson notes. "Sub-prime has put everyone on notice," he maintains.

"All that liquidity has put some pressure on the market," observes Paolo Obias, managing director of the CMBS group at Moody's Investors Service, which rates CMBS. Increased competition has led to some deterioration in underwriting standards and in credit metrics.

Ratings agencies have tightened up on CMBS in recent months, beginning to push subordination levels back up. Moody's for example, put out a report in April putting investors on notice that subordination levels were likely to increase, warning that "the additional enhancement will be deal specific, but will typically be the credit support equivalent of half a notch to one notch throughout the capital structure." Fitch has also altered its ratings criteria, concerned that underwriters were relying on projected cash flows based on current, and likely unsustainable conditions to value CMBS offerings.

While the process has begun, Obias notes: "We do not anticipate the full effect of the adjustments until after 1 July." But the Moody's report states that: "Only those deals with the best possible market selection, a disproportionate share of investment grade quality large loans, or other credit-positive features can expect to receive subordination at or near first quarter 2007 levels."

The concern is a response to several factors. One is the increased loan to value (LTV) ratios, which Moody's notes have reached record high levels. In addition, there is a significantly increased use of interest-only (IO) loans. These averaged 85% of conduit deals in the first quarter of 2007, meaning "less build-up of protection from balloon risk at the loan level and little or no build up of subordination at the deal level". At the same time, market conditions have changed, and cap rate compression can no longer be relied on for appreciation.

Moody's moves, like those of the other ratings agencies, have been positively received in the market. "We have had a positive response," says Obias. "Market participants have told us that they welcome our leadership in calling the issue out and trying to do something about it."

"The ratings agencies have taken a proactive role at a time when the outlook for the commercial real estate market fundamentals are good. It has caused some short-term pain, in the medium and longer term it strengthens the CMBS markets and will help keep it among the best performing asset classes. We would rather have this than the sub-prime crisis," notes Lancaster.

Some market participants call on the ratings agencies to take a lead role in keeping the market self-regulating. "The ratings agencies are key - they are the gatekeepers," says Lancaster. "They set the parameters for underwriting, although of course the Street has some leeway. But if the ratings agencies say that want more amortising loans and give more credit for amortising loans, they will get more amortising loans - they play the most critical role."

But Moody's Obias does not agree. "Our view is that CMBS should be governed by market forces," he says, "and every part of the market should do its own part. Some people say we should be the gatekeepers. But we view ourselves as a provider of opinion, not as a regulator." But in calling the market to order "we need the support of investors, too - and it seems like they are supportive", Obias adds.

And this seems to be the case. "It feels like the market is policing itself," said Peterson. He pointed to the B-piece buyers - those who buy unrated CMBS and as a result can take out loans prior to issuance. In the past few months, the B piece market has slowed down and more loans are being removed. In this way the B piece buyers are forcing better loans, because if the B-piece buyers will not take the riskiest loans, the originators will be stuck with them.

In addition, Peterson believes that investors will become more diligent in assessing risk. "The sub-prime collapse was an example of a market not keeping up with risk," he says. That is changing in the CMBS sector. He cites the example of a recent deal issued by a syndicate including GE Capital, Barclays Capital, Bank of America and Deutsche Bank - under pressure from potential investors in the super senior AAA deal bonds who were concerned about the property's ability to cover its debt, the syndicate was forced to pull one apartment mortgage from the loan pool. So now, it is not just the B-piece buyers making demands, but also senior buyers.

This market conservatism casts a new light on some of the megadeals made earlier this year. It seems unlikely now that the kinds of financial structures that pushed through EOP would be possible today.

Lancaster points out that the change in standards means that the 2006 CMBS vintage is probably the weakest in terms of underwriting because of a combination of the prevalence of IO loans and pro forma underwriting. However, this has been priced into the market. CMBS originated in the first part of 2007 are in the same boat. The result of this aggressive underwriting is that some in the industry, such as Fitch Ratings, expect default rates to rise, Whereas default ratings over the past decade averaged around 3.7% annually, Fitch expects them to rise over the next decade to more than 15%.

There are various ways for cautious investors to stay clear of risk. "We've been looking for safety by staying far up in credit," said Peterson. "There are some very good deals in AAA with the widening spreads we've seen since the beginning of May, when historical wides resulted from concerns on rating and the quality of underwriting."

Lancaster also notes that super senior AAA CMBS, either fixed or swapped into floating, make sense for European investors as these bonds have 30% credit enhancement, about 2-2.5 times the level required for a regular AAA CMBS. "While it is important to consider the commercial real estate collateral, particularly of the largest loans, the investor at this level has a lot of protection against losses or potential downgrades," he says. Collateral evaluation and selection is, of course, critical for those investors considering lower-rated CMBS. "With lower-rated CMBS, where the credit enhancement is so thin, downgrades are more likely."

Peterson points out that it is also possible to hedge risk in CMBS exposure by investing in synthetic CMBS, which in their simplest forms are essentially credit default swaps (CDS), although more elaborate types are also available. These have been around since 2003 and have been steadily growing in use, especially since 2005 when a standardised template was developed.

Another alternative is the CMBX, a group of -indices that began trading in 2006 - investors can trade a CMBX index as a CDS contract, and the contract is designed to mirror the cash flows of the underlying CMBS bonds. Around one-third of the investors in synthetic CMBS are CDOs, another third are hedge funds; the remainder are money managers. Unlike many structured financial CDS possibilities, CMBS CDS tend to play in the AAA area; with CDS based on home equity loans, for example, most are concentrated in the BBB area.

Lancaster explains that like other collateralised debt obligations (CDOs), commercial real estate CDOs represent an attractive option for international investors. They are floating rate, which European investors tend to prefer. In the US market for direct investment in CMBS, only around 7% of issues were floating rate, representing $7.8bn, according to Commercial Mortgage Alert, compared with 84% of fusion deals (the remaining 9% classified as ‘other'). CRE CDOs also tend to be used for financing, with the issuer retaining the riskiest tranches, and their spreads currently have widened out significantly because of problems in the residential CDO market, even though commercial real estate delinquencies and losses are still declining, he points out.

A lot of CDO opportunities also are managed deals - a potential investor can assess the quality of the manager, who will be the party with the in-depth local knowledge of the collateral, which is easier than opining on all the loans in the deal. "It is key that the manager's interest is aligned with the investor's, and that the manager's skills are aligned with the collateral going into the deal," explains Lancaster.

It is possible that provider selection will start to play a more important role in the CMBS market as performance starts to differentiate in the near term and at the time of maturity.
Peterson believes that as investors become more aware of risk, they will start evaluating deals not just on the basis of the component loans, but also on the quality of the originators. Up to now, the market has not really been differentiated, in part because risk has been priced consistently across deals. However, Peterson points out that "every deal is very different, and we are more comfortable with some issuers than with others".