Its ride has been nothing short of meteoric, but these days, the commercial mortgage backed securities vehicle is trying to avoid the crash-and-burn phase of its journey.
Created from virtually nothing a decade ago into a vast cottage industry, the CMBS market is experiencing a sharp tailspin, dropping from $16 billion of securities issued during the first quarter of 1999 to just $7 billion for the same period this year. That follows a subpar campaign in 1999, when dealings fell from $77 billion in 1998 to just $66 billion. Domestically, activity was off by 25 percent to $58 billion.
They are having their struggles, financing specialist George J. Fantini Jr. said last week of the fledgling industry. It’s going to be a tough year in terms of volume.
While other factors are also in play, a drop-off in demand from borrowers is considered a leading reason for the slowdown. Higher interest rates have cooled the refinancing trend, as has the busy pace of such activity during the past several years, where many borrowers rushed to obtain notes during a favorable lending environment. In some respects, observers say the market grew so fast that it has already consumed much of its future potential.
You can’t continue to punch out $70 billion a year, said Hunneman Co. Principal Mark Hall. If somebody is not asking for a loan, it’s hard to securitize it.
Hall, however, is among those who see CMBS as a lasting force in the commercial debt sector. As underwriting and performance standards become more established, the efficiencies will attract both borrowers and CMBS investors, he said, insisting that the current swings are merely a reflection of reduced demand and not an indication that the concept itself is unworkable.
Any time you have the kind of growth like we’ve seen, there are going to be growing pains, but it is maturing, Hall said, adding that the advent of new technology such as the Internet will only improve the flow of information needed to bolster the industry.
Also bullish long-term is Stephen L’Heureux, portfolio manager for AEW Capital Management’s Fixed Income and Securities Group. While acknowledging that conditions are difficult at present, maintaining that, in this market, it’s just a matter of surviving, L’Heureux nonetheless said he believes the concept of CMBS is a sound one, and will continue to gain acceptance over time.
It appeals to a broad matrix of buyers, he said, including mutual funds, life insurance companies and pension funds.
With a typical flow of refinancings in the $100 billion to $150 billion range annually, L’Heureux said the lethargic climate will not last indefinitely, noting that CMBS has been capturing an increasing piece of that activity since emerging during the credit crunch of the early 1990s. Indeed, one report estimates that CMBS has risen from representing 1 percent of the country’s commercial mortgage debt in 1991, when it stood at $10 billion, to today’s level of $260 billion, or 26 percent of the total pie.
I think the CMBS market is actually getting much better in terms of providing liquidity in the commercial real estate market, said Hall, who noted that there is still room for expansion. Some 60 percent of residential mortgages are sold on the secondary market, for example.
Shakeout Ahead
At the same time, most also are anticipating a shakeout in CMBS players, ranging from those who originate the loans to underwriters and servicers. Even before demand fell back, the industry was seen as being overloaded with participants, and the reduced activity is expected to force some to the sidelines even sooner.
A number of firms will get out of the business because it’s expensive to run a CMBS operation, said Fantini. He also predicted that investment banks will be replaced by commercial banks and life insurance companies as the primary originators of CMBS loans. That trend will occur partly because the profits will be squeezed beyond palatable levels for the investment bankers, who have traditionally driven the origination activity.
With existing client relationships, distribution systems and balance sheets upon which they can hold loans indefinitely, commercial banks and insurers have a better infrastructure in place to handle such operations, Fantini said. L’Heureux concurred, adding that such entities as the Bank of America, First Union and Wells Fargo Bank are all stepping into the fray.
Fantini added that commercial banks have relaxed their collateral rules to better compete with CMBS, which have had one advantage in being able to provide non-recourse financing to borrowers. Following the banking debacle of the late 1980s, federal regulators have demanded strict guarantees by banks, but Fantini said many institutions are now requiring only that the top portions of a loan be personally guaranteed. It was, he said, a response to the CMBS onslaught.
Banks were losing volume at a frightening pace, Fantini said.
Despite that, Fantini said he does not believe the credit quality of banks will be threatened, maintaining that the oversight is still too strong to allow the situation to erode irreparably.
There are very few banks today reaching out of the box and making bad credit decisions, he said. It’s pretty hard to find a dumb lender today.
With the response, the banking industry has made significant inroads in winning back customers from CMBS originators, Fantini said, adding that life insurance companies are also back in the game. In many respects, Fantini said he believes CMBS is losing ground to traditional lenders because borrowers see a more flexible product. It is still unclear, most agree, what would happen during a downturn in the commercial market given that CMBS notes cannot be rewritten to reflect short-term difficulties. There are also strict rules regarding pre-payment or refinancing of CMBS loans.
A lot of the top-tier borrowers feel it is impossible to conduct business with this rigid wrapper around the loan, Fantini said. They will only go there when they have no other choice, and right now, there are plenty of other choices out there.
For 2000, Fantini said he expectation is that CMBS will do less well than even they think they will, while L’Heureux predicted that issuance could drop off by another 40 percent by year’s end. In an extensive report on CMBS outlining last year’s activity and looking ahead to 2000, E&Y Kenneth Leventhal predicted substantial changes in the coming year.
According to the report, much of the growth this year will come from overseas issuance. After ballooning from $600 million to $9 billion in 1999, international CMBS activity could reach $15 billion this year, with increasing deals in such countries as Canada, Italy and Japan. As with L’Heureux and Hall, E&Y maintains that the CMBS market will prove itself as a permanent concept, calling it the most important component of real estate finance.
The conduits of the future will have multiple product offerings, a balance sheet, client relationships, large staffs able to sift through hundreds of loan packages and an institutional lending mentality that will translate into higher quality underwriting and win investor confidence, E&Y maintained. In other words, they will be just like the traditional lenders of yesterday, expect that their lending activity will be funded by the capital markets when spreads allow.