Kevin C. Phelan – Cloud over industry

In more ways than one, the commercial mortgage backed securities market isn’t going anywhere in 2001, but that is not necessarily a bad thing.

CMBS activity for U.S. real estate is expected to remain relatively the same as in 2000, when issuance finished at $48.9 billion. But following a 16.4 percent dip from 1999, and a 37 percent slide off the market’s peak of $77.7 billion in 1997, maintaining equilibrium could be viewed as a positive development, especially given the gloom-and-doom atmosphere that kicked off last year’s campaign.

“There was more volume than most people expected [in 2000],” said George J. Pappadopoulos, director of debt research for Boston-based Property & Portfolio Research. With interest rates on the rise at the start of 2000, CMBS should benefit from a reverse trend this year, he said. On the flip side, a lack of refinancings due to the credit crunch of 10 years ago could curb any significant growth, given that few commercial loans were written in that time frame.

“Certainly, volume-wise and trend wise, I think it will be very similar to last year,” said Pappadopoulous. One continuation, he said, should be the rising acceptance of CMBS overseas, with 2000 making impressive inroads along those lines. Real estate loans from Italy to Japan to Australia went the securitized route last year, including the first collaterization of mortgages from multiple countries to be converted into euros. Overall, international CMBS volume reached $12 billion last year, up from $9.3 billion in 1999. In 1998, just $600 million of overseas loans were securitized.

A more daunting challenge could be trying to assuage borrowers who fear their loans might be retraded due to either outside forces or lenders trying to squeeze more upside out of a deal. Meredith & Grew Executive Vice President Kevin C. Phelan acknowledged that borrowers still remember the difficulties caused in mid-1998, when global economic woes and fears over a collapse of the Russian bond market prompted many CMBS lenders – also known as conduits – to renegotiate terms mid-stream.

“It’s a cloud that continues to hang over the industry,” said Phelan. “It isn’t as severe as it was, but it still goes on.”

The key, Phelan said, is to target established lenders that have a track record of working cooperatively with the borrower. But while that might seem an easy approach, he noted that the evolution of the CMBS market keeps changing the players, such as when Paine Webber – a conduit lender Phelan praised – was absorbed last year by UBS.

“It’s a tale of two cities,” said Phelan. “Can they deliver? Yes. Will they deliver as applied for? You never know.”

Another concern, he said, is what might happen in a down market or if an unusual event takes place where the borrower requires flexibility in the loan terms. Largely to appease regulators and analysts, most CMBS terms are rigid in their repayment regulations. In a strong economy, that aspect may not be as important, but with the real estate industry now appearing to slow, the ability to respond to change is increasingly an issue for borrowers.

Herd Mentality
Despite the potential pitfalls, however, Phelan praised the advent of the CMBS market, calling it “an excellent capital source” and one that can respond to unique situations that traditional lenders such as life insurers often cannot. CMBS lenders, for example, might be willing to accept more risk in a deal, while non-recourse funding is considered another bonus.

One potential trend to watch in the coming months is whether life insurers and commercial banks take over the conduit role that heretofore has been dominated by the investment banking firms. George J. Fantini Jr. of Fantini & Gorga said he believes insurers and commercial banks are better equipped to originate and service CMBS loans, but added that the biggest reason for a shift lies in the thin margins conduits must accept when assembling a pool of loans for securitization. Many of the earliest companies are already out of the business, battered by inefficient strategies, while others continue to carefully weigh their future role in the industry.

“A lot of conduit lenders right now are not sure it is a business they can afford to stay in,” Fantini said.

On a $1 billion pool of securities, for example, a conduit would likely receive about $20 million. While that is a substantial amount, Fantini said the cost of assembling and analyzing a package might not make it worth the effort, particularly given the up-front risk involved. A $1 billion pool could encompass several hundred loans, Fantini noted. Outsourcing the servicing aspect only adds to that cost. With such systems already in place, insurers and commercial banks may be in a better position to take CMBS to the next level, he said.

Yet another X factor which has yet to be fully defined is whether pension funds will gravitate toward mezzanine traunches in a conduit pool now that they are permitted to do so. Previously restricted to A classes and above, the federal regulators last year loosened the rules to allow pension capital to invest in BBB-rated pools, but just because that is an option, Pappadopoulos said there may not be an immediate result given the conservative approach that institutional capital has typically taken.

“Pension funds are a herd mentality, generally,” said Pappadopoulos. “For some investors, it’s something new and therefore a little more difficult to get their hands around. But I do think you will see more and more of them considering [mezzanine traunches].”

Ever since the CMBS market emerged in the early 1990s from virtually nothing, conduit lenders have had to face a seemingly endless supply of challenges and potential pitfalls, so much so that Fantini said he was originally skeptical that the industry would survive. But while he warned that there are still issues that must be addressed, and 2001 will hardly be a banner year, Fantini said he is generally impressed by the sector’s resilience.

“By any measure, the conduit business has matured to the point where we know it is going to stay,” he said. “It is a very well-organized secondary market that ensures good liquidity, and that is certainly welcomed.”