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Will CMBS Recovery Trigger a Pricing Backlash?

The market for commercial mortgage-backed securities (CMBS) will begin to recover when issuers and bond buyers agree on pricing, probably late this year or early in 2009, observers say. Once that begins to happen, however, a potential flood of pent-up trading could plunge the market back into price volatility and value losses.

The worry that CMBS investors will unload large volumes of bonds and affect pricing is one of the forces stalling the CMBS market today, according to real estate attorney Doug Buck, a partner at Foley & Lardner LLP in Madison, Wis. “A lot of people are holding these CMBS issues in their portfolios right now and the fear is that these would be dumped onto the market and the pricing would come way down,” Buck explains. “There’s a huge quantity of these things that are on people’s books, and they’re not really trading at the moment.”

Investors are certainly shying away from CMBS so far this year. Through the first week of May, United States’ CMBS volume in 2008 amounted to a mere $10.8 billion compared with the $78.5 billion in bonds that sold during the first four months of 2007, according to industry newsletter Commercial Mortgage Alert.

Log-jammed loans earmarked to go into future CMBS pools amount to between $40 billion and $70 billion, estimates Beth Lambert-Saul, director of Dallas-based Archon Group LP, a subsidiary of Goldman Sachs. The unknown volume of existing CMBS securities that investors have been unable to sell this year due to weak demand only increases the potential for a selling frenzy when trading picks up speed. “There’s so much stuff to be liquidated, as soon as there is a market I could see there being a flight to sell,” she says.

A mass movement to the selling block would benefit buyers of commercial real estate securities by pressuring prices downward, but Lambert-Saul doesn’t expect enough of a price drop to discourage most sellers from closing deals. “I don’t think we will see dramatic drops in prices, but there may be some diminution and pricing will get more aggressive,” she says.

The prospect of motivated sellers in the market later this year has inspired some investment groups to raise acquisition funds capable of taking down sizeable bargains. Archon Group is forming Mezzanine Partners Fund, a $2.5 billion investment vehicle that, when leveraged, will wield about $4.5 billion in purchasing power. The fund will seek to acquire a variety of debt such as CMBS bonds, CMBS B pieces, mezzanine loans, whole loans and other instruments.

Would-be buyers need a large and ready supply of capital in order to access liquidation sales, and the limited playing field of qualified buyers will help to contain deal volume even in a rush to sell, Lambert-Saul predicts. “The folks that liquidate these mortgages aren’t looking for $10 million or $20 million buyers,” she says. “They’re looking at people who can buy $100 million, $200 million or $300 million of this stuff in a lump sum.”

The CMBS market may never regain its pre-credit crunch glory, according to Rich Walter, president of Faris Lee Investments in Irvine, Calif. “I don’t think CMBS is going to come back with anywhere near the exuberance that it had. I think that’s gone,” Walter says. “It will be a factor in lending, a place to go, but it’s not necessarily going to be the favorite place to go.”

Retail developer Frank Kass says the anticipated changes in future CMBS — namely lower loan-to-value ratios and wider spreads on interest rates to reflect increased perceptions of risk — may make conduit loans less appealing to borrowers than debt from other providers such as life insurance companies, which typically keep loans and can work with borrowers if property income hits a snag.

“If [CMBS] doesn't have the advantage of higher loan-to-value ratios and slightly lower rates, I can tell you about the disadvantage it has — there is no one to talk to if there is a change in the real estate a year or two down the road,” says Kass, chairman of Columbus, Ohio-based Continental Real Estate Cos. Unlike loans from life companies, CMBS loans must adhere to rigid standards to maintain consistency in the loan pool.

Back in Dallas, Lambert-Saul is optimistic that CMBS will eventually bounce back, and with more sustainable practices in loan underwriting, better loan diversification in CMBS pools and increased transparency in ratings issued by ratings agencies that better enable investors to discern levels of risk. “We’ll see the CMBS market tweaked a lot,” she says. “But I don’t think it’s going to go away.”

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