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Commentary: CMBS Excitement Bubbling Up

Bond market activity is signaling better days ahead.

To be sure, two distinct camps exist when it comes to predicting the course of the commercial real estate market. On one side, buyers who have not yet found their opportunities believe asset values will drop further. On the other side are owners who say potential buyers greatly undervalue debt and properties, and that prices will soon stabilize and freeze out those buyers.

Because the two-year-old standoff between buyers and sellers has now grown tired, an independent source will likely be the final arbiter. And that independent source so far appears to be the bond market. Recent activity in bonds indicates that asset prices will not decline much more, and that stability is already here despite some pessimism.

Corporate bond outlook

One of the earliest predictors of commercial real estate finance and investment activity has been corporate bonds, particularly high-yield bonds. It was that market segment that in July 2007 first predicted the real estate decline. At that time, private equity firms first began to experience trouble raising debt, especially for leveraged buyouts.

Today, after almost two years of rising defaults in corporate debt, there is a sign of hope. The U.S. default rate among corporate bonds is expected to drop below 3% by year's end, according to Moody's Investors Service, compared with a high of 14.6% in November 2009.

This projected decline represents a default rate that is even below the 3.1% level of August 2008, just as the bottom began to fall out of the real estate capital markets. Since based on historical trends the real estate debt market trails the corporate debt market by about six months, better liquidity in real estate debt may be just six months away.

Meanwhile, Moody's reports that the number of companies with “junk-rated” debt and most likely to default has plummeted from 288 to 195 in just over one year.

Familiar faces

All eyes are now fixated on the nascent commercial mortgage-backed securities (CMBS) market, where major players such as JPMorgan Chase, Royal Bank of Scotland and Goldman Sachs have transactions already issued or on their way to market.

Fitch Ratings has already put out initial coverage of several CMBS issues, including pre-sale ratings of the $1.1 billion JPMorgan Chase Commercial Mortgage Securities Trust 2010-C2. Fitch has stress tested the issues, giving them good marks for high underwriting standards and strong credit enhancements.

U.S. mortgage-backed bonds without government backing stand at their highest price levels in two years with brisk bidding. Despite reports of a slowing housing market and a bearish sentiment from some skittish real estate investors, CMBS remains a bright spot.

Some recent debt financing transactions with CMBS loans prove that the market's dependence on government guarantees is dissipating. This is welcome news to bond investors and property owners searching for refinancing.

Moreover, the most recent PriceWaterhouseCoopers' Korpacz Real Estate Investor Survey concludes that pent-up demand from investors is targeting higher-quality commercial properties, a class of assets that is ideal for a returning CMBS market.

While the survey points out that investors perceive less risk in the second quarter than in the previous two years, it also points out that upcoming CMBS due dates may jump start distressed buying, or a wave of CMBS refinancing.

Firmer pricing

Finally, the absence of high-quality distressed properties and loans at fire-sale prices continues to be one of the foremost reasons behind higher loan trading prices. Boston-based DebtX, a loan sale advisory firm, recently pointed out that loan prices continued an upward trend that began in January.

In its September client letter, DebtX wrote that the aggregate value of CMBS collateralized loans rose from 79.4% in July to 81% in August. The value of loans DebtX prices was 77% as recently as August 2009, an indication that firm pricing has been present for awhile.

Thus, there are signs that the commercial real estate recovery is for real. Since the biggest contributor to the market decline was overleverage, any news that a loan or package of loans has reached some resolution is another step in the right direction.

Joe Caton is a South Florida journalist who provides training and development services to real estate finance professionals.

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