Don't Delay CMBS Write-downs

Over the coming months, holders of commercial mortgage-backed securities (CMBS) may be faced with write-downs as the values of commercial property decline and defaults on these loans rise.

Anyone holding CMBS or portfolio loans should seize the opportunity to identify any securities that are likely to have problems and decide whether to unload them or write them down.

It's true, not many expect that commercial property values will be hit as hard as housing prices. Unlike residential mortgages, the default rates on loans backing commercial property are still quite low.

Commercial fundamentals are still relatively sound, with relatively little overbuilding. With vacancy rates stable, borrowers can rely on rental income to make their loan payments, even if they have trouble selling or refinancing.

Last year, just $1.2 billion, or 0.22% of the $535 billion of loans backing CMBS rated by Fitch, entered into default. The cumulative default rate, or total of loans in default declined to 2.71% in 2007.

That was partly due to the heavy volume of issuance over the prior two years, which meant there were a large number of newer loans with less chance to go bad.

Still, the rating agency expects the combination of a weakening economy and liquidity crisis to bring more defaults in 2008 and beyond. It's calling for the cumulative 10-year default rate, another key metric, to rise to more than 7.75% by 2009 from 7.37% currently.

Pressure points

Fitch notes that recent CMBS vintages have had large concentrations of loans with interest-only periods, high loan-to-value ratios, and the presence of existing or future subordinated debt. Highly leveraged loans or those beginning to pay off principal may be sensitive to a slowdown.

Fitch expects loans on multifamily properties to lead defaults this year; the ratings agency also is concerned about defaults in the hotel and retail sectors, which are also more likely to be affected by the slowing economy. Defaults on office properties are likely to be concentrated in the secondary and tertiary markets, where more tenants are smaller local and regional companies.

CMBS valuations also are under pressure from a supply overhang. Wall Street firms securitized over $230 billion in 2007, according to the Mortgage Bankers Association, but the market for these securities dried up at the end of the year.

Issuance has started to pick up, but with just $11 billion of new deals pricing in the first half and little trading in the secondary market, holders of CMBS have been forced to rely on the CMBX indexes of credit default swaps on these deals.

These indexes are extremely illiquid, and trading has been distorted as banks and brokerage firms use them to hedge against declines in the value of all kinds of commercial real estate.

The selling pressure moderated in the first half of 2008, but spreads over U.S. Treasuries started to widen again last month. As of mid-June, the triple B-rated tranches of 10-year, fixed-rate paper were 1,720 basis points over Treasuries, compared with the 52-week average of 1,012 basis points, according to industry newsletter Commercial Mortgage Alert.

Sobering reality awaits

Financial institutions holding CMBS are going to have to take a hard look at what the paper is really worth. Those investors hardest hit are likely to be the same players who took big hits on their holdings tied to subprime.

The value of these securities won't be easy to determine. It may be necessary to look at what has happened to cap rates in specific markets, both before and after major market crises such as 9-11 and the 1998 Russian debt crisis.

Due diligence will also be key. Factors like the credit strength of tenants, property age and location, and the location of competing properties come into play.

In some markets, valuations of property backing CMBS will be influenced by the sales of large properties. Real estate titan Harry Macklowe recently sold several office buildings in Manhattan, and that's going to set cap rates in New York.

Granted, some of those assets, like the General Motors Building, which recently brought $2.9 billion, are trophy properties that aren't necessarily a bellwether. Still, sales like these help set the tone for the rest of the market.

While commercial values are unlikely to fall as long or as hard as residential, still, investors would be better served to identify their problem holdings now and recognize their losses early, rather than risk further declines in the future.

Sean Cannaday is managing director of New York-based Duff & Phelps, which provides financial advisory and investment banking services. He can be reached at [email protected].

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