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CMBS Hang Out on a Limb

The Commercial Mortgage Securities Association held its annual Investors Conference the first week in January in South Beach, Fla., at a particularly precarious moment. Credit markets remain locked up, which has turned the previous deluge of commercial mortage-backed securities (CMBS) issuance into a drizzle. As a result, there are deeply dampened expectations for CMBS issuance for 2008. Meanwhile, talk of which — if any — commercial real estate sector might go the way of the residential market clearly had some attendees worried.

The mood was in stark contrast to one year ago. The CMBS industry closed 2006 with $297.8 billion in CMBS issuance ($202.6 billion in the U.S.) and $39.8 billion in CDO issuance, according to Commercial Mortgage Alert. Expectations were that CMBS issuance in 2007 would approach $363 billion, including $245 billion in the U.S. (a figure calculated by averaging the predictions of 14 analysts and experts).

In the end, CMBS originators finished 2007 with $314.7 billion in new CMBS issuance (with much of that coming in the first three quarters) and $39.3 billion in CDO issuance. Now, expectations are that the CMBS market will remain lackluster well into 2008. The same pool of experts expects issuance to drop from 2007's levels down to $158 billion overall and $113 billion in the United States.

And new issuance is not the only thing the industry has to worry about this year. There is also concern about the overall state of commercial real estate and whether a prolonged slump in housing will damage the prospects of other sectors. Furthermore, while most attendees expected the U.S. economy to avoid a recession with GDP growth slowing to between 1 percent and 2 percent this year, most have not ruled out the prospect of a downturn entirely. This is a key concern because any downturn in commercial real estate fundamentals could cause an increase in defaults and delinquencies in existing CMBS pools, which, for now, remain near record lows.

A panel of real estate economists debated the prospects of the major sectors and came away with some very disparate conclusions. The baseline for all three economists, Jon Southard, chief economist, CBRE/Torto Wheaton Research; Sam Chandan, chief economist, Reis Inc.; and Len Mills, director of debt research and risk management, Property and Portfolio Research (PPR), was that the U.S. would avoid a recession. Still, they foresaw that a slowdown would have a devastating effect on some sectors — primarily lodging. Interestingly, the economists had widely divergent views on retail.

A point in retail's favor, Southard said, was the fact that the sector has long-term leases. That provides stability that some other sectors won't share and means it would take longer for a downturn in rents to negatively affect the sector.

Chandan had concerns about the health of CMBS that could suffer even if commercial real estate fundamentals continue to grow. “There is a question in that the assumed growth in the underwriting of some CMBS is too aggressive and that will pressure the mortgages,” he said. Some loans may be too aggressive in the loan-to-value ratios and have mortgages based on escalating incomes, which may not materialize. And that could lead to defaults.

Chandan also thought retail would remain stable, pointing out that huge increases in materials prices in recent years kept development in check. Mills, however, had a much different view of the sector stemming from PPR's assessment that, in fact, retail construction had progressed at a much higher pace. PPR bases its figure on an aggregate accounting of construction in 54 markets it monitors, in addition to information from Reed Construction Data. PPR's figures show that 145 million square feet of new retail space was delivered in 2007 — which is more than 30 percent higher than the historical average of 106 million square feet added each year since 1982. In 2008, it expects 122 million square feet to be added.

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