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CMBS Market Dampens Real Estate Cycles

Despite its relatively small share of the market, the commercial mortgage-backed securities (CMBS) sector tends to receive the lion's share of attention in the debt arena. In fact, it has become an indicator of the overall health of the commercial real estate world.

Last year, the CMBS market reached $241.7 billion or 16.9% of total U.S. commercial real estate debt, according to the investment research arm of Atlanta-based Lend Lease Real Estate Investments Inc. (See chart below.)

At the same time, banks and S&Ls were carrying loans totaling $686.6 billion in commercial real estate debt, representing 48.1% of the market.

During 1998, when international currency issues created ripples in interest rates around the world, the commercial real estate industry carefully scrutinized widening CMBS spreads.

Interest rate questions in the middle of 1999 widened CMBS spreads one more time, prompting the industry to again ponder the long-term effects.

In each case, the CMBS market tanked for a brief period, creating a sense of doom among borrowers, if not lenders. In each case, however, the CMBS market recovered quickly.

Not static by any means In an analysis of the capital markets titled "Capital Flows: The Dramatic Influence of CMBS," the Lend Lease investment research department explains this volatility by concluding that the rise of CMBS as a financing alternative has driven a sea change in capital's relationship to the real estate debt and equity markets.

One element of this sea change is that a capital "governor" now controls the flow of money into CMBS issues through day-to-day and month-to-month pricing changes.

In short, brief periodic pricing disruptions in the CMBS market will likely continue in future months and years. When the public financial markets move one way or another, the public CMBS market will react instantly and dramatically regardless of the real estate fundamentals underlying the issues. Judging by the events in this market during 1998 and 1999, the CMBS market will also steady itself in short order.

Likewise, industry trends can influence the availability of CMBS capital. "With CMBS, the public securities markets have become involved in real estate transactions," says Greg Spevok, director of origination with New York-based Bear, Stearns & Co. Inc. "As a result, there will be an instantaneous reaction to industry events."

For example, in 1999 there were red flags in the hotel industry that led CMBS lenders to rethink hospitality loans. "Some stopped. Some remained liberal. Others raised prices," Spevok says.

"The net effect was that capital quickly became less available to the hospitality industry," he explains. "In the past, this wouldn't have happened so fast. The overbuilding cycle would have continued longer, leading to greater problems and a deeper trough."

The same is true on the upside, Spevok continues, noting that the scrutiny applied to publicly traded securities will produce an equally swift reaction to good news and expand the supply of capital.

"It's nonsense to say that real estate cycles are a thing of the past," Spevok concludes. "The CMBS market will not eliminate cycles. But I think it will dampen the cycles. You may never again see a trough as severe as in the early 1990s or a peak as high as 1987."

Year in review During 1999, CMBS lenders had logged the second largest total of issues ever - more than $62 billion. "Coming into 1999, expectations for the CMBS market were very optimistic," says Rob Schneiderman, executive vice president with Parallel Capital LLC, a New York-based CMBS subsidiary of Fleet Boston Financial. "By the end of the year, I think most players considered the year to be all right, but not great.

"We had some disruptions in the market again in 1999, as in 1998," he continues. "Spreads widened again, and that always hurts our market by creating volatility in pricing. In the latter part of 1999, we also had some rate uncertainty when the Federal Reserve Board acted to push rates up. In retrospect, the sentiment now seems to be, 'So what else is new?'"

Prospects for 2000 Looking ahead, less money may be pooled into CMBS issues in 2000, Schneiderman says, because the availability of product to finance is likely to decline.

Dottie Cunningham, CEO of the Commercial Mortgage Securities Association, concurs that the CMBS market activity may wane during 2000, saying the analysts expect the market to produce about $40 billion in new issues.

Whether the CMBS market in 2000 rises or falls in terms of total capital, it will affect conventional commercial real estate finance.

That's because the CMBS market has begun to provide exit strategies for portfolio lenders such as banks and life insurance companies.

To be sure, CMBS providers usually seek different business than banks and insurance companies. Portfolio lenders carry loans on their books and prefer short-term loans of five years or less. CMBS issues carry longer terms of five to 10 years. But portfolio lenders seeking to cash out after five years have come to rely on the CMBS market.

"To the extent that the capital markets are rich with conduit money, our customers can build their projects, stabilize them, and then move out of our loans and into the long-term conduit market for permanent financing," says Ron Lubin, senior vice president with the shopping center finance group of Fleet Boston Financial in Boston. "That gives us a better opportunity for our take-out.

"When there is not a lot of conduit money available, you look back to more traditional sources like life companies or other long- term investors to take you out," Lubin explains. "In any event, when you evaluate the underwriting risks on construction loans, you look to the availability of capital in the overall market."

Perhaps even more significant, some conventional lenders have begun to underwrite loans with an eye toward securitization.

"Lenders seeking to manage their portfolios always want to build as much flexibility as possible into their loans," says Bill Hughes, senior vice president in the Newport Beach, Calif., office of Marcus & Millichap Capital Corp.

Lenders are underwriting loans with the notion that they may later sell into the securitization market, he says. Thus, the product line is narrowing as life insurance companies, banks and thrifts originate loans that may ultimately be sold into the CMBS market.

"From one point of view, this is good," Hughes says. "The ability to sell into the secondary market makes more money available. From another point of view, securitization options may reduce some of the flexibility that was available five years ago."

By way of example, Hughes points to the elimination of step-down prepayment options that life insurance companies offered with traditional loans. "Loan originations intended for the secondary market do not offer step-down options," he says. "In this regard, loan products have begun to look the same."

Pricing issues Bank loans intended to be held in a bank portfolio don't need to follow the pricing models of CMBS loans, so banks are free to take a more aggressive stance in the retail development market, notes Lawrence Silberman, vice president of Old Kent Bank in Chicago.

"A bank might price its loans a little cheaper," he says. "That's possible because bank loans come with other strings attached: shorter terms, floating rates, and recourse."

In the current environment, banks can offer developers flexibility in terms of floating-rate bridge loans, allowing developers to wait until interest rate volatility recedes. "Banks today may have a willingness to do floating-rate business with limited recourse," Silberman says.

"Right now, rates are about as high as they've been for awhile, and they probably won't go much higher," he predicts. "I can justify doing a loan without 100% recourse because properties are more stable, and our credit committee is willing to consider going up to three years at a floating rate. That's enough time for a developer to watch interest rates stabilize and then move for a permanent loan."

Since all lenders compete with each other in terms of price and dollars, Silberman notes, even non-securitizing lenders must respond to the CMBS market by strategizing how to win their fair share of transactions.

"If the overall market grows tighter in terms of spreads, which means cheaper pricing, then a bank may become more aggressive in terms of underwriting," he says. "More aggressive underwriting means more loan dollars, perhaps in terms of extended amortization periods and less stringent loan-to-value ratios."

In mid-1998, the CMBS market drove the entire marketplace with aggressive spreads. "Today, that market can't sell CMBS issues as profitably as they could back then," Silberman says. "The spreads they were offering have widened, which means the price of the money has gone up."

When a development company faces a higher than acceptable cost for CMBS money, the company may return to the bank or insurance company market.

And so it will go, back and forth. CMBS lenders will drive down the price of money and force conventional lenders into more aggressive underwriting postures. When CMBS prices decline too far, investors will refuse to buy, the price of CMBS money will rise, and conventional lenders will tighten their requirements.

The outlook for traditional sources of capital in the retail development world appears to confirm the two-faceted point of view that all lenders must maintain.

"What we hear is that commercial banks will be more conservative in their approach to lending," says Hughes of Marcus & Millichap Capital Corp. "But what we see on the street today is still very aggressive lending when it comes to construction finance."

Conservative lending principles dictate that loans should never exceed 80% of the cost of a project, he says.

However, "We are seeing construction loans provided at between 75% and 80% of completed value," he notes. "Ultimately, this means that on a cost basis, developers are making deals with as little as 5% and 10% equity.

Concern is growing among lenders about overbuilding in some segments of retail development. "As lenders look at this issue, they will sooner or later begin to move to the conservative side of the equation and require more, rather than less, equity," Hughes says. "For now, there is a lot of capital in the market chasing deals."

Equity point of view "I think the greatest difficulties in financing projects going forward will arise on the equity side, because there are fewer equity investors than there were," says Rick Kuhle, senior vice president with Phoenix-based Vestar Development Co.

Kuhle cites two reasons for this conclusion. First, he notes that less equity is coming into the market from REITs, which have suffered from low stock prices for more than a year now. Second, he says that Wall Street companies with large equity investment funds have pulled back.

"Five years ago, these funds bought a lot of RTC (Resolution Trust Corp.) properties and made huge returns," Kuhle says. "They still require huge returns, but it's difficult to get that level of return on development today. As a result, I think less of that money is going into shopping center development."

In their 1999 book, Net Success, authors Christina Ford Haylock and Len Muscarella estimate that the value of the 1998 e-tail market ranged between $5 billion and $10 billion.

That may sound like a large sum, but compared with the nation's massive $2 trillion retail economy, e-tailing has yet to acquire anything more than a tiny share of retail sales. Still, electronic retail is a growing market destined to compete in some ways with brick-and-mortar stores.

Then again, it may also complement conventional retail. "In the long run, there is no doubt that e-commerce will play an important role in the U.S. retail industry, but players that integrate physical stores with online activity stand to win the most market share," says Bernard J. Haddigan, national retail group director in the Atlanta office of Marcus & Millichap Real Estate Investment Brokerage Co.

Haddigan also notes that the Internet sword flashes two edges: "Beyond e-commerce, technological advances in customer tracking, inventory control and pricing will continue to increase retailers' productivity."

In other words, electronic commerce may eventually make investments in retail development look more attractive to the capital markets.

For now, lenders will factor in questions about the effect of electronic commerce only in special cases, says Greg Spevok, director of origination with New York-based Bear, Stearns & Co. Inc.

"The Internet question has come up only recently among lenders," he says. "It may arise in relation to refinancing a center where the dominant retailer has a marginal credit rating or no credit rating. In such a case, one of our many questions might be, 'How will this business be affected by people shopping online?'"

When searching for permanent financing, Richard Tucker, president of Highland Park-Ill.-based Tucker Development Corp., routinely queries life insurance companies and CMBS conduits, looking for the best rates and terms.

Tucker, whose firm develops power and grocery-anchored centers, recently completed a securitized deal on a freestanding Kohl's department store, finding the CMBS deal more attractive than the terms offered by life insurance companies.

In another case involving a power center with a number of tenants carrying high credit ratings, Tucker is setting up the financing in pieces. "This center will have a Wal-Mart, Walgreens, Office Depot and other high-credit tenants," he says. "When it comes time for permanent financing, the market will tell us the best way to handle each piece."

Viewing the CMBS world as an extremely demanding capital market, Tucker asserts, "Securitized financing requires a strong stomach."

"Some players make it easier than others," he explains. But there is a big difference in that once you put the financing in place, the players you were dealing with originally are not the long-term holders of the paper."

If questions or problems arise, Tucker says, the borrower must take inquiries to bondholders, who may take a different view of issues than conventional lenders.

"With a CMBS deal, you also need high-credit tenants," he says, "because issuers want to be sure that whatever happens, the rent is coming in. Sometimes, for example, a lease might suspend the rental stream if there is a casualty or condemnation. With a Wall Street deal, you may be forced to buy condemnation and casualty insurance."

Rick Kuhle, senior vice president with Phoenix-based Vestar Development Co., has chosen to avoid the CMBS market, preferring instead to deal with a stable of 10 life insurance companies with which Vestar has long-standing business relationships.

Vestar specializes in developing and redeveloping shopping centers of 100,000 sq. ft. to 1 million sq. ft. with a strong presence in Los Angeles, Phoenix and San Diego.

According to Kuhle, Vestar finances its projects with substantial equity and deals only with top-tier tenants. "As a result, when it comes to construction financing, we haven't seen and don't expect to see much of a change in our business," he says.

You might call it a no-nonsense agenda. "Transforming Ideas Into Action" is the theme of the Mortgage Bankers Association of America's 10th annual convention, slated for Feb. 6-9 at the Walt Disney World Swan & Dolphin hotel in Orlando.

Hot topics ranging from the Internet to international business will be open for discussion.

"This is the largest commercial real estate finance conference of the year. The networking potential is limitless, and the learning potential is tremendous," says Joseph B. Rubin, a managing director at Ernst & Young LLP in New York, and one of the featured speakers. "Everyone in the business is there, and we will be talking about some leading-edge trends."

Growing convention The official program title of the four-day event is the "2000 Commercial Real Estate Finance/Multifamily Housing Convention," which has come a long way since it was launched in 1991. The gathering has evolved from a comparatively small conference of 770 attendees to a major industry-wide affair that attracts more than 4,000 professionals.

"It has grown exponentially over the past 10 years," echoes Bronwyn Morgan, the MBAA's director of commercial real estate finance.

The 1999 convention attracted 4,209 attendees, and the MBAA is anticipating an equal number at the 2000 event. This year's convention will feature the largest exhibit hall in the event's history with approximately 150 exhibitors, up from 100 last year.

The 1999 show in San Diego provided limited exhibition space, which resulted in a waiting list of exhibitors, Morgan says.

The "Transforming Ideas into Action" theme is an intentional departure from the millennium concept. "Everyone and their brother is doing that theme," Morgan says.

The theme for 2000 offers a new twist on last year's message: "Riding the Waves in a Sea of Change." However, topics will continue to address changes in the industry such as consolidation, new players and the rise in commercial mortgage-backed securities (CMBS).

"Because change is still a part of what's occurring, we selected a theme to reflect the dynamism of the industry as we move into the new millennium," Morgan explains.

"We've designed the panels to give mortgage bankers issues to think about in the next decade," she says. For example, most of the technology panels in the past focused on new computer hardware, software and Y2K. The 2000 convention will delve for the first time into issues such as the Internet and e-commerce.

Identifying trends Rubin will participate on two technology-related panels, "Business on the Net" and "E-Commerce: Lender Strategies Going Forward." "This is all brand-new. The commercial mortgage industry only in 1999 started focusing on how the Internet can better its business," Rubin says.

The shift toward Internet usage started in the residential sector and is slowly moving into the commercial lending arena.

"Obviously, commercial real estate is more complicated. So it takes longer to develop technology and processes to do online lending," Rubin explains. Although not all components necessary to underwrite a mortgage can be handled online, a considerable amount of the process can be automated, he adds.

Rubin's "Business on the Net" panel will focus on how the Internet can be used as a business tool.

"Commercial mortgage lending today is a very, very competitive business. One of the key areas where a lender can compete is being the low-cost producer, and having the most cost-efficient systems," he says.

All of the major processes of lending, such as underwriting and the aggregation of loans into a pool for securitization, can be enhanced by e-commerce, Rubin says. "It can make your process more efficient," he adds, "and give you better connectivity with constituents such as borrowers, brokers and rating agencies."

The e-commerce presentation will offer an overview of this emerging marketplace and address effects on commercial lenders. "Mortgage lenders today are clearly taking a harder look at retail, and trying to understand the Internet's impact on retail," Rubin says.

Stores are still necessary for many retailers, but one possible outcome of online shopping is that percentage rent may drop due to an increase in a retailer's online sales, Rubin suggests. Consequently, lenders may pay more attention to how leases are structured when underwriting retail properties.

Attendees at the 2000 convention will find a similar offering of correspondent meetings that have been present in past years, but the number of panels has been reduced by about 15%. "That's mostly because there are so many other meetings, and this is such a great networking opportunity," Morgan says.

One of the common complaints in the past was that the conference offered "too much." "We want to make sure that the panels we do offer are well attended," she says. The 2000 convention will feature 58 correspondent lender meetings and 22 panel discussions.

Economic overview Retired Gen. H. Norman Schwarzkopf will preside over the opening session with his presentation, "Leadership: From the War Room to the Board Room." "Gen. Schwarzkopf is a wonderful speaker," says Morgan. "He really rallies the troops."

MBAA President and CEO Christopher J. Sumner will provide his annual state of the industry address, updating members on the organization's initiatives.

In addition, Tony Pierson will mark his 10th appearance as a convention speaker. Pierson is the managing director of real estate research and strategy at CIGNA Real Estate Investors in Hartford, Conn. Pierson will deliver his annual state of the market outlook with a presentation on "The Forces Transforming Markets."

Both commercial and multifamily markets have enjoyed a tremendous economic environment, although a slowdown is inevitable, Pierson says.

Real estate markets are experiencing a general equilibrium, with some threats looming on a long-term basis but short-term conditions still positive, he adds.

Pierson will address concerns about overbuilding and discuss evidence of discipline in construction markets. "There are good signs that construction is much more controlled than in previous years," he says.

Pierson also will discuss individual markets and property types with the best prospects. "Retail is benefiting from this super-buoyant consumer economy," he says. However, when consumer spending slows down, some weaknesses will be revealed in the market. "I think a slowdown is inevitable."

It will be impossible to sustain the employment growth levels, and it is prudent to expect slower growth in other economic indicators such as income, Pierson says.

As a result, the strong retail centers will remain strong, but weaknesses will be revealed in centers that have performed only moderately amid the strong economy, he concludes.

Other panels at the conference will discuss additional forces transforming commercial real estate, such as new business lines, international business opportunities, servicing of the CMBS market, and mergers and acquisitions.

"One major value of the convention is getting a good overview of the state of the industry, current conditions and future prospects," summarizes Pierson. "Equally important is the opportunity to network with peers."

For more information about the conference, contact the MBAA at 202-861-6500. An electronic brochure detailing the event is available at

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