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CMBS market goes south

A lack of properties in need of refinancing combined with rising interest rates are two major factors creating a competitive commercial real estate lending market and a low-volume year for commercial mortgage-backed securities (CMBS).

Wall Street investment banks, conduit originators and portfolio lenders all are scrambling to find quality real estate product on which to make loans, whether it be to meet institutional lending allocations or to gain the critical mass needed to fill securitized loan pools.

Although commercial lenders may be seeing a cyclical and rate-influenced slowdown, CMBS is at the same time experiencing an increase in foreign activity, changes in the structuring of deals, a rising use of Internet technology and other innovations that all point to a broader, more mature market.

"We are entering a period of low issuance. It is a cyclical trend as fewer properties are coming up for refinancing," says Tad Philipp, a managing director at New York-based Moody's Investors Service.

Brian Lancaster, a managing director at New York-based Bear Stearns & Co., says the sluggish CMBS market can be traced to what transpired a decade ago on Wall Street. "Most commercial mortgages typically have 10-year balloons. So, the trough in originations in the early 1990s is flowing through now," says Lancaster, referring to the low volume of commercial mortgage origination that occurred between 1989 and 1992.

Competition heats up New York-based Standard & Poor's predicted earlier this year that issuance levels of CMBS in 2000 will be between $50 billion and $55 billion, a considerable decline from the $67 billion issued in 1999 and the $78.4 billion that came to market in 1998. "The volume was pumped up in the last few years because of a lot of acquisitions and repositions that all needed financing. Now, they have all been taken care of, there are fewer properties needing refinancing, and interest rates are up as well," says Philipp.

With a lack of product on hand, portfolio lenders are having difficulty filling their origination quotas and are being as aggressive as they can, giving Wall Street lenders a run for their money, says David Fallick, a managing director at Standard & Poor's. "There is less product with just as many lenders chasing that product. No one has dropped out," he adds.

Despite the heightened competition from portfolio lenders, CMBS lenders may have the edge because they can offer more leverage and both fixed- and floating-rate loans. "CMBS has the complete menu of financing options, whereas a lot of institutional lenders are more limited to fixed-rate loans and certain leverage levels," says Philipp.

Bond markets in general have been significantly affected by rising interest and Treasury rates. "With interest rates rising, buyers are experiencing sticker shock, although the overall cost of financing is relatively low compared to the past," notes Kim Diamond, a managing director at Standard & Poor's.

Rising rates have meant that "the typical borrower is unwilling to lock into higher interest rates and instead is opting for short-term, floating-rate financing," says Diamond.

Roger Lehman, who is director of CMBS research at New York-based Merrill Lynch & Co., confirmed that fixed-rate conduit issuance , "the bread and butter of the industry," is down significantly.

Floating-rate transactions appeal to a borrower who "has a short-term horizon and doesn't want to be locked into a rate," says Philipp. Nevertheless, the fall in fixed-rate volume has been greater than the rise in floating-rate volume, he adds. Lehman also sees a sluggish market that will be further slowed if interest rates remain high.

"Lending across the board is down, with both conduits and non-conduit lenders seeing a drop in activity," says Lehman. Despite a modest jump in CMBS issuances at mid-year, Lehman expects the second half to remain slow due to higher interest rates.

Foreign investment sparks market Although the domestic CMBS market is sluggish, activity abroad is picking up some of the slack. However, it won't be able to make up completely for the drop in revenue in the U.S market. "The problem is that you don't have the volume that you do in the United States," says Lancaster. Further complications arise from accounting and regulatory issues and more fixed costs in establishing a system to produce the necessary steady stream of deals, he adds.

Philipp notes that Japan has been a particularly active market for CMBS, with several single-asset transactions completed there this year. U.S. banks and opportunity funds have been seeking single-asset securitizations abroad, and Japanese institutions are exploring securitization as well. The start of conduit programs in Japan follows a period of illiquidity, and Philipp expects to see more non-performing deals in Japan, similar to the Resolution Trust Corp. transactions that first fueled the market in the United States. Philipp expects extended growth in the Canadian market in the next few years. Meanwhile, in Europe some high-profile office building transactions have been recorded, he adds.

Standard & Poor's characterized the first quarter of 2000 as "a major turning point for international CMBS." European CMBS issuance in the first quarter totaled a record $3.7 billion, according to Standard & Poor's. The biggest transaction, Europa One, was handled by Rheinhyp, a German mortgage bank and subsidiary of Commerzbank AG, and it included assets spread across five European countries. Standard & Poor's reports that "market speculation hints that other German banks will seek to replicate this deal."

However, Philipp cautions that the high level of arbitrage involved in CMBS makes those transactions work better in the United States than in Europe. The issue boils down to "whether you can sell bonds for more than you can sell mortgages," he says.

Trends in the U.S. market Back on the domestic front, trends include smaller CMBS loan pools, more stand-alone loan deals and an increase in deals brought by multiple originators. According to Merrill Lynch's Lehman, CMBS offerings are smaller because it is more difficult to make loans, so consequently it is harder - and takes longer - to get to the $1 billion-plus conduit level of loans. With a reduced appetite for aggregation risk, securitized lenders are trying to decrease their need to warehouse loans by offering smaller and more frequent deals, he says.

Philipp agrees that the trend toward smaller deal sizes is the result of an increased concern for aggregation risk. "The longer you hold the loans, the more exposure you have to market volatility," he says, adding that the average deal size has dropped steadily in the past few years. Philipp says the market also is experiencing a surge of stand-alone, single-asset large loan deals in the $100 million range. Deals also are more frequently being brought to market by multiple originators, which is another way to reduce loan warehousing risk and reach an efficient deal size quicker.

Diamond adds that more unusually structured transactions that may have been unnecessary or inefficient in former years gradually seem more appealing in this maturing market. The structures are affecting both pool and single borrower/property-specific transactions, she says. In order to be more profitable, most securitized lenders are "playing with structural concepts to have a more efficient execution," says Diamond. These concepts may include A/B and non-sequential pay structures, as well as more credit enhancement mechanisms. Internet technology also has had an impact on CMBS origination and placement, with a bevy of new web-based services rolled out in the last year, adds Diamond.

Changes in the wind The CMBS market continues to await a ruling from the U.S. Department of Labor regarding proposed changes to ERISA rules for pension fund investment in CMBS. Currently, pension funds are allowed to invest only in the most senior bond in a structure and not other investment-grade classes. Proposed changes would allow pension funds to invest in all investment-grade portions. Lehman says the expected ruling is likely to encompass at least the Single-A portions, and perhaps go all the way down the ladder.

Such an expansion in the universe of CMBS buyers would be positive for the market. However, Lehman adds that he does not expect an instantaneous stampede by pension funds to purchase lower-grade portions of CMBS deals. "It will take time, as pension fund investors find out where they want to be on the credit curve. But it is obviously positive," says Lehman. "The sector that will most likely benefit is Double A, an area that we feel is currently under priced."

Philipp agrees that anything that opens the market to new investors is positive. He adds that if pension funds are allowed toinvest in mezzanine debt, it will narrow spreads and allow for more competition between securitized and traditional lenders.

Changes for the good In another sign of market maturation, CMBS was added last year to the Lehman Aggregate U.S. Bond Index, a benchmark used by investors. This will help broaden the market since the Lehman Index is widely followed by money managers. Potential investors may now perceive CMBS as a less esoteric product since it is included in a mainstream bond index, which encourages an increase in CMBS holdings.

Lehman of Merrill Lynch says the initial impact of the placement of CMBS on the index was overstated, but notes it has helped create a positive perception about the market because it encourages more investors to look at CMBS as an alternative to other bonds.

Lancaster agrees that inclusion in the index gives CMBS "more respectability," but adds that CMBS still trades cheaper than corporate bonds. More importantly, Lancaster says, CMBS have been trading regularly and with stability in comparison to interest rate swaps, which adds predictability to the market.

"I am a big proponent that CMBS is maturing as a product," says Lehman. "Actual and perceived liquidity of the market continues to increase, and as a result, you will see a tightening of CMBS product relative to other fixed-income spread sectors."

Popular properties Of the various property sectors included in securitized offerings, multifamily properties remain in favor. The retail sector, on the other hand, has experienced problems that make investors more cautious.

Lancaster points to store closings in the Jacksonville, Fla.-based Winn-Dixie grocery chain and Rite Aid's credit problems as examples, but adds that these issues primarily affect subordinate deals, and have little impact on securitizations or Triple-A transactions.

Retail and hotel properties are not popular investments in the current CMBS market. "Retail is seeing some overbuilding, some struggling retailers and some dislocation, as well as the Internet effect, which should have the biggest impact on big-box, commodity-type stores," says Lancaster.

Overall, there are fewer esoteric, or marginal, property types included in CMBS loan pools than there were some years ago, notes Moody's Investors' Philipp. Conduit lenders have returned to the "five basic food groups," he says, referring to the primary sectors of commercial real estate. This reliance on traditional favorites will likely continue as the CMBS market struggles to emerge from the doldrums.

In a competitive financing market in which lenders are trying to cut costs and find profit any way they can, the Internet is proving to be an increasingly valuable tool to facilitate both the origination and placement of commercial mortgages. Both lenders and borrowers can benefit from the growing number of services offered on commercial Websites.

"The Internet will have a considerable effect on how CMBS transactions are brought to market, as a plethora of mortgage origination, due diligence and trading websites have cropped up," says Kim Diamond, a managing director at New York-based Standard & Poor's.

Since e-commerce sites reduce origination costs and decrease holding risks associated with securitization loans, lenders can boost profits, says Diamond. The Internet also can be a faster way for both lenders and borrowers to do business. Borrowers can look forward to more competitive, firm and binding pricing, she adds.

So far, many well-known lenders have developed Internet sites, either independently or through a lending consortium. However, the Internet is a relatively untapped source. The low execution volume is no doubt due in part to today's tough market conditions. But a lean CMBS market may prove to be the best time for web-based lenders to get attention, build brand awareness and inform the industry of their capabilities.

"Profit and efficiency are so strained at this point, that if the Internet format helps reduce expenses for loan originations, it will be embraced and accepted," says David Fallick, a managing director at Standard & Poor's. For that matter, when mortgage volume picks up in the future, the Internet may be poised to become the main vehicle for closing loans, Fallick adds.

Many of the new Internet-based companies have different approaches and platforms. Some concentrate on matching borrowers and lenders, while others add value by providing underwriting and due diligence services. Some are providing one-stop real estate shopping by handling sales and acquisition services as well as the mortgage process. Sites that originate loans have considerable market and property data at hand to provide customers.

One of the founding premises of New York-based CapitalThinking Inc.'s on-line commercial mortgage marketplace (, is that "seasoned technology and real estate professionals working together can leverage the Internet to dramatically streamline the loan process and benefit all parties in a transaction," says Heather Shively, the company's co-founder and chief executive officer.

Shively expects to see a further integration of the on-line and off-line worlds in the next few years. "We won't see all mortgages closing on-line, as there is a longer ramp up before we have significant volume. But off-line businesses will see profitability and efficiency improve from Web technologies," she says.

CapitalThinking is using human resources to compensate for what the Web cannot do, Shively says. "The Web is not good at developing a relationship," she says. "You can't go golfing with your client over the web. But it is good at sharing work flow and providing analytic tools with a national network." By re-engineering and leveraging technology, CapitalThinking claims to cut the time it takes to process and close loans by up to 60%. Lenders conducting business with CapitalThinking include Heller Financial, J.P. Morgan, GMAC and Wells Fargo.

CapitalThinking realizes the importance of keeping the human element in the Internet mortgage process, Shively adds. Each lending account at CapitalThinking has a relationship manager. "We ask lenders how we can do better. It's a service business, not an automated faceless interaction," she says. "We know the complexities of commercial mortgages. A multi-million-dollar trade will not happen without talking to someone. You need to know the people involved and the probability of closing."

CapitalThinking's employees have backgrounds in both portfolio and conduit lending, so they can assess each transaction to determine whether it will benefit the customer. CapitalThinking also is constantly upgrading its Website based on customer feedback.

Other dot.coms specialize in linking mortgage companies with lenders by providing multiple listing services comparable to those offered in residential real estate. Kenneth Cohen, chairman and chief executive officer of Los Angeles-based, says his firm's Website assists in the placement process by providing mortgage companies access to more lenders in this manner.

"Historically, what you have seen is that every mortgage banker has a Rolodex, and if they have a loan to place, they think of their correspondents and send them material," says Cohen. "Now, mortgage bankers can deal with any type of financing request from a borrower, because through the Internet they can find a lender who fits."

Traditional mortgage bankers are concerned about competition from new strictly on-line originators, says Cohen. This is not necessarily because on-line bankers can do a better job, but because "they can compress origination fees without any hard experience So if traditional mortgage bankers want to compress their fees, they have to do more volume. To get more volume they have to reach more lenders. That's where can help, he says.

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