After growing at a record-setting pace for the last six years, the commercial mortgage-backed securities market hit a record again in 1997 and is well on its way to set another record in 1998, provided no major blip occurs in the economy with respect to real estate values and interest rates. Most industry leaders predict that CMBS market volume will reach the high-$50s billion mark in 1998 from an estimated $42 billion in 1997 and a mere $4.6 billion 1991.
A few skeptics, on the other hand, are starting to detect some dark clouds on their radar screens as far as CMBS spreads and a balance in demand and supply are concerned. They are predicting widening of spreads at least through the first quarter of 1998 and a wave of consolidations in the CMBS industry in late 1998 and 1999. Given a large and still-growing list of CMBS originators, a possible consolidation in the industry is not necessarily bad news though, they say.
Both skeptics and optimists, however, seem to agree on two major points: First, the fundamentals of real estate remain strong today; and secondly, the CMBS industry has matured enough to withstand any minor shakeup.
The CMBS market, they argue, is here to stay and plays a vital role as a major source of refinancing or new financing in commercial real estate. They also say that the CMBS market continues to be innovative and that it would always invent new mechanisms to deal with any obstacle or find new ways of financing. One of its most recent inventions has been the establishment of the Financial Asset Securitization Investment Trust, or FASIT, which became effective Sept. 1, 1997. This new vehicle, which provides a mechanism of securitizing both mortgage andnon-mortgage assets, may create new opportunities in the CMBS market once its tax regulations are clarified by the Internal Revenue Service.
Other factors that are likely to have a major positive impact on the CMBS market include increasing the number of mortgage real estate investment trusts (REITs) and a growing appetite for CMBS by real estate mutual funds, pension funds, money managers and banks. Life insurance companies, which are seeing a decline in their role in the traditional debt market and are unloading their portfolios to reduce their exposure, are also becoming major buyers of CMBS and are expected to play a more active role in the CMBS market in the near future.
During the last seven years, the CMBS industry has grown by leaps and bounds. Exceeding the industry's expectations, the volume of commercial mortgage-backed securities rose to an estimated $42 billion in 1997 from $30.4 billion in 1996, $18.3 billion in 1995, $20 billion in 1994, $17.2 billion in 1993 and $16.6 billion in 1992. The first quarter of 1998 is expected to see the largest issuance of CMBS volume in any single quarter in history, says David Oliner vice president of real estate investment banking at New York-based BT Alex. Brown, a subsidiary of Bankers Trust.
Sheridan Schechner, managing director in real estate department of New York investment giant Goldman Sachs, says CMBS volume will break the high-$50s billion mark in 1998, provided interest rates remain low. "Interest rates a lot higher will slow down the CMBS market volume, but no one is expecting rates to be high," Schechner says.
Given the $1.1 trillion in outstanding commercial real estate debt and between $100 billion and $200 billion of commercial debt originations every year, the potential for CMBS growth is immense. Of the $1.1 trillion total debt outstanding, CMBS accounts only for about 15%, according to industry estimates. Since its inception, approximately $150 billion in CMBS has been issued.
New accounting rules that became effective early this year are also encouraging banks and insurance companies to securitize commercial mortgages. The new accounting and regulatory standards, which allow transactions to achieve sale treatment status, enable issuers to remove assets from their balance sheet. The role of insurance companies, which used to be one of the main sources of permanent commercial debt volume, is also changing as competition is moving from life companies to securitized loans. Some insurance companies are getting into the CMBS market as active players. Cigna, for example, is considering its own conduit program.
Newark, N.J.-based Pru-dential Insurance Co. of America, one of the nation's largest property investors that is getting out of the direct real estate ownership business, already formed a commercial mortgage conduit in August. Known as Prudential Mortgage Capital Co., the new Prudential subsidiary is expected to significantly increase the amount of its annual debt origination. Prudential Mortgage Capital will originate loans on most major property types and Prudential Securities will underwrite the securitization.
"We are looking to get in excess of $3 billion a year," says Clay Lebhar, chief executive officer of Pru-dential Mortgage Capital. He says the company's loan origination will vary in size between $2 million and $20 million and $20 million and up. "The CMBS origination market has a very positive environment," Lebhar says, adding that the only negative side of the business today is that there is more competition than ever for commercial lenders. "But the overall market is very positive and that will continue well into 1998," Lebhar says, adding that said other insurance companies would likely follow Prudential's footsteps in forming their own commercial mortgage conduits. "I know some other life companies are looking at it."
"Prudential is trying to take advantage of both worlds," says Peter Riemenschneider, managing director in the real estate group at Prudential Securities. "This is a good example of what the outlook really is for the CMBS market." He says some insurance companies are getting out of the commercial lending business, some are buying CMBS and some are sticking with traditional lending and some are doing both lending and buying CMBS. Life companies are buying mostly investment-grade bonds. "It's easier for them to hold bonds than loans because of regulatory issues."
"The CMBS market is taking a large volume from insurance companies," says Jon Pettee, a managing director in the Boston office of AMRESCO, a subsidiary of AMRESCO Advisors Inc. "Insurance companies, however, are becoming big buyers of CMBS. There are still some life companies that are active as originators of loans as well as buyers of CMBS. Some of them have softened making loans and are buying bonds."
Pension funds are also getting into the CMBS market by securitizing their commercial mortgage portfolios, as has been the case with life companies' mortgage portfolios.
"It's fairly attractive for us. We are issuing more money into the fixed-income and high-risk arena," says Richard Piket, a portfolio manager at the $9 billion San Francisco City & County Employees' Retirement System. He says his fund has invested 3% of its total assets in commercial mortgage-backed securities. The fund doubled its investment to $170 million within a year in investment-grade securities. In December, the fund invested $100 million in non-investment-grade commercial mortgage-backed securities. "We just started below investment grade. We were a little concerned because spreads were a bit narrow. But now it's a perfectly good time to buy such securities."
Industry insiders say mortgage REITs are also becoming a bigger player in the CMBS market as is evidenced by their growing number. Since mid-May, about eight mortgage REITs have successfully completed their initial public offerings, raising $1.48 billion. In addition, there are at least 11 mortgage REITs in registration and together they expect to raise approximately $1.6 billion. One of the firms that is considering a mortgage REIT is AMRESCO Capital LP. "We have some plans under way to sponsor a mortgage REIT," says Michael Maberry, president of AMRESCO Capital. "It will probably invest in standard mortgages and also in higher yield mortgages such as mezzanine financing. It will also invest in lower tranches of commercial mortgage-backed securities."
Riemenschneider of Prudential Securities predicts that there are going to be more REIT CMBS deals in the future, and that CMBS is going to get a tremendous boost from mortgage REITs because they are sitting on a lot of cash.
Loy Saguil, vice president of fixed-income research at Prudential Securities, says CMBS deals are also growing bigger and bigger and getting more diversified, including multifamily, retail office and others. It's difficult to find CMBS deals solely dependent on one particular sector. CMBS deals are reaching $1 billion and $2 billion in sizes. In September, GMAC Commercial Mortgage completed its $1.7 billion CMBS offering - one of the largest commercial mortgage conduit securitizations. These securities are backed by 355 mortgages on 380 properties in the United States and Puerto Rico. The collateral is diversified and consists of retail, multifamily, office, industrial, hotel, senior living, mixed-use and self-storage properties. In November, First Union completed a $2.2 billion CMBS offering - the largest CMBS ever.
Michael Mazzei, managing director of CMBS for New York investment firm Lehman Brothers, which was the deal manager for the GMAC and First Union transactions, says CMBS volume will continue to grow as long as the real estate market remains strong.
"It allows real estate to be valued and priced every day more rationally compared with other investments," Mazzei says. "Since the 1990s, real estate is being valued in a more rational way." He says the real estate market remains strong, and unlike the 1980s, there is not any pervasive building going on that is not being erected by real estate needs.
Returns on commercial real estate are also reaching the levels of the booming 1980s. Total return performance on commercial properties during the third quarter of 1997 reached 3.06% - the highest quarterly return since the fourth quarter of 1984, according to industry data. In addition, owners of commercial real estate are feeling confident - confident enough to purchase assets, to develop new buildings and to refinance their real estate assets. All these factors provide for new lending opportunities, which will help fuel the CMBS market.
The blockbuster CMBS market is now overwhelmingly dominated by conduits, which represented more than half of the total CMBS issuance in 1997. Large loans, seasonal mortgages and others accounted for the rest. Tim Mazzetti, director of corporate business development at Midland Loan Services, a Kansas City, Mo.-based real estate financial services firm, says conduits have become not only a very popular vehicle but also a major driving force in the CMBS market.
Conduit volume set another record in 1997 and was expected to surpass its own record in 1998. "Conduits have been growing significantly since 1992 and have become the mainstay of the CMBS arena," says Mazzetti, whose firm's current loan servicing portfolio consists of approximately 13,000 loans totaling $23 billion, and 75% of that is CMBS. Conduits have risen from less than 5% of CMBS in 1992 and 33% in 1996 to more than 50% in 1997, according to industry estimates.
The CMBS market is expected to get a further boost from FASITs. If murky tax issues related with this new instrument are clarified, FASITs can play a vital role in the CMBS market in providing construction loans, bridge loans and 10-year takeout loans, say some analysts. Others remain skeptical.
Schechner of Goldman Sachs says no one is sure yet what the FASITs will do. "Some tax issues have been left murky," he says.
Chris Seyfarth, a partner in the Boston office of E&Y Kenneth Leventhal Real Estate Group, says that FASIT is a major new change since the inception of the CMBS industry. "That is going to add fuel to the fire to the securitization industry," Seyfarth says. "The picture will become clearer in 1998."
So far, most of the growth in the CMBS market has been through the real estate mortgage investment conduit (REMIC), which has allowed issuers to pool and securitize commercial real estate mortgages into a variety of financial products.
The advent of FASIT will further boot the CMBS market. "FASIT is very flexible. In fact, it is more flexible than REMIC," Seyfarth says.
Unlike a REMIC, which has a flexibility derived from its ability to issue a wide variety of bond and derivative securities, a FASIT is the first securitization vehicle to provide issuers flexibility over the collateral backing the issued bonds, according to a report in Online, an E&Y Kenneth Leventhal newsletter. "FASIT allows issuers to substitute collateral, withdraw collateral representing over-collateralization, and add assets over its life, making it a powerful tool for risk management of loan pools," the report says.
"FASIT legislation still needs some work and refinement like any other new legislation," says Mazzei of Lehman Brothers. "There will be a number of FASITs in 1998. They will allow you to have a more dynamic and chaging loan. You will have the ability to modify the loan, remove the loan. It's a living and breathing vehicle. REMIC is a stagnant trust."
As far as CMBS spreads are concerned, many analysts expect to them to continue to widen at least through the first quarter of 1998 because of the expected heavy volume during early 1998. AAA CMBS at 10-year maturity rate widened to about +76 basis point to the Treasury curve at the end of October, up from +62 bp at the end of June, according to Nomura Commercial Real Estate Research.
"The market has maturity to it now," says Jim Reichek, a senior managing director at New York-based investment banking firm Bear Sterns. "It continues to follow an evolution based on residential market, and it is going on fast-forward," Reichek says. "Wall Street's role as a direct originator and buyer of loans will continue to grow. It has also made it easier for borrowers to understand. The CMBS market is very bullish."
Andy Stone, a manager and principal in the transactions group of New York-based Credit Suisse First Boston, says CMBS and REIT markets are continuing to grow. "It is a permanent change in the real estate arena CMBS is going to continue to blossom," Stone says. "We are seeing huge demand for B and below-grade securities. We have seen strong demand for junk paper." Industry analysts say that every investor in all tranches of CMBS has made money during the last two years, but that was unlikely to continue forever. "It will be a thinner margin and higher risk market. Volumes will be large," Stone says. "Wall Street has gotten more creative to get different types of assets in CMBS. We are going to surpass $50 billion in 1998."