Last week we heard from the originator side of the CMBS table and now the investors get their shot in this second of a two-part overview of the market. Larry Duggins, president and COO of Dallas-based ARCap REIT, doesn't hesitate to say that this year's volume will be down a bit over 2003. He says that competitive forces and a need to choose carefully the deals he wants to buy into act as a check on the REIT's rush to buy just for the sake of buying. But ultimately, the executive, who founded ARCap in 1999 as a venture between Apollo Real Estate Investors and his own Remicap, is bullish on the sector as a whole. And in an exclusive interview, he recently explained why.

GlobeSt.com: You traffic solely in the B-piece sector, is that right?

Duggins: We do. Essentially, we buy triple-B minus through non-rated, but we always buy bottom up because we're long-term buy-and-hold investors. We think it's very important to be the special servicer with that investment.

GlobeSt.com: You've indicated that there's a particular risk in investing bottom up. Explain.

Duggins: There are a number of factors that are squeezing B-piece investors today as the market matures. For one, loans are a little more aggressive than they have been over the past couple of years.

GlobeSt.com: Dangerously so?

Duggins: Not dangerously so, but it's time to start being careful. There's also more competition among the ratings agencies, which is pushing down subordination levels and creating more competition among B-piece investors. All of these things can be positive for the market, but they could also push us a little too far.

GlobeSt.com: How is your volume looking year-to-date compared with the same time last year?

Duggins: It's about equal, but we'll probably not buy as much in the second half as we did in the second half of '03.

GlobeSt.com: Because of all the reasons stated above?

Duggins: Yes. We're being extremely careful. There are a number of originators who have maintained their origination disciplines in the face of the competition and all those other factors I described, and we're comfortable buying from them. But there are fewer transactions that make us feel comfortable.

GlobeSt.com: Are the ratings agencies hurting themselves?

Duggins: I have a great deal of respect for what they do. Without exception they're run by competent people who understand this marketplace. But I disagree with their attempts to push for ratings parity among various types of fixed-income instruments. They want a double-B rating to mean the same thing and have the same risk of default for a corporate bond and a CMBS bond. That sounds logical, but corporate credit ratings reflect the operation of a company. That company exists independently of its credit rating, and the operation won't change for a better rating.
CMBS works the other way. Mortgages are originated to the rating-agency models. Mortgage originators use the criteria established by the agencies in forming the portfolios that become CMBS. If the agencies send the message that more defaults in double-B bonds are tolerable and appropriate because they want ratings parity, then the originators are essentially getting the message that it's okay to go out and make more aggressive loans. That will show in lower subordination levels but it also comes through in the quality and leverage in the underlying mortgage.

GlobeSt.com: We spoke with a lot of people who say their volume, like yours, is flat or down, but the market as a whole is up. What am I missing?

Duggins: CMBS is steadily growing as a percentage of commercial-mortgage finance. So more commercial mortgages are being financed through CMBS as a percentage of the total. In addition, we're beginning to see the refinancings flow off of the original wave of CMBS. If you recall, CMBS started to show viability in the mid 1990s and really stepped up in '96 and '97. Assuming that 10-year mortgages were the norm in those deals, they're being refinanced now, and so there's an influx of refinancing from those people who are used to having CMBS financing. So the activity is not solely from people looking to lock in low rates.

GlobeSt.com: So your overall outlook is positive?

Duggins: Our view of the market continues to be optimistic. CMBS is the right way for the vast majority of owners of commercial real estate to finance those assets. We also believe it's incumbent on all of the participants in the marketplace to exercise a little restraint and judgment relative to the creditworthiness of the loans they originate. It's still a young market, and we have to be careful not to allow the marketplace to go to extremes.

GlobeSt.com: How reasonable is that to expect?

Duggins: This is a market of experienced, smart people--at both the originator and the investor level. And those are the folks who have to apply that discipline to the market.