Badly Needed CMBS Issuance Inching Back

Financing availability is improving across the lending spectrum but caution still rules. Commercial banks and life insurance companies have become more active in financing commercial properties, but tight underwriting and restrictive risk guidelines will the limit their full impact on investment sales in 2011. It is clear that the CMBS (commercial mortgage-backed securities) market has also started to recover. We estimate total issuance for 2010 just shy of $13 billion, roughly four times the volume in 2009 but still a fraction of the $234 billion peak in 2007. Even prior to the market froth of 2005-2007, CMBS issuance averaged $85 billion per year from 2002 through 2004, providing a critical source of financing to the commercial real estate market. The recovery should gain momentum as the secondary market continues to expand thanks to improved confidence and better underwriting.  Approximately $8 billion of issuance is expected for Q1 2011 alone, and we agree with Standard & Poor’s forecast of total volume of $35 to $40 billion for 2011. 

The primary factors driving this recovery are slowing pace in the growth rate of CMBS delinquencies (including a growing number of successful loan modifications), improving CRE market fundamentals and increasing demand from CRE investors. The large spread between CMBS returns and alternative investments also helps.  CMBS delinquency rates are the highest in the industry, but investors are distinguishing the new round of deals from the underperforming pools of the past, particularly 2005-2007 vintage loans.

Does this mean a return to the go-go years of 2004-2007 any time soon? Hardly. If $35 billion is issued in 2011, it would be just 15% of the peak. Also, the new underwriting criteria are far more conservative and issuances are smaller and geared toward low-risk assets. For example, the average Loan-to-Value of CMBS deals in 2010 was 58%, compared to more than 80% at market peak. And, importantly, originators are increasingly being required to retain stakes in the offering. 

We expect to see the CMBS market to steadily climb this year and could see more of a burst in issuance in 2012, perhaps reaching $100 billion by 2013.  This would still be less than half the peak level witnessed in 2007, but a sizeable amount nevertheless, bringing needed liquidity to the CRE market. As important as the total volume, the risk appetite should broaden to include Class B assets and assets located in better secondary metros. Financing for Class C assets and lower tier markets will lag for some time.

Growth in CMBS activity will help fill a hole that traditional lenders (in particular commercial banks and life insurance companies) may not be able or willing to fill for some time. Although banks’ improved financial position, clarity on higher reserve requirements and lower losses bode well for increasing commercial lending, their allocation will likely fall short of increasing demand until improved valuations and property fundamentals provide a safety net to the next wave of loan maturities. In the next three years an estimated $1.4 trillion in commercial loans will mature in addition to re-maturing loans that were extended during the crisis, according to Foresight Analytics. Approximately half of this debt is considered under water based on current valuations, according to Trepp LLC. 

Commercial banks will also have to contend with regulatory pressure from the FDIC and the wild card of home foreclosure losses yet to come. That is not say these traditional sources of financing will not increase their participation in the market. In fact, they already have been. But their capacity to substantially increase commercial lending levels will be limited and conservative, highlighting the importance of the CMBS market recovery.

The bottom line is that we expect the availability of debt capital to gradually increase, with much of the growth taking place via CMBS issuances. However, borrowers will continue to be forced to contribute significant equity, and underwriting criteria will be conservative.  This will limit the rise in investment activity and keep the volume of seller financing and loan assumptions higher than usual. It also gives cash-rich and low-leverage investors – high net-worth individuals, REITs and pension funds – in strong positions, especially as they become more willing to acquire Class B assets.

Hessam Nadji is managing director, research and advisory services, at Marcus & Millichap Real Estate Investment Services. Contact him at hessam.nadji@marcusmillichap.com