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Brian Lancaster co-authored this article.

Commercial mortgage-backed securities issuance could reach $60 billion this year and rise another 10% in the first half of 2003 as borrowers continue to lock in record-low interest rates and bid-offer spreads narrow. CMBS now accounts for about 20% of commercial real estate financing and, despite deteriorating real estate conditions, should remain a relatively safe haven for investors in the coming months, according to the latest Wachovia Securities industry outlook.

Although deterioration in the commercial real estate sector could push CMBS delinquencies to 2.5% from the current 1.8%, CMBS defaults should be cushioned by low cap and interest rates, conservative underwriting, prior rent run-ups and positive equity positions among borrowers. That’s in keeping with CMBS’ historically strong track record. According to data from Intex Solutions, of the approximately 70,000 CMBS loans originated to date worth slightly more than $400 billion, there have been only 243 losses worth six basis points of the combined original balances passed on to bondholders.

Overall, the commercial real estate market will continue to deteriorate through the end of the year and into 2003, but at a moderating pace. Anemic demand growth and substantial overhang from business contraction have been offset somewhat by the lower interest and cap rates, robust capital inflows, high risk premiums and waning supply growth.

In the office sector, revenues are expected to continue their downward slide due to weak demand growth. Office vacancy rates reached 15.3% nationwide at the end of the second quarter and are forecast to hit 16.5 to 17% by year-end–just shy of the last recession’s 19% peak in 1991.

In the midst of what some are calling a jobless recovery, vacancy rates are also under pressure from new space delivered in the market. Some 35 million sf of new space came on the market in the first half of the year, and another 34 million feet of new construction will be delivered in the second half of the year.

Meanwhile, sublet space nationwide is estimated to have reached 150 million sf, and shadow space–space leased by companies for expansion but now sitting empty–could account for up to 5% of all unused office space.

The process of converting this vacant space to economically vacant space will stress some borrowers and will increase the downward pressure on rental rates in some markets–most notably in suburban areas. One of the more interesting twists to the current downturn is that while performance as a whole is deteriorating, investment-sales activity for office properties has been robust. Pent-up demand in the wake of Sept. 11 and an appetite for investment-grade and trophy properties have pushed down office cap rates to an eight-year low.

The apartment sector, historically considered a safe haven by real estate investors, should continue its decline through the end of the year before beginning to recover in 2003. Vacancy rates should peak at 6% to 7%, just shy of the highest levels of the last recession.

The national average vacancy rate increased a nominal 10 basis points in the second quarter to 5.8%, moderating from the 90 to 100 basis point increases in each of the previous two quarters.

With mortgage rates near all-time lows, and home ownership at record levels, apartment owners face stiff competition in attracting tenants. Overbuilding was also expected to contribute to a further softening in the market through year-end, with 80,000 new units coming online during the second half of 2002.

Despite the deteriorating factors, multifamily CMBS-loan delinquencies have remained stable during 2002, in part because borrowers built up cash-flow cushions from substantial run-ups in apartment rents from 1997 to 2000.

The hotel sector, hardest hit by the terrorist attacks of Sept. 11 and the economic downturn, continues its painful recovery. Year to date, the industry benchmark revenue per available room is down about 7%.

Barring any additional terrorist events, we anticipate a return this fall and winter to slow RevPar growth commensurate with economic recovery. Although increased domestic and leisure travel has contributed to a rebound in occupancy levels, business travel, which is linked to corporate profitability, is critical to a sustained recovery in hotel revenue growth.

Retail continues to be one of the bright spots in the commercial real estate sector and in the economy overall. The retail market is already showing some signs of overall stability, although some metropolitan areas–including Orlando and Phoenix–continue to suffer from oversupply.

Due in part to the lagging nature of the commercial real estate sector, overall commercial real estate delinquencies and foreclosures have remained at their lowest levels in more than 20 years, even as vacancies recently topped 10%–the highest level since 1994.

As we look forward to the end of the year and into 2003, this dichotomy of low delinquencies and high vacancies sends a clear warning about the direction of the market. But with loans underwritten to sustainable rents and realistic vacancy levels, and riskier loans kicked out to B-piece buyers, we believe CMBS loans can withstand substantial revenue declines without a significant increase in defaults in the coming months.

Think Tank member Ben Williams heads Wachovia Securities’ fixed income division, which includes a real estate capital markets group that originated more than $3 billion in CMBS issuance last year. Williams guided the formation of Wachovia Securities’ commercial real estate investment banking business over the past two years.

Brian Lancaster is a managing director and head of Wachovia Securities’ real estate and CMBS Research.

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