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Erika Morphy is co-editor of Debt and Equity Journal, from which this article is excerpted.

i>Dallas-CMBS volumes in 2006 will probably reach or exceed levels from 2005–a record-breaking year in which CMBS issuance totaled close to $170 billion, an 80% rise from 2004. To understand why this slice of the real estate capital market continues its upward trajectory, consider what Dan Smith, the recently appointed managing director of RBC Capital Markets‘ real estate mortgage capital division, has to say.

Some three months after RBC launched its US platform–luring Smith from GE Real Estate to lead the initiative–the institution is preparing to close on a sale of nearly $300 million of bonds. It also has more than $2 billion in the pipeline, he adds. Smith spoke with Debt & Equity Journal earlier this month during a business trip to New York City where he was talking with potential partners. By the end of 2006, Smith says, CMBS will probably exceed last year’s volume, registering between $180 billion to $200 billion. “Rates have been friendly and deal flow has been strong,” he concludes.

However, investment opportunities in the CMBS market can still be difficult to find, at least according to most industry experts contacted for an informal survey by D&E. While most still like the asset class and the opportunities it offers, margins are tightening close to the break-even point, forcing some investors to look elsewhere for returns. For the most part, however, Derrick Wulf, senior vice president of Dwight Asset Management, a Vermont-based asset management firm that buys CMBS for insurance and other institutional investors, summed up the sentiments of those interviewed. “There are opportunities in CMBS, no question,” he says. And yes, pricing is almost perfect, which makes it harder to find value. So for the CMBS investor, it is now more important than ever to be selective and careful about which part of the capital stack in which to invest.”

For instance, Fitch Ratings says the delinquency rate for vintage 2004 transactions continues to rise, despite the overall decline in the market. But many investors still favor older vintage deals. Smith, for instance, speaking generally–not about 2004 transactions that is–says as deals season, investors can tell more about performance. “Older vintage deals make sense as underwriting has gotten very aggressive,” he says. “Traditional lenders are even more aggressive because they are not subject to market underwriting scrutiny and rating agency reviews. CMBS lenders are still subject to more scrutiny, which is good for investors.”Not all investors think CMBS underwriting is aggressive enough. One institutional investor with an aggressive risk profile–which did not want to be identified–says CMBS is priced too well for it to invest in, even though it has looked at it closely. Debt markets are priced to perfection and they are simply not a high enough return opportunity, the investor notes. There would have to be some dislocation and distress in the marketplace for a significant return opportunity to develop, it concludes.

Wulf is on the other end of the spectrum. He likes the security CMBS offers, especially the high subordination levels offered by the super seniors (12%) and super duper (more than 30%) CMBS structures which have developed during the past 18 months and are now common in many structures. “Depending on what type of a mandate an investor is running, in my opinion, a lot of the senior classes in CMBS still represent good relative value versus other opportunities—namely higher grade corporates,” he says.

For instance, Wulf points to two deals in the market earlier this month, both of which were priced at 25-and-a-half basis points over swaps or 75 basis points over Treasury. They are enhanced AAA rated securities comparable to rates where unsecured debt is trading now, he notes. “Investors can buy these senior CMBS classes at spreads comparable to AA rated high grade bank paper and own a diversified pool of assets with more than enough credit support to withstand most economic shocks.”

Also, he notes, investors can buy certain CMBS classes that would benefit from defaults, namely, discount priced bonds that would receive pre payments at par, thereby increasing the yield or return to the investor. “Certain classes within the senior portion of the CMBS deal, due to their structural characteristics, can benefit from unscheduled pre payments. These types of classes can be a partial hedge against the deterioration in collateral performance because they would stand to benefit from defaults.” Again, with a 30% credit support, he says, “They could withstand quite a few defaults before one would have to worry about any sort of a principal loss.”

Respondents say collateralized debt obligations also offer investment opportunities. Stuart J. Boesky, CEO of New York City-based Pembrook Capital Management, says CDOs are changing at breakneck speed, noting, “The sector is one of the most watched, emerging securities markets. CDOs may very well be to this decade what CMBS were to the ’90s.” Boesky, the former CEO of CharterMac, founded the real estate investment management firm this month with Mariner Investment Group Inc.

“Unlike CMBS, which tends to group loans with similar characteristics, CDOs allow more bells and whistles such as supplemental financings and varying prepayment features so that every CDO has a different personality,” Boesky explains. He says the company is monitoring the market to see if real estate developers and owners prefer that flexibility to the slightly higher cost of borrowing versus CMBS. Speaking of Pembrook’s own securitizations, Boesky responds, “The most highly structured financings are often those that allow for the most creativity. We’re using some of those new technologies in our lending platform and adding our own twists.”

Pembrook does not have a volume target. Instead, Boesky says, “We can put as much capital to work as there are good deals. Increasingly sophisticated capital markets allow for leaner firms such as ours to compete effectively with the biggest conduits and CMBS issuers. There is greater market transparency and liquidity than ever before and it’s changing the landscape of players in the real estate securities markets.”

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