• Good news ahead in CMBS market
  • Apartment market looks to some like best CMBS market
  • Broader market among pension funds

To paraphrase Mark Twain, reports of the death of the commercial mortgage-backed securities industry may have been greatly exaggerated. Apartment loans are an important reason why. Insiders in the commercial mortgage-backed securities (CMBS) industry are optimistic about their future, they say. Despite a shake-out in 1998-’99, the securitization of real estate loans remains big business and an important source of loans for apartment borrowers.

The CMBS industry’s trouble began in the financial crisis of 1998. That summer Russia defaulted on a mass of old bonds issued by the Soviet Union, sparking a “flight to quality,” as investors sold their investments. Several major CMBS issuers, as well as investors in the subordinate “B-piece” of CMBS issues, cut back their operations or left the business altogether.

As some firms dropped out of the business, or saw big declines in volume, commercial banks and credit companies solidified or expanded their positions. Banks relied on their retail network for loan origination and their capacity to hold loans in portfolio if necessary. Among the firms gaining the most market share or making new commitments to the business in 1999 and 2000 were units of First Union National Bank, Deutsche Bank and J.P. Morgan.

But the industry bounced back in 1999, and demand for CMBS grew stronger in 2000. In 2000, $61 billion in CMBS were issued over the entire year. In October 2001, the issuance of CMBS was on track to break all records, with $60.9 billion issued in the first nine months of 2001 alone.

As of Aug. 31, 2001, delinquency rates for CMBS transactions more than one year old have risen to 1.3% of current balances outstanding, a slight increase over July’s rate, according to a recent report by Morgan Stanley’s Securitized Products Research Group. An October report by Fitch, Inc., does not expect a sudden increase in defaults on the loans that underlie the bonds. Furthermore, Fitch expects multifamily have fewer defaults than other property types on the grounds that in bad economic times, tenants are likely to stay in their apartments and not buy homes.

Good news ahead in CMBS market

In 2001, in a sign of the industry’s resilience, Criimi Mae, once a pillar of the commercial mortgage-backed securities (CMBS) market, finally emerged from bankruptcy. A spokesman for Criimi Mae would not discuss its future plans, but the company’s return will help make more capital available through Wall Street mortgage conduits.

Criimi Mae completed its bankruptcy reorganization plan in April 2001. In June, Standard & Poor’s reinstated Criimi on its Selected Servicer List. “To its credit,” said a statement by Standard & Poor’s, “the servicer has retained nearly all key staff, maintained sound operating procedures and also been able to focus on technology improvements in the past two years.”

Fitch and Moody’s Investment Service also have approved the company as a servicer of loans.

Before its bankruptcy in October 1998, Criimi Mae’s core business was buying low-rated and unrated CMBS bonds. These subordinated, or B-piece, bonds earn higher returns for an investor, if the buyer can manage their risk. About 30% of Criimi Mae’s B-piece bonds were backed by commercial mortgages on multifamily properties. Criimi Mae also was the servicer on the bonds and still holds a mortgage portfolio of more than 3,500 loans valued at $20 billion.

Since Criimi Mae left the CMBS market, there has been a shortage of buyers for these B-piece bonds, according to Jon Rickert, vice president for Commercial Finance at JP Morgan. The lack of competition allows the buyers of these bonds to be pickier. “The number of loans kicked out of pools has increased dramatically,” Rickert said. Many investment banks also now prescreen loans, which slows down the closing time for a deal. Fortunately for multifamily, the loans kicked out tend to be from other sectors, like hotel, health care or single-tenant building mortgages.

If Criimi Mae returns to its core business, it will be only good news for the multifamily sector. As Rickert puts it, “more money for CMBS means more competition.” This competition to put money into CMBS could have a myriad of possible effects, one of which could be better terms and more availability for developers seeking commercial mortgages. Certainly, more cash flowing into the commercial mortgage market can’t be bad.

In addition, Criimi Mae originated 30-year commercial mortgage loans totaling about $1 billion between the end of 1997 and the end of 1998.

Apartment market looks to some like best CMBS market

Conduit lenders (that originate loans for securitization) are hungry for apartment deals, said John B. Levy, president of investment banking firm John B. Levy & Co., Richmond, Va. “The feeling is, apartments are safer” investments than other real estate categories, he said. Most of the mortgages financed by conduits are in the $3 million to $5 million range, though loans as small as $500,000 can be securitized, Levy said.

“The apartment market is the best CMBS market – I think that’s pretty clear,” Levy said. Pools with larger shares of apartment loans “seem to trade better.” If a pool contains at least 30% apartment loans, “that kind of turns on the lights.” In fact, even Freddie Mac and Fannie Mae get interested in buying such pools.

Conduits responded to changing conditions in 2000 by consolidating. The three biggest combinations were: J. P. Morgan and Chase Manhattan Bank, Donaldson Lufkin & Jenrette and Credit Suisse First Boston, and Union Bank of Switzerland and Paine Webber.

Industry insiders agree that Freddie and Fannie are the most aggressive competitors for deals on the highest-quality properties. For most Class B or C garden-style apartments, however, conduits can offer more favorable terms, he said.

Borrowing from conduits can also be faster and “less painful” than meeting the paperwork and underwriting requirements of secondary mortgage companies.

Conduits sometime are willing to tolerate higher loan-to-value ratios than agencies, because they calculate operating cash flows more liberally than competitors. For example, conduits may be willing to consider such income streams as deposit forfeitures, cable franchise fees, and late payment fees in calculating property values, unlike Freddie and Fannie, said Ken Dickey, chief operating officer at Deutsche Bank Alex. Brown.

Where conduits fall short for many borrowers is prepayment flexibility and servicing. Mortgage bankers who make loans they later securitize often don’t even know who will service them. That gives some borrowers pause, because of concerns about changing circumstances during the term of the loan. Also, conduit loans are almost exclusively 10-year deals that bar prepayment and require eventual refinancing.

One factor boosting CMBS is that, despite the image of CMBS as risky, conduit loan defaults are lower than for corporate bonds. One rating agency, evaluating $232 billion in CMBS from 1990-1999, found that investment-grade CMBS had an average annual default rate of 0.06%, compared with 0.08% for bonds. For issues rated below investment grade, which are important to CMBS, the CMBS average, 0.14%, was much lower than 3.07% for corporates.

Broader market among pension funds

Another new development that may bode well for CMBS is a broader market among pension funds. Under the Employee Retirement Income Securities Act, pensions could invest only in the most senior securities rated at least A until recently, but the Department of Labor has authorized them to buy CMBS rated as low as BBB-.

Mortgage-backed securities, rarely issued before about 1991, developed into an important vehicle for residential, industrial, and commercial properties through the 1990s. By 1998, annual volume exceeded $50 billion, but then the market crashed. By the first nine months of 1999, volume at such active issuers as Credit Suisse First Boston and Citicorp had ground to a halt, and others were fading. So last year’s stability came as a surprise.

Conduits may still be the best place to get a loan for purchasing or refinancing Class B project in a second-tier markets and smaller multifamily deals. These are the transactions that generally are not up to Fannie, Freddie or insurance company standards. Conduits also tend to allow for higher level of loan proceeds, more forward looking cash flow projections.

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