Market Data

CMBS Slowdown Restores Financial Market Balance

After issuing a record $78 billion in commercial mortgage-backed securities in 1998, the CMBS market is expected to end this year well below that mark, at between $60 billion and $65 billion. Three factors are responsible for the market's decline: a reduction in conduit lending, a slowdown in commercial real estate transaction activity, and aggressive competition from traditional lenders.

Conduit-Lending Crisis
Tumultuous conditions in conduit lending have reduced CMBS issuance. The dramatic increase in CMBS spreads during the second half of 1998 threw conduits into turmoil. In the case of the CMBS market, conduits have established relationships with loan originators to purchase their funded loans. This allows loan originators to earn fees while not having to carry loans in their portfolios on a long-term basis.

But the increased spreads in fall 1998 forced conduits to choose one of three options. They either could purchase contracted loans at a loss, purchase the loans at higher-than-contracted interest rates to cover increases, or refuse to honor the loan-purchase contracts.

When conduits chose the second option and purchased loans at higher-than-contracted interest rates, loan originators either had to fund rate increases or pass them on to borrowers, which left loan originators open to breach-of-contract litigation.

With the third option, loan originators had to hold loans or refuse to fund them. Some originators, such as banks, had the financial structure to hold loans in portfolio. However, originators with short-term capital structures were unable to fund loan commitments. This led to finger pointing and lawsuits between borrowers, originators, and conduits.

As a result, conduits have made several changes that decrease their vulnerability to sudden spread increases. They have priced their loans at higher margin levels to account for sudden spread increases. In the severe competition for deals in 1998, many conduits priced loans at razor-thin margins. When spreads increased, small profits became major losses.

Second, conduits now have joined forces to pool loan inventory and shorten the inventory assimilation period, dramatically reducing their interest-rate risk.

In addition, conduits also have made alliances with long-term lenders to reduce interest-rate risk. Another favorable trend is smaller CMBS deals.

Also contributing to the CMBS slowdown is the decreased number of commercial real estate transactions this year. Reduced acquisition activity by real estate investment trusts played a significant role. In addition, life insurance companies and pension funds last year sold much of their commercial real estate inventory that they had targeted for disposition this year. These factors have decreased demand for commercial real estate financing, which in turn has slowed the CMBS market.

Increased competition from traditional real estate lenders also has affected CMBS issuance activity. Having been stung by conduit lenders in 1998, borrowers are returning to traditional lenders that offer more flexible terms and the assurance of a deal closing in lieu of the lowest interest rate.

Although many traditional real estate lenders also are active in the CMBS market, they can move loans into their portfolios if market conditions take a sudden downturn. This offers borrowers certainty that loan commitments will be honored.

This year, greater balance returned to commercial real estate lending as the CMBS downturn allowed traditional lenders to regain lost ground. In 1998, conduits were burned when heated competition for volume factored interest-rate risk out of the loan-pricing structure. But interest-rate risk has re-entered the conduit loan-pricing structure, which eventually will create a more stable CMBS market.

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.

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