Based jointly in Charlotte and New York, Lancaster heads up the CMBS and fixed-income real estate research effort as well as assisting Wachovia's underwriting efforts in the corporate finance area. He joined the firm from Bear Stearns in July 2001. He was assisted in this article by his research colleagues Davis Cable and Kathy Mixon.
CMBS: Smaller Is Better
The 2002 commercial mortgage-backed securities vintage is expected to be smaller and of higher quality. Although we expect the delinquencies of aged CMBS to approach or exceed 3% by year-end, outstanding non-credit tenant lease, investment-grade CMBS should perform well. The spreads of 10-year triple-A CMBS, in particular, should remain within their 2001 range versus swaps. Slight premium, first-tranche triple-A CMBS, which have widened considerably because of concerns regarding default induced prepayments, look attractive.
From the property perspective, commercial real estate can be characterized by further but moderating deterioration. Although hotels have shown the greatest weakness, softness has now spread to the multifamily sector. Dramatic increases in vacancies in 2001 for the office and industrial sectors will evolve into rental rate declines this year.
This year will be the first in which the CMBS markets are tested by a real estate downturn. Given our current economic outlook of sluggish growth and the general real estate market lag in recessions, we expect the delinquencies of CMBS loans older than two years to rise to 3.0%. We do not expect investment-grade CMBS to be significantly affected. These levels are well within the expectations the rating agencies incorporate in CMBS investment-grade ratings. Moreover, CMBS underwriting standards today, in part due to the prodding of B-piece buyers, have improved since the inception of the market in the early 1990s with significant reserves being set aside for insurance and tenant rollovers.
Given this scenario and our expectation of slowly rising rates in the coming year, which should reduce the amount of CMBS priced at a premium in the market, we expect benchmark triple-A 10-year CMBS spreads to swaps to remain range bound between levels they have traded at in the past year. Currently, this is swaps plus 49 basis points, with one standard deviation of +/- 56 basis points. One potential issue for the large loan market is terrorism insurance, with the prospects for Federal legislative action uncertain at this time. Moody's Investors Service plans to substantially increase subordination levels on CMBS with collateral properties that have inadequate terrorism insurance.
By and large, given a +/-3% delinquency scenario, a 35% average severity and current subordination levels, we would expect issues to rise in the lowest-rated CMBS tranches and in first-tranche triple-A CMBS trading at a premium.
Another potential issue that merits watching is the Financial Accounting Standards Board's (FASB) proposed changes to FASB 94 (BW,3/10). If adopted, the changes would, among other things, require that the amount of equity capital for a non-qualifying special purpose entity (SPE), the legal structure often used for collateralized debt obligations be increased from a minimum of 3% to 10% to receive off-balance-sheet treatment.
In addition, the changes may require that the originator of the assets not hold any equity as is currently often the case. Although some CDO issuers could use a "brain dead" qualified special purpose entity in place of an SPE to avoid the proposed restrictions, others, needing more managerial flexibility, may not be able to. Thus, although it is by no means a foregone conclusion at this early stage, the CDO market and demand for triple-Bs and double-Bs could potentially be affected.