CMBS Challengs & Opportunities - notes from Mark Sunyderman

Are CMBS Securities Mispriced? No The size of the US Commerical Property market was $5.3 tril (retail 36%, office 29%, multifamily 24%, industry 4%, hotel and other 7%) as of Dec 31, 2007 The size of CRE Debt market was $3.3 tril as of Dec 31, 2007, of which CMBS accounted for ~25% and banks holds ~35%. Construction of commerical properties was oversupplied between 1981 and 1990, where new construction accounted for more than 2% of annual stock. Since then new contruction generally encompassed less than 2% of annual stock. Annual commercial properties cash flow growth rate maintained to ~5% since 2004. By now average annual cash flow growth rate have not dipped to the negative yet. But valuation cap rate (cash flow/price) reached 30 year low, 5%-6%, by Q2 2007, implying that the properties was overpriced relative to their cash flow. Since then the cap rate shot up. The cap rate implied from REIT prices rebounded to ~10%, almost 30 year high. What happened in real estate debt securities market? Before the subprime crisis occured, many investors in real estate debt used significant leverage and underwriting standards were relaxed. With credit and securitization market being shut down, many investors could not find debt financing and were forced to sidelines. Big loan providers such as banks and insurers struggled with their issues and could not pick up the slack. Rising property capitalization rates pressured overlagged borrowers; Recession weakened economy and CRE's cash flows. As a result CMBS prices were geard toward plummeting and vicious cycles started. Active CMBS market capitalization was ~750 bils by the end of 2008, where new issuances of vintage of 2005, 2006, 2007 was ~600 bil. Average credit support to BBB bonds also dropped from ~15% in 1996 to below 5% since 2004. By the end March 2009, BBB CMBS spreads were trading ~4000 bps. Historic Mortgage Credit Performance based on life insurance company originations 1972-1992 Historic Average Losses: 6% Best Vintage Losses (1977): 3% Worst Vintgage Losses (1986): 9% Worst Originator Defaults: 2.5x best Commercial mortgage Investment Strategies --New first mortgages --Mezzanie debt Investing in CMBS --cannot trust ratings --musts analyze property by property --vintage matters --leverage matters