27 April 2010

Rising Defaults Aside, Commercial Mortgage Market Rallies


NEW YORK -(Dow Jones)- Commercial mortgage bonds continue to find favor with investors, who see value in these securities despite forecasts that the default rate will climb above 11% this year.

Both cash bonds and the derivative index that tracks commercial mortgage bonds tightened considerably in recent weeks. The Markit CMBX 5 index for triple-A bonds, a benchmark, traded near 90 points Friday, not far from its record high of 95.31. It had been as low as 55 in 2009, when investors feared that commercial real estate would follow residential mortgages off a cliff.

Even at these levels, investors say commercial mortgage securities are cheap compared with similarly rated assets in other sectors and suggest that the level of defaults priced into the market may be higher than what is to come.

"No doubt there are a lot of defaults that are yet to come in commercial real estate, but it's not as bad as some people say," said Jeffery Elswick, managing director and director of fixed income at Frost Investment Advisors in San Antonio.

The money manager has been ramping up his purchase of cash bonds backed by commercial mortgages for his clients from the start of this year.

"If as an investor you are able to look at fundamentals for every single bond, then there are many opportunities where the market's implied defaults are higher than reality," Elswick said.

Unemployment, which is a key determinant of commercial mortgage performance, remains stubbornly high at 9.7%, suggesting that commercial real estate is likely to remain under stress. But evidence of economic recovery and investor confidence are helping this sector finally catch up with the rally in other credit markets.

Other issues remain. The second-largest whole loan in the sector, a $2.9 billion five-year loan spread across six commercial mortgage securities, was transferred to its special servicer last week. Beacon Capital is seeking to modify or restructure the loan, which matures May 2012.

The key for investors is knowing what to buy and what to avoid. Elswick and his team delve into the nitty gritty details of each loan that is pooled into a bond, and determine, on a property-by-property basis, the likelihood of default before they put their money down.

Mary MacNeill, managing director at Fitch Ratings, and her team undertook a similar exercise recently, and found that large loan defaults increased sizably in 2009. She expects that trend to continue this year.

They also found other pockets of weakness--poorly underwritten loans from 2006 to 2008, luxury hotel and retail loans--are likely to keep commercial real estate generally under stress for the rest of the year.

Citi analysts say the index could tighten another 100 basis points to get close to its historic trends, but much of the gain is likely to be restricted to the top-rated tranches.

"The credit curve will continue to steepen as the lower tranches face the very real risk of near-term credit events with interest shortfalls," Citi said.

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