Despite a severe disruption last fall in the market for commercial mortgage-backed securities (CMBS), a record $78.3 billion were issued in 1998.

According to the report from the E&Y Kenneth Leventhal Real Estate Group, this record level of issuance demonstrates that CMBS are a fundamental and growing component of commercial real estate finance; however, the transition to the capital markets has not been easy.

E&YKL's seventh annual CMBS Market Update points out to both CMBS issuers and investors the critical lessons to be learned from the events of 1998.

"The CMBS market, despite its rapid growth, is still a young sector. Real estate players are just beginning to learn how to operate in a capital markets environment," said Joseph Rubin, National Director of E&Y Kenneth Leventhal Real Estate Group's Financial Institutions practice. "When you bring Main Street and Wall Street together, liquidity and investor perceptions become as important a driver of real estate values as location," said Rubin. "Property and mortgage loan values can fall even in a strong real estate market with delinquencies at historical lows."

For bond investors, according to Phoebe Moreo, National Director of Real Estate Securitization, E&Y Kenneth Leventhal Real Estate Group, there were also important lessons to be learned last year.

"Clearly, investors in CMBS must more effectively price risk and, to do so, they must have a much clearer understanding of what they are buying," said Moreo.

"CMBS cannot be compared to corporate, or even REIT, debt because of the uniqueness of the mortgage collateral," she added. Although spreads narrowed through the summer, investors were boosting their yields by lever aging their CMBS purchases. "The hidden private financing market supports the notion that risk had not been adequately rewarded," said Moreo.

Despite the market's halt in September, issuance of CMBS investments almost doubled from 1997 levels. Issuance in 1997 totaled $43.9 billion, a figure that was reached and exceeded just six months into 1998, putting the market on a pace to exceed $85 billion. The fact that the issuers managed to securitize almost $80 billion in debt despite the long standstill in the fall is an indication of the CMBS market's importance in providing capital to real estate.

"CMBS provided about two-thirds of overall commercial mortgage funding last year," said Rubin. "If volume declines in 1999, borrowers may find loans harder to come by," he warned.

Among the lessons to be learned from events last year, the EYKL report points to:

• The CMBS market requires a renewed commitment to quality underwriting. Industry leaders must step up and sponsor the development of standardized computations for Underwritten Net Operating Income. Such standardization will increase investor confidence and attract capital to the market.
• Issuers need to refine their origination strategies. Projections of profitability must reflect hedging costs. The interval from loan closing to pool securitization must be shortened to reduce exposure to spread risk. Conduits will have to form alliances and pool assets to achieve this goal.
• Issuers and investors must look beyond CMBS to recognize broader trends in the capital markets. The CMBS market seemed to ignore the fall of REIT share prices and widening of spreads on unsecured REIT debt in the first six months of the year. The flight to Treasuries after the Russian crisis hammered home the interrelationship between CMBS spreads and global capital trends. "What we call the 'Bangkok-to-Wichita Paradox' means that issuers and investors have to keep their eye on world events as well as real estate supply and demand," said Rubin.
• Special servicers may be a weak link in the structural protection offered to investment grade CMBS investors. If market forces or over-leveraging wipes out most of the value of a transaction's subordinated classes, the special servicer owning those classes may lose its incentive to maximize resolution of mortgages in default. If the decline in value forces the special servicer to seek bankruptcy protection from its creditors, the rating agencies may have to downgrade certain classes of the bonds.

"The break in CMBS issuance enabled market participants to look hard at real estate fundamentals and relative risks of CMBS and the alternative investments. Everyone had time to catch their breath and get their houses in order," she said. "Renewed focus on quality will ensure continued growth and depth of market for this core component of real estate finance," Moreo added.

The potential for continued market volatility creates opportunity for lenders that can originate for securitization or for their portfolios. The real winners in the conduit game, according to E&YKL, may be the large credit corporations that have big balance sheets and a fully-integrated organization to originate, underwrite, securitize and service the loans and resolve any defaults.

"These companies haven't led the market in issuance yet but they were first out of the gate when other conduits halted business late last year. They have the muscle to stay in the game," says Rubin.