CMBS market set '98 record despite fall disruption.

Last autumn's severe disruption in the commercial mortgage-backed securities (CMBS) market is just a memory now. Most of the major players have worked off their backlogged inventory and the market has regained its equilibrium.

What may come as a surprise, however, is that despite the temporary shutdown in the last quarter, a record $78.3 billion of commercial mortgage-backed securities were issued in 1998, according to E&Y Kenneth Leventhal's seventh annual CMBS Market Update. Clearly, this demonstrates that commercial mortgage-backed securities have taken their place as a fundamental and growing component of commercial real estate finance.

Nevertheless, last year's experience suggests that important lessons can be learned by CMBS issuers and investors alike.

The CMBS market is still a young sector. Real estate players are just beginning to learn how to operate in a capital markets environment, and when Main Street and Wall Street come together, liquidity and investor perceptions become as important a driver of real estate values as location. We saw last autumn that property and mortgage loan values can fall even in a strong real estate market with delinquencies at historical lows.

Certainly, investors in CMBS must price risk more effectively. To do so, they must have a much clearer understanding of what they are buying. CMBS cannot be compared to corporate, or even REIT, debt because of the unique nature of the mortgage collateral. Although spreads narrowed through the summer, investors were boosting their yields by leveraging their CMBS purchases. The hidden private financing market supports the notion that risk had not been adequately rewarded.

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.

Remarkably, CMBS provided about two-thirds of overall commercial mortgage funding last year. This suggests that if volume declines in 1999, borrowers may find loans harder to come by.

Other points to be noted from events last year include the following:

* 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. This will increase investor confidence and attract capital to the market.

* Issuers should 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, keeping their eyes on world events as well as real estate supply and demand. For example, 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.

* Special servicers may be a weak link in the structural protection offered to investment-grade CMBS investors. If market forces or over-leveraging wipe 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.

The exodus of subordinated-class investors last fall demonstrated the reliance of CMBS issuers on a small group of capital providers. To maintain liquidity, issuers must demonstrate the quality of their loans to buyers of non-investment grade paper.

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, therefore, 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.

Dale Anne Reiss, Managing Partner - New York, E&Y Kenneth Leventhal Real Estate