Is the Commercial Mortgage Market Healing?

In 2009, after the residential mortgage market had pretty clearly collapsed, people began worrying about commercial mortgages. Although bad subprime mortgages were responsible for popping the housing bubble, it continued to rapidly deflate when prime mortgages also began to default as the recession deepened and unemployment grew. Those same recessionary pressures began weighing on businesses, so some hypothesized that a commercial mortgage market collapse might be next. Delinquencies began rising and some thought those fears were confirmed. But the market appears to be healing.

The easiest way to determine if things are getting better would be to look at delinquencies. Here are some measures:

cre delin 2010-q3.png

Let's look at each of these lines. First, the green one shows commercial mortgage-backed securities (CMBS) portfolios and includes the earliest-term delinquencies. Although they continue to rise, they're doing so consistently more slowly, as the distances between each point have been decreasing for about a year. The red line is the most severe delinquencies, as 90 days or more delinquent means that the properties are essentially defaulted. Its story is similar, as delinquencies have continued to grow, but not as quickly as they had in prior quarters. Finally, delinquencies on 60 or more day multi-family portfolios owned by Fannie Mae actually declined during the quarter.

This data hardly indicates that all problems are behind the commercial mortgage market, but it does suggest that a recovery probably isn't far off. And indeed, Wall Street appears to agree. The frozen CMBS market began to very slowly thaw last year. Little by little, we saw more deals getting done, and according to a new report, some big banks are preparing $4 billion in CMBS to hit the market very soon.

In fact, none of this should surprise us. It makes sense that commercial mortgages delinquencies would be getting better. After all, most businesses are doing much better than they were a year or two ago. Sales are up, and so are profits. They shouldn't be having the sort of trouble making mortgage payments that they were a few years ago. Remember, it was the recession that drove the commercial mortgage problem.

Investors must realize that a steady recovery can quickly heal the CMBS market, which is why the bonds aren't seen as toxic anymore. Other than the properties already delinquent, few new commercial mortgages will likely go bad in coming months. So new deals backed by mortgages that are performing well should provide relatively little risk.

If the CMBS market does recover, this is particularly good news for three reasons. First, it signifies that firms will have an easier time rolling over principal on maturing commercial mortgage debt into new loans. If investors are willing to buy CMBS, then funding won't be a problem.

Second, easier funding means that businesses that are looking to grow over the next year will more easily obtain new commercial mortgages for expanding their structures. Of course, this means hiring will be less constrained by commercial mortgage funding difficulty.

Finally, as the CMBS market heals, residential mortgage-backed securities (RMBS) could slowly follow. While the housing market's problems are obviously much worse than what commercial real estate faces, stability is only one concern holding back RMBS. Some investors also became concerned with the concept of real estate securitization during the financial crisis, so CMBS could help make some of them comfortable enough to get them back into the RMBS market as well.

We'll have to wait to see how these CMBS sales do, but if banks are bringing them to market, then they've probably already tested for investor demand. If the deals succeed with relative ease, then this will be a very positive sign for the broader economic recovery.