A Resilient Product

Location is just as important in the commercial real estate world as
it is with homes. A key difference is that a building's functionality
and the reputation and track record of its tenants are what give it
value for commercial investors, whether it's a glistening new tower in
Midtown Manhattan or a dusty warehouse just off the interstate in
Nebraska. "In a commercial property, you have to underwrite what you
think the cash flows are," Gyourko says. "There are no cash flows on my
house."

Gyourko did choose his house, in part, because it's in an excellent
school district. But schools, the age of a house, its distance to the
closest major city, roads and other factors are relatively intangible
when compared to a commercial building's measurable underlying assets.
That office building in Manhattan, for example, has an easily accessed
history of cash flow from tenants, who typically sign firm 10- or
15-year leases. In terms of where pooled securities get their value,
the chasm between commercial and residential loans is significant. What
they have in common is one thing: the word "mortgage."

CMBS could be in uncharted waters with this year's drought of
issuance. Mandzy notes that the only truly comparable period was in
1998, during the Russian bond crisis. That, too, was a systemic credit
crunch, as opposed to a collateral deficiency. Mortgages still
performed well and there was not much collateral loss, though Wall
Street flooded capital into Treasuries and all structured finance
vehicles fell in value.

In 2005, Hurricane Katrina took a more direct swipe at the assets
that backed CMBS bonds. "When Katrina hit, it proved how resilient and
diversified the asset class was," Mandzy says. "Three states were
basically knocked out of line, with thousands of properties devastated.
Defaults climbed substantially, but they still never reached 1%. That
tells you something. Bond investors suffered only incidental losses on
the lower-rated classes. But they were all prepared for this. When
Katrina hit, they knew right away what would be problematic."

Still, Mandzy and Gyourko agree that, like the residential side,
CMBS deals were becoming looser, structurally. Top CMBS issuers,
including Wachovia Securities, Credit Suisse First Boston, Deutsche
Bank, Lehman Brothers and others, increased their offerings to meet
bigger foreign demand for bonds backed by American properties.
Hyper-growth in India and China, Mandzy notes, pushed the number of
deals and their sizes upward.

"Loans were becoming generous," he says. "There were some that
didn't need amortization, mezzanine financing [debt that can be
converted to an ownership stake] was widely available, and you could
buy commercial property for close to no money down in some places.
Anything that was structured, investors were buying." Also, an
increasing number of loans were made based on projected, or pro-forma
property cash flows, and not existing cash flows.

An indication of lax loan writing can be seen in the fact that more
than $30 billion of all the commercial mortgages securitized in 2007
(about 16%) are on "master servicers' watchlists," meaning they have
potential problems, according to analysis by Credit Suisse. The report
says that, in contrast, $64.2 billion, or 12.3% of the $521.2 billion
of mortgages securitized between 1996 and 2006, are on watchlists.