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Commercial Mortgages Approach a Record Best Not Broken

Commercial mortgage loans now represent a record 15% of gross domestic product, and this record is likely to be broken soon, causing concern for Moody's Investors Service.

The credit rating agency reports that the 15% peak was last reached in 1988, at the height of the last real estate cycle, and cautions that "some records are best not broken."

Tad Philipp, Moody's managing director for commercial mortgage-backed securities, said, "Given the tremendous momentum in commercial mortgage lending, the record is almost certain to be broken shortly."

In the most recent 25 years, which represents the more modern period of real estate finance, the average for commercial mortgages outstanding as a share of GDP is 12.2%, Moody's said.

"Assuming that 12.2% represents a normalized level, the current 15% mark suggests that the present market is out of balance by almost 25%," Mr. Philipp noted.

He observed that while much of the excess capital that flowed into commercial mortgages during the last cycle went into construction lending, this time around it is being deployed mainly into additional debt on the existing stock of properties.

Mr. Philipp believes that the return of capitalization rates, or the returns expected by investors from real estate investments, to their lowest levels in 40 years accounts for some of the excess capital getting into the sector, even in the absence of a construction boom.

Before the current decline in capitalization rates began in the late 1990s, they had been at or above 9% most of the time, according to Moody's.

The rating agency also sees the decline in capitalization rates as accounting for the recent surge in CMBS issuance seen last year, since many loans made just a few years ago "that were thought to be safely tucked away" for seven to 10 years were defeased and "came back for a second helping of proceeds based on soaring values driven by declining capitalization rates," as Mr. Philipp sees it.

"The CMBS industry is regulated primarily by the 'invisible hand' of the capital markets. Continuous vigilance is required by issuers, investors and rating agencies as no one party can enforce industry standards.

"Without such vigilance the prospects for the continued success of the large and vibrant CMBS market is at risk," Mr. Philipp cautions.

In fact, some issuers are "unapologetically" making high-risk loans on the basis that "that is where the market is."

The rating agency also reports that loan-to-values on Moody's-rated conduit loans went up to 103% in the fourth quarter, from 101% for the third quarter.

As well, the debt-service-coverage ratio on loans has gone down from 0.98 times in the third quarter to 0.96 times in the fourth quarter.

And issuance of collateralized debt obligations went up to about $21 billion in 2005, about three times the size of the market in 2004, the rating agency reports.

Moody's-rated loans saw more upgrades than downgrades in the fourth quarter, but below-investment-grade-rated classes saw downgrades "significantly outpace" upgrades.

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