Stronger Economy Means Defaults May Be Nearing Peak

Employment numbers, the piece of the economic puzzle that has been holding back the current recovery, are finally shaping up, with March and April employment figures coming in really strong (the economy added 288,000 jobs in April, following March's strong job creation of 337,000, the Department of Labor has reported).This leaves no doubt that the economic recovery is moving ahead on all fronts. Federal Reserve action to move toward a tighter money policy by gradually raising interest rates, sooner rather than later, to curb inflation is likely to be the next step.

In this sort of scenario, the economic script calls for commercial mortgage delinquencies to peak sometime this year, considering that this is a lagging indicator, before they start declining. In a departure from this script, commercial mortgage delinquencies have been reported as declining for the first quarter, by Standard & Poor's.

The rating agency says in its first-quarter 2004 CMBS roundup that delinquencies on commercial mortgage-backed securities have actually declined from 1.96% for the last quarter of 2003 to 1.77% at the end of the first quarter (on a base of CMBS rated by S&P). However, the rating agency doesn't expect the decline in delinquencies to hold up. According to S&P analysts Roy Chun, Larry Kay and John Kemp, "The sustainability of the delinquency rate decline is in question. As one quarter does not make a trend, it is still too early to say that the upward trend has been broken. Even though positive job growth will benefit many property sectors, the effect will not immediately appear in the delinquency numbers. Standard & Poor's expects the delinquency rate to rise in 2004." One explanation for the seeming contradiction could be that the economic recovery has been gaining traction right from the middle of last year after the brief war in Iraq concluded, and that commercial mortgage delinquencies have already peaked.

All the different commercial property types are likely to benefit going forward though, as employment levels continue to gain. The office sector saw a delinquency rate of 1.24% for the first quarter, S&P reports, unchanged from fourth-quarter levels. In the multifamily sector, the rating agency has seen delinquencies move from 0.71% in the first quarter of 2003 to 1.60% in the first quarter of 2004. This is higher than the delinquency rates for the other property sectors, S&P reports, considering a retail property-backed CMBS delinquency of 1.11% for the first quarter, industrial property-backed CMBS delinquency of 1.15%, and office property-backed delinquency of 1.24%. Of course, the multifamily sector has been thrown a double whammy in this economic cycle, having to contend with a historic low interest rate environment that has encouraged homebuying while rising unemployment levels following the bursting of the dot-com bubble in 2001 resulted in the loss of some existing renters.

Delinquency in the lodging-backed CMBS sector went down to 7.28% in the first quarter, from 7.78% at the end of the fourth quarter of 2003, S&P reports. The S&P analysts believe that lodging delinquency peaked at 8.37% last June. The rating agency says, citing Smith Travel Research, that revenue per available room in the hotel industry (a commonly used performance measure in the sector) began to improve in the second quarter of 2003, increasing 6%. And in the first quarter, RevPAR was seen to increase 7.7%.

Moody's Investors Service also believes that the hotel sector has bottomed out and is poised for a rebound. Tad Philipp, Moody's managing director/CMBS, sees hotel loans returning to CMBS fusion and conduit deals, after a "near absence" following 9/11.

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