Darrel! Wheeler and Jeffrey Berenbaum
The CMBS market has seen strong growth over the past few years with issuance levels of $78.3 billion in 1998, $67.0 billion in 1999, and $60.1 billion in 2000. As the market has developed and liquidity has improved, the triple-A CMBS sector has become more closely linked with other fixed income debt instruments and has increased its investor base while the lower rated, unrated, and IO sectors have remained primarily with those investors willing to do more fundamental real estate analysis. CMBS IO segregation with the lower rated credit classes has limited the investor universe and potentially created a relative value opportunity.
Most investors view CMBS IO as a specialized credit sensitive product requiring detailed default analysis. This is in contrast to the single-family, residential IO market where most investors' analysis revolves around the high interest-rate sensitivity of prepayments. The strong fundamentals of the current commercial mortgage market, however, suggest several reasons to expect CMBS IO to have a fairly stable return:
■ We expect strong underlying commercial real estate fundamentals to moderately slow down during the next 24 months. During this time CMBS transactions should experience a low level of prepayments from defaults making their IO classes good relative value.
■ Conservative default and prepayment assumptions suggest CMBS IO could provide a 200bp (basis points) to 250bp spread over treasuries.
■ Relative value analysis comparison with other spread products suggests CMBS IO offers significant excess return. Considering the CMBS market's improved liquidity in 1999 and 2000, CMBS IO characteristics justify a tighter overall spread.
The purpose of this chapter1 is, firstly, to provide a brief description of CMBS IO; and secondly, to present a table that addresses the cash flow uncertainty of 78 CMBS IOs with a ranking by mean yield change under 82 different stressed scenarios. We have created the summary table to highlight IO relative value and take some of the unknown qualities out of the IO investment. The table will hopefully expand the investment class opportunity to a broader base of investors.
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