A Tale of Two Markets: Present vs. Past CMBS

Summer 2011

The CMBS market may not have ramped up to 2007 levels, but the contrast between this year and last year is stark: according to Standard & Poor’s, the first quarter saw nearly as much in new CMBS volume ($8.7 billion) as it did in all of 2010 ($9.8 billion). The new bonds are being snapped up, including the B-pieces, and spreads are tightening.

Estimates for total issuance for 2011 vary, but the range is generally ex­pected to be between $30 billion and $50 billion. Along with the volume of new issuance has come what to some observers seems like a troubling trend: on paper, there are higher loan-to-value ratios and underwriting has loosened.

But others are not worried about be­ing in “here we go again” mode. Fitch Ratings, for example, in a recent weekly CMBS newsletter, posed the question: “Does this loosening tell us where we are heading? Fitch Rat­ings would argue that the answer, for the most part, is no. Certainly, if it were to keep on the same trajectory as the past year, LTVs would be over 115 percent in three years.” But, it maintains, “the change in loan attributes over the past year have been from very conservative to more traditional attributes and, as such, are relatively benign. Fitch Ratings expects this loosening trend will con­tinue in 2011. Eventually however, the market will balk at a continued further loosening of standards. Even if they didn’t, the increased credit enhancement to reflect the loosen­ing would start to make future deals uneconomic.”

Among the findings in Barclays Capital’s CMBS Outlook 2011, the firm expects that declining cap rates are positioned to boost commercial real estate. “By historical standards, current cap rates still have room for further compression (from the stand­point of the spread to Treasuries), implying that commercial real estate valuations could improve further.”

Toward Improving Underwriting, Disclosure

Over the past year, the CRE Finance Council (CREFC), composed of lenders, issuers, servicers, and loan and bond investors, has developed a number of market standards that could be used in the CMBS market immediately and provide support to U.S. federal regulators as they work to implement the Dodd-Frank Act’s goal of better aligning investor and origina­tor interests.

Issuing the standards in late March, the CREFC formally submitted them to the Department of the Treasury, Federal Reserve Board of Gover­nors, the Federal Deposit Insurance Corporation, Securities and Exchange Commission and the Office of the Comptroller of the Currency -- the agencies that are charged with developing risk-retention regulations. CREFC expects that these bodies will come up with final regulations in the Fall or the end of 2011.

John D'Amico

John D’Amico

John D’Amico, CRE Finance Council’s interim CEO, explained that the orga­nization’s market recommendations cover three areas: loan underwriting; additional disclosure; and representa­tions and warranties. Specifically, the standards are:

Model Representations and Warran­ties standardize the representations and warranties that lenders must make concerning the qualities and characteristics of the loans and due diligence performed on the borrowers and properties. These representations and warranties will now be standard across the industry, and issuers are expected to present prospective bond investors with a comparison of any changes made from the CREFC Model to a deal’s representations and warranties. Additionally, loan-by-loan exceptions to the representations and warranties should be disclosed to prospective bond investors.

To further enhance and enforce the Model Representations and Warran­ties, the Model Repurchase Remedia­tion Language creates a process to resolve breach claims through manda­tory third-party mediation prior to the commencement of any legal action.

Principles-Based Underwriting

Framework is a set of principles that help identify underwriting principles and procedures designed to generate lower credit risk loans. Importantly, however, commercial properties and their related markets are unique and therefore the risk analysis for the related loans must be property- and sponsor-specific.

Annex A is a chart providing more than 180 data fields for each loan and related property collateral in a securitization that is included as an attachment to the disclosure docu­ment given to investors during the of­fering of a CMBS issuance. CREFC’s Investor Reporting Package™ tracks ongoing loan, property and bond-level information, some of which is included in the initial Annex A. The changes in Annex A expand upon and standardize the initial information provided to prospective investors.

Regarding Annex A, D’Amico remarked that “bond investors are clamoring for more disclosure and greater detail on subordinated debt. It helps define risk.” Although he believes that conflicts of interest between bondholders in different tranches has been “hyped up,” he ob­served that in some of the new CMBS transactions there is an operating adviser whose responsibility it is to “look over the shoulder” of the spe­cial servicer if the B piece bonds are controlled by the special servicer.

The Old CMBS Hangover

Ann Hambley

Ann Hambley

Ann Hambly, CEO of Grapevine, Texas-based 1st Service Solutions, believes that the CREFC’s standards “have to be implemented and will be.” Hambly started this business in 2005 because she saw “a real need for someone to help owners to ma­neuver through the CMBS process.” Since then, it has resolved more than $3.2 billion in loans for its clients, has $4 billion in its active portfolio and $4 billion more in the pipeline.

Hambly believes that the CMBS busi­ness is here to stay and is a healthy product for borrowers. But even though volume is increasing, “there are not enough proceeds; it won’t bail us out any time soon,” she said. Cur­rently, defaulted loans are at the $90 billion level, or slightly more than 10 percent of the entire CMBS universe (versus a historic one to two percent default rate). Hambly expects de­faults to climb this year and through 2017 – when 10-year maturities are coming due. There are more defaults in locations with big bubbles. Mean­while, hotels, self-storage facilities and multi-family are recovering more quickly than office and retail.

She expects that the majority of CMBS loans originated in 2005 to 2007 vintages will not be able to be refinanced. Complicating the issue is that in some areas, it takes longer to foreclose when a loan is in default. The Northeast takes longest; New York takes 445 days, she reported. That speaks to how much interest there is in working out solutions with borrowers and bondholders.

Hambly noted that her clients fall into three categories: those seeking modifications in payments; clients whose property is upside down today but can have their debt deferred if the property is expected to recover value by 2017; and those looking to have part of their debt forgiven. 1st Service Solutions’ average size deal is $40 million, with owners holding a few properties to big portfolios.

Among the restructuring solutions the company has arranged with special servicers on CMBS loans have been A/B splits; discounted payoffs; exten­sions of loan maturities; reductions of interest rate; and assumptions. In one A/B split, the value of the real estate at the time of the restructure request was about half of the loan amount (originated in 2006). The A note was equal to the current value of the real estate. The remaining loan balance became the B note. At time of sale or refinance, the proceeds will be split with (1) payoff of the A note; (2) repayment to the borrower of any new capital infused after the restructure date plus a preferred rate of return equal to the note rate; and (3) split of the remaining proceeds: 70 percent to the borrower and 30 percent to the CMBS Trust.

In finding solutions, she said, “a lot depends on who the special servicers are.” As for the potential conflict be­tween tranche holders, Hambly com­mented, “I don’t know how it’s being resolved. I think it may be resolved by the court system over the next couple of years.”