CMBS 2.0: An Overview Of Changes And Challenges

Capital Markets Overview

For over 20 years an increasing percentage of commercial real estate has been financed efficiently through the packaging of commercial mortgages into commercial mortgage backed securities (CMBS) sold into the capital markets. Issuance exploded in 2007 to over $230 billion, right before the broader economy imploded into the Great Recession, after which issuance plummeted: $12 billion in 2008, and a paltry $2.9 billion in 2009. In 2010, lenders returned to the market with issuance of a still anemic $12 billion. Yet investors made it clear they wanted more transparency, better underwriting and stronger alignment of risk. Thus began an effort to bring about changes that would encourage a return to the sector by investors as well as loan originators and issuers, led in part by the Commercial Real Estate Finance Council (CREFC), a key industry group composed of participants in all aspects of CMBS. Meanwhile, Congress, trying to address the economic catastrophe, passed the Dodd-Frank Act in July of 2010, calling for significant financial market regulations and studies. The new and evolving changes in the market for CMBS, which include self imposed industry standards and implementation of legislative and regulatory mandates, are referred to as CMBS 2.0.

Unfortunately, the third quarter of 2011 finds the Great Recession unabated, unemployment still painfully high, the U.S. economy barely growing and dire European markets negatively impacting recovery in U.S. markets. Commercial real estate remains overleveraged, with over $1 trillion in loans maturing during the next 3 years. There is a huge equity gap due to a precipitous drop in valuations, and fundamentals do not give encouragement for a quick rebound. Consequently, owners and buyers struggle to salvage fledgling properties, or even refinance performing properties that have suffered valuations drops. This is true even though new capital sources have entered the market and traditional sources have considerable lending allocations. We do not have a lack of capital, we suffer from substantial valuation losses and market volatility.

Even with this negative backdrop, CMBS has managed to change the trajectory in issuance from severe downward to a positive, albeit bumpy and moderate, increase. Most participants expect around $35 billion in issuance for 2011. Recent volatility in the capital markets has tempered that outlook somewhat, as CMBS spreads have widened and planned transactions have slowed. Congress and the Administration, rather than forging a recovery, have demonstrated an intractable partisanship, offering the country little confidence they can bring about a restoration of the economy, reduction of the excessive national debt or, more importantly, a reversal of the severe unemployment problem. Thus, the tepid recovery for CMBS still faces many challenges.

What Has Changed for Lenders?

Lenders, chastened by investor reaction to pro forma underwriting, lack of escrows and reserves and overleveraging, for the most part have imposed a greater discipline on new loan origination. Underwriting is more conservative, tax and insurance escrows and tenant finish reserves are more common and cash management and lockbox structures appear with greater frequency. Moreover, lease rollover, purchase options and tenant credit risk have taken on increasing scrutiny, as investors have demanded more information about these risks. On the retail side, co-tenancy rights and "go-dark" provisions also receive more attention.

In the past, the debt service coverage ratio (DSCR) and loan to value ratio (LTV) were key metrics for assessing a potential loan's credit risk. In legacy CMBS, a typical loan would have a minimum 1.25 DSCR and up to 80% LTV. As will be shown later, those have changed to roughly 1.5-1.7 DSCR and 55-65% LTV, reflecting the more conservative underwriting. Significantly, lenders are now using another metric that better assesses the property's ability to handle loan payment terms: "debt yield," which is calculated by dividing net operating income (NOI) by the loan amount and multiplying by 100%. This measure gives a more clear and consistent picture, for example, than applying DSCR measures to a loan that has a low interest rate, is interest only or has amortization variances. In today's market a minimum 10% debt yield is common.

Sponsor background, which has always been important even in a market that boasts non-recourse lending, has received increased focus as well. Lenders perform more extensive background searches and probe further into sponsor histories to get a better idea of what to expect when times turn bad. Usually, that includes control parties as well as any owner of at least 10% of the borrower equity.

Lenders have also been whipsawed by an increasingly unpredictable cost of funds and pricing for securitization. Even though the Federal Reserve has kept interest rates at historic lows, market volatility has made loan pricing and hedging virtually impossible. For example, spreads on 10 year triple A CMBS in May were around 110-125 basis points (bp). If a lender originated loans at rates of 200+ over swaps, it could expect to make two points or more of profit on the securitization. However, midsummer the triple A spreads widened to over 200 bp, and that profit quickly turned into a loss. In fact, a rule of thumb is that an increase of 15 bp in triple A spreads equates to a one point loss on expected profit. Lenders reacted by increasing spreads to swaps for new loans, but the three month aggregation period for a securitization precludes timely reaction to the...