As issuance of CMBS ramps up again, so do concerns about the deterioration in the quality of loans used as collateral.
Spreads investors were willing to accept on CMBS narrowed early in the year amid a broader decline in risk premiums and a reach for the relative yield offered by these securities. At the end of March, the average CMBS 2007 super-senior tranche traded at 194 basis points over swaps, down from 320 basis points over swaps six months earlier, according to Trepp.
However, there was some resurfacing of market volatility in April, based on news that the Federal Reserve is looking to offload CMBS acquired as part of the AIG bailout through the Fed's Maiden Lane III vehicle, along with the resurfacing of European and U.S. economy-related concerns. (Please see Maiden Lane story on page 20.)
This does not mean that the CMBS market is slowed by this recent turn of events. In fact, Deutsche Bank Securities CMBS analyst Harris Trifon noted in a research report that "the same technical and fundamental credit stories that caused us to be bullish on the space coming into the year are all very much still at work here and will continue to be so."
Deal Deluge
The spread tightening in the beginning of the year sparked a frenzy of deal making, with $4.1 billion hitting the market by the end of the first quarter, including deals from Morgan Stanley, Deutsche Bank, Goldman Sachs/Citi, Wells Fargo and Royal Bank of Scotland, according to the ASR Scorecards database.
There was another $1.1 billion of activity backed by single-borrower deals in the first quarter.
There's also a robust pipeline of deals in progress. Moody's Investors Service said on April 16 that it expects to rate five transactions in the second quarter.
Furthermore, the rating agency said that second-quarter transactions are expected to pick up considerably in terms of deal size and loan diversity. The average offering size will rise by roughly 40% from 1Q12, to roughly $1.3 billion. The effective number of loans, as measured by the Herfindahl Index, will also trend up to the low 30s from the low 20s, Moody's predicted.
Some participants expect that issuance could reach $40 billion for 2012 as a whole. This pickup in activity has inevitably attracted more lenders eager to finance the mortgages used as collateral. The problem is scarcity.
"The competition is heating up, and lenders are competing quite aggressively again at this stage for loan assignments," said Jeffrey Berenbaum, a CMBS strategy analyst with Citigroup Global Markets.
Berenbaum said the spread tightening makes conduit lenders a bit more competitive in relation to portfolio lenders for certain properties and weaker markets.
"Everybody is trying to cannibalize the same business," said Dan Alpert, a managing partner with the investment banking firm Westwood Capital. "What happens is that they find themselves fighting over the same product. They try to extend more and more until they find they can't sell the paper."
More conduit lenders are active, with established lenders such as Barclays and Cantor Fitzgerald aggressively looking for product, and there are also newer market entrants.
In early 2011, there were three or four active conduit lenders, according to Berenbaum. This went up to about 24 lenders as the market started heating up last year.
He said that when the market volatility surfaced last summer, about six players dropped out, including a prominent departure by Credit Suisse, leaving about 18 active players currently.
Berenbaum is not sure whether enough loans will be able to be made that meet lender requirements. "A lot of the loans that are coming due are either fairly low on a debt-yield basis or way too overleveraged," he said. "It's a matter of whether the borrowers can inject enough equity to get down to the 70 to 75ish loan-to-value ratio that lenders are requiring on the first mortgage."
Still, Berenbaum expects that loans at the margin will have an easier time refinancing this year as the market situation eases.
Taking advantage of the demand for product, two recent small deals from JPMorgan have even been backed by distressed loans, a development not seen since the mid-1990s, according to Berenbaum.
One of these deals, the $132 million JPMorgan Rialto distressed loan deal that priced in early April, was backed by 282 loans, of which 224 are nonperforming and 38 are REO properties.
The collateral backing the loans includes about 75% commercial real estate property types and about 24% homebuilder and commercial lots as well as homebuilder inventory.
He expects that this sort of deal, which has been well received by the market, will find favor with the more savvy investors, such as hedge funds that want to invest in distressed real estate.
Considering the competition for product, Berenbaum is seeing investors get more leery about the loans that are made. "Investors have to be cautious and look through the loans that are making their way into these pools," he said. "The gatekeeper is still the B-piece buyer, who is in the first-loss position, to put the brakes on any overly aggressive lending."
According to Standard & Poor's, during the 2006-2007 peak of the CMBS market there were about a dozen B-piece players that bought more than $5 billion worth of the bonds.
This year, as of the first quarter, three B-piece buyers have been active, buying about $250 million in B-piece bonds.
James Manzi, an S&P senior director in CMBS research, noted that a study by the rating agency on the composition of recent CMBS deals prior to 2012 found that more manufactured housing and hotel collateral is getting into these deals, at the expense of stronger collateral such as office and industrial properties.
Hotel collateral tends to be viewed as more vulnerable to a downturn since hotel prices reset daily, whereas industrial and office properties have long-term leases.
Hotel delinquencies were at 10.63% in March, compared with 9.68% for all CMBS delinquencies, according to Trepp. However, hotels were the only major property type to show an improvement over February, when they had a delinquency rate of 11.05%. They have also improved from almost 16% in March 2011.
By comparison, overall CMBS delinquencies were up from February's 9.37%, as newly delinquent loans put upward pressure on this metric.
Multifamily, at 15.39%, and industrial properties, at 12.54%, were the worst performing on the delinquency front in March. Office and retail properties were at 9.41% and 8.24%, respectively.
Balloon loans from 2007 that don't pay off and are not current could further pressure delinquencies this year, Berenbaum noted.
While B-piece buyers may still be scarce, Vic Clark, a managing director with Centerline Capital Group, said that this year there is a more diversified base of CMBS investors that is hungry for yield, which has created demand for lower-rated CMBS tranches.
With the emergence of the "CMBS 3.0" format last fall, which brought back public issuance and a super-senior tranche with heightened subordination levels, money managers who had restrictions on participating in private 144A issuance are now able to invest in recent CMBS offerings. As well, those who are interested in index-linked deals are drawn in.
Centerline Capital is partly owned by C-III Capital Partners, a company that is looking to ramp up its conduit lending activity. As to what will make for survival in today's market, Clark expects that those who are able to partner with the big conduit lenders are more likely to endure than other lenders.
He also pointed to local presence as a factor that added to staying power for originators. "A lot of Wall Street firms that pulled out don't have that presence," he said. "A Texas borrower doesn't want to go to New York to get a loan. They want to deal with local people who know the local market."
Berenbaum expects that lenders with managements that are more committed to this space, and that don't see more attractive places to put their capital, are more likely to stick around.
He said a return of market volatility could pose a problem considering that there is still no good hedging mechanism for loan originators who warehouse loans until they come to market.
Even then, Alpert is not fully convinced about the staying power of the economic recovery, considering that in the past two years the recovery has slowed down just as it was getting to a critical takeoff stage.
"There's been the assumption that we're seeing some kind of recovery in the United States, if not globally," Alpert said. "And the problem is that it is being driven almost entirely by excess liquidity, this time not from the Fed but from the European Central Bank. Whether any of this has any meaning once the effect of that liquidity has been absorbed is anybody's guess."
