Securitization of very large commercial loans, a hallmark of the CMBS market before the financial crisis, is making a comeback -- but with a twist.
It is still not practical to include commercial loans of several hundreds of millions of dollars in CMBS conduits, as was common in 2005, 2006 and 2007. That is because conduit deals have yet to reach the size that would provide enough diversification for a loan backing, say, a Manhattan skyscraper.
But there are an increasing number of deals securitizing single, large commercial loans: some $10.9 billion for all of 2012, up 114% from $5.1 billion for all of 2011, according to FTN Financial.
Fourth-quarter issuance has been especially strong, with deals backed by One Times Square, 1290 Avenue of the Americas, 101 Park Ave, Las Vegas’s Fashion Show mall and Bridgewater Commons, an upscale mall in suburban New Jersey.
Yield-hungry investors have been snapping up such offerings, making it possible to finance these properties more cheaply than with insurance companies, their traditional lenders.
John Murphy, a director and research analyst at Conning, an investment management company that caters to insurers, said that some of the single-asset deals marketed in 2009, the early stages of the CMBS market’s recovery, were a tough sell. The credit curve was quite steep, which diminished the securitization market’s ability to compete with private lenders. CMBS originators had to offer higher risk premiums to compensate the uncertainty associated with spread volatility and liquidity in the market at the time.
“Large lenders with a deep staff could go and look at the property physically and get comfortable with the asset, and they were able to step in at pretty attractive levels with depressed property prices,” said Murphy.
“Twelve months ago, the CMBS originators were probably struggling to compete with what have been the typical lenders in this space – insurance companies or other balance sheet lenders,” said Peter Eastham, managing director and lead analytical manager of U.S. CMBS Ratings at Standard & Poor’s. “But now because of contraction of spreads and the pricing phenomenon in CMBS, potential issuers can compete better to attract these sorts of loans.”
Single asset/large loan CMBS is a good space to pick up that yield. Kevin Howell, vice president/structured product strategies at FTN, said single-asset CMBS deals give investors the ability to stay at the top of the capital structure and still pull in the neighborhood of 20 basis points of extra yield compared with conduit CMBS deals, without having to sacrifice the credit enhancement.
There is a tradeoff, of course—additional yield comes at the cost of additional risk for investors. Large loan deals don’t offer the property type diversification or issuer diversification that is available in a conduit CMBS. Trading of paper issued by single-name deals in the secondary market is also somewhat less liquid, said Howell.
The bottom of the capital structure is a different story. Here, an increase in demand for lower-rated tranches of single-asset deals, coupled with the very limited supply, has pushed spreads inside those of similarly-rated tranches of conduits, according to Paul Vanderslice, co-head of CMBS at Citigroup.
An example is VNDO 2012-6, a $950 million deal backed by the fee interest in 1290 Avenue of the Americas. In November, the deal’s triple-A tranche priced at LIBOR plus 110 basis points, 20 basis points wider than spreads on similarly-rated tranches of conduits priced at that time. But the deal’s triple-B bonds priced at LIBOR plus 270 basis points; well inside triple-B rated tranches of conduits, which priced that month in the area of LIBOR plus 500 basis point.
At the top of the capital structure, “buyers want to get paid more than a conduit because the issues are privately placed and have no diversity; but lower down the credit curve, people are paying up because they like the ability to look at the one asset, and they like being able to get paid a very good spread relative to other markets,” explained one market source.
Historically single asset, large loan deals haven’t been a large part of the CMBS market. Vanderslice calculates that these deals made up around 5% of total dollar volume during the boom years of 2005, 2006 and 2007, when CMBS issuance surpassed the $200 billion mark. At the time, he said, “it just didn’t make sense” to securitize a single large loan because conduit deals were so big they could readily absorb larger loans. “You would typically get $5 billion to $6 billion conduit deals, so you could easily fit in a loan that was 10% of this large pool.”
But today, placing a large loan into a conduit isn’t an option because the conduit sizes have shrunk dramatically. A $300 million dollar loan would ruin a CMBS conduit’s diversification score with ratings agency, and, from an investor’s standpoint, it would make the CMBS pools too lumpy and concentrated.
Eric Thompson, who heads the CMBS group at Kroll Bond Rating Agency, believes that the volume of single-asset CMBS deals will be boosted in 2013 by the need to refinance boom-era conduit deals that included large loans. “If you see $10 [billion] to $12 billion worth of single borrower transactions, it wouldn’t be surprising, given refinancing needs and the low interest rate environment.” he said.
Some of the loans that are coming out of existing conduit deals tend to be larger, in the $200 million plus range; and they can run to as large as $800 million. “The ramp up in maturing loans means that you will have naturally larger loans from seasoned deals that are going to come due and will need a home in securitization,” said Murphy.
How much of that refinancing activity will be absorbed as single asset/large loan CMBS really depends on how fast the conduit market grows. Murphy said that it isn’t likely that conduits will reach the size of 2007 deals; and the execution that issuers are getting for single property deals right now suggests that issuance of single property deals will rise.
Refinancing of existing single-asset CMBS will also contribute to new issuance volume. One candidate is a $2.6 billion deal backed by Extended Stay Hotels. The existing deal, Extended Stay America Trust 2010-ESH, which came to market in 2010, is managed by Deutsche Bank Securities and JP Morgan Securities. Although the deal doesn’t mature until November 2015, it is likely the issuer will look to refinance to take advantage of the low interest rate environment and strong investor demand, according to market participants.
According to Eastham, there are several hundreds of billions of dollars’ worth of large loan maturities that will need to be managed over the next three years. “The conduit market is doing well, but having a healthy single-borrower and large-loan CMBS segment helps supplement the health of the conduit space,” he said. “If we come across some larger loans that may have previously been broken up and put into multiple CMBS programs, it may be possible that when it is time to refinance that large loan, it may be done as a standalone CMBS transaction.”
Many of the single-name deals are backed by shopping malls and office buildings, although Howell said that these kinds of properties expose investors to more idiosyncratic risks. For instance, leases in some of these securities actually expire before the term of the deal. It is something that also occurs in conduit deals but it becomes a lot more relevant when the entire deal is backed by a single property.
Kroll has rated 10 single-asset deals backed by shopping malls in the past 18 months; the ratings agency says these kinds of deals make the most sense for properties with relatively high sales per square foot. Kroll also focuses on how competition from neighboring properties might affect the future viability of the property, given the high loss severities that loans collateralized by malls can experience upon default as they lack alternative uses. “When we analyze those properties we look at their competitive position in the market, as well as the potential impact future development may have on the center,” said Thompson.
Of the single-asset mall deals Kroll rated in 2012, many were backed by either a “fortress” mall or a dominant mall that had relatively high sales; all but three of the properties had in-line sales per square foot above $400, five of which were above $750.
A recent example of a deal collateralized by a fortress mall is Bridgewater Commons, a $300 million loan in a deal from Goldman Sachs that was rated by Kroll. The mall generates sales of $782 per square foot and is located in a county that has the sixth highest disposable income in the United States. According to the U.S. Census Bureau, four of the six counties within the region are included in the top 100 counties in by median household income in 2011.
For malls that are not “fortress” centers, Kroll considers how long they have coexisted with competing properties, and their ability to do so in the future. Thompson added that in the single borrower mall deals Kroll rated, if the underlying loan collateral was not a fortress mall, it generally lacked competition or was a number two mall that peacefully coexisted with others in its competitive set for several years, if not more.
Several large office buildings were brought to market this year as well; including Nine West 57th, 1290 Ave of the Americas and the HSBC Tower and more recently 101 Park Ave. These properties are all examples of prime real estate in irreplaceable locations and are atypical of the latest crop of conduit CMBS transactions according to Thompson. “In addition, two of those transactions were relatively low leveraged, and were assigned all ‘AAA’ ratings. Of these transactions, 101 Park Ave., was rated by KBRA” he said.
The year 2012 also brought a pair of standalone lodging transactions – a deal backed by a $1 billion Motel 6 loan in October and another backed by a $412 million Fontainebleau Miami Beach loan in April. Thompson said Kroll has a more conservative view of lodging properties and hasn’t been as active in rating these deals. “In our view, there is increased risk of cash flow volatility because revenue isn’t derived from long term leases, as it is in the office and retail sectors” said Thompson. “As such, we have not given credit to future revenue growth at this point in the cycle. That is not to say that the lodging market is overheated, we just have a more conservative view of the sector than others.”
Fitch Ratings has looked at most of the single borrower deals that came to market in 2012, but was only selected to rate a few, because the debt it is willing to ascribe to a certain ratings category is relatively conservative. “You get less proceeds out of Fitch on your typical single borrower transactions, for investment grade bonds” said Huxley Somerville, managing director and head of the ratings agency’s CMBS group. There is nothing inherently wrong with the deals, however. “These aren’t weak deals and we haven’t identified any particular issues that have caused us to be weary of rating the transactions,” he said.
