Ever since forming the company in early 1999, investors at Irving, Tex.-based ARCap have based their entire operation on the belief that the subordinate pieces of commercial mortgage-backed securities transactions offer some of the best value in the mortgage market. That precept laid the foundation for the company's inception, and almost a year later, that opinion rings even more true than before.

"We feel like there is really good value in subordinated CMBS right now," said Larry Duggins, chief operating officer of ARCap REIT, Inc. and REMICap, LLC. "If you carefully analyze the underlying real estate risk, the yields available are greater than the risk justifies."

ARCap was formed when REMICap and Apollo Real Estate Advisors decided to create an investment company that would specialize in the acquisition of double-B or lower-rated CMBS. "It started as a joint venture. We watched the dislocation of the market at the end of 1998 and we were out looking for a strong capital partner, and [Apollo] was looking for a way to get into the market and it just made a lot of sense for us to come together," Duggins said.

Already, ARCap has bought five transactions and achieved its goal for the first year. The company is currently working on a capital raise, and it is "essentially fully capital-deployed at this moment," Duggins added. The company's current portfolio has a $300 million face value, all in subordinates. "We're looking to bring in incremental investors and incremental money because we still think it is a good time to buy."

Indeed, as B-piece buyers become more sophisticated and understand real estate risk to a greater extent, the yields become more reflective of appropriate risk, making B-piece buying even more attractive. These two factors are very good for his market, and both the quality and structure of mortgages in today's market should make a subordinate buyer quite comfortable.

"What we're finding is that, as a general rule...the quality of the real estate we're seeing is reasonable for a conduit and the quality of the underwriting is generally pretty good, and those things together help us to be comfortable in buying," Duggins noted. "We're very real-estate-centric. We review all mortgages in a transaction before we deploy capital into it."

Borrowers Beware

As a panelist at a recent session discussing the outlook for CMBS B-piece buyers at this month's Fabozzi conference in Naples, Fla., Duggins explained that sub buyers are signing on for a specific type of real estate risk and mortgage risk that makes it all the more important to pay close attention to the borrowers in a transaction.

"When you buy subs, you are projecting the long-term performance of the individual mortgages," he said. "Lots of things affect the way those mortgages perform. One of the things that really affects it is the ability of the borrower to appropriately manage his property, and another thing is the integrity of the borrower. If you have a borrower that steals from you, it doesn't matter if the building is great or not. You're going to have to go through a collection action to get to it. That's what we don't want to do."

Therefore, it is a high priority of ARCap to deal with borrowers who have dealt with lenders in a forthright manner and do not have a history of fraud or aggressive bankruptcy. Moreover, he is in favor of special purpose entities, "which help us not worry about other things related to a borrower's transaction.

"Issuers understand - not origination fees - but whether loans make sense from a real estate perspective and whether B-piece buyers will be interested," Duggins added.

Additionally, Duggins rates as equally important, "getting good information flow from servicers," who should be "well paid at market rates." He also asserts that late fees should go to servicers, "not to IO holders."

But given that B-piece buyers like ARCap buy everything at a deep discount - sometimes 20 or 30 cents on a dollar - Duggins "selfish" wish is that all borrowers would prepay. "If the entire issue is prepaid, we'd get immediate hundred-cent dollars on all those bonds, and we would be brilliant."

Competition for Subs? Yes and No

While the B-piece market saw a lot of activity in 1997 and 1998, the market is not quite as competitive as it once was. According to Duggins, there is not a whole lot of capital down in the B-piece world right now.

"There are four or five companies that have capital and are deploying it now," he said. "So from that perspective, it is not as competitive as it has been in the past. But it is more competitive in that the people who are investing in B-pieces now are smart and experienced."

Unlike earlier years, B-piece buyers can compete with others who are doing a good job in their analysis, and are not just having money burning holes in their pockets. "They know how to analyze the real estate risks and appropriately position their bids in the market."

This sea change in the constituency of sub buyers means that there will be fewer "throwaway bids," and more intelligent competitors grabbing at mezzanine pieces in the near future.

Floating-Rate Deals and Modified CBOs

Though he hasn't seen many of them in the market yet, Duggins is very interested in looking at conduit-type floating-rate transactions.

"Most of the floaters that have been done up to this point have been three to five-year deals that have been based on properties that have some kind of turnaround story associated with them," Duggins noted. "And I'm less excited about that. Pure fixed-rate financing isn't great for us."

ARCap is also a proponent of modified CBOs. Bear Stearns & Co. has been successful in essentially resecuritizing low-rated CMBS or high yield CMBS using a CBO product, dubbed the "ABC" product. A little bit of the credit enhancement outside of the CMBS is used to improve the execution of the CBO, which gives investors the ability to put long-term match-funded debt against a long-term asset, which is the CMBS.

"That's a good thing, to match the length of your liability with the length of your assets," Duggins added.

To Defease or Not to Defease

On the question of whether defeasance is a positive thing for B-piece investor in the long run, Duggins says that it is certainly a reasonable approach for somebody who needs to do something with a property that has a long-term lockout in it.

"As long as defeasance is properly structured, in general it is a positive for me when somebody defeases because I remove a whole lot of credit risk from my transaction," Duggins said.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.