The lending market cycle invariably turns to favor borrowers, but the commercial mortgage-backed securities (CMBS) market’s near miraculous turn around and the bonds’ plunging spreads, as well as indications of deteriorating credit quality, suggest buyers should beware.
The average spread on ‘AAA’ tranches is nearly half last August’s, falling to 75 basis points in mid-May from 143 basis points last summer, while lower-rated bonds have fallen even further, according to Trepp.
Spreads for CMBS rated BBB- dropped to 298 basis points from 614 basis points over the same period.
Meanwhile, if new issuance through the rest of 2013 follows the pace of the first quarter, total volume this year could top $100 billion, more than doubling 2012 volume and multiples above the $11 billion issued in 2010.
“It’s an amazing recovery in a short time, from the depths of the market to where we are now,” said Manus Clancy, senior managing director at Trepp. “Five years ago, people wondered whether we’d be back to $40 billion in five years, and now it could be $100 billion—it’s almost euphoric.”
CMBS is clearly benefiting from the liquidity central banks around the world are injecting into the financial system, which makes higher-yielding assets relatively more attractive.
A number of other factors also suggest CMBS could be headed toward troubled territory, including skyrocketing property prices in major markets, increasing loan-to-value (LTV) ratios and interest-only periods, the return of “pro forma”-type cash flows, and sponsors “pushing the documentation.”
Property prices in second- and third-tier markets have risen only marginally since their lows in 2009, the 24-hour cities—major metropolitan areas such as New York, Chicago and Seattle—have been on a tear. Moody’s Investors Service’s Real Capital Analytics now tallies prices in the major markets at a smidgen below highs reached in 2007, while prices in non-major markets are still 30% down.
“We’re now approaching if not above peak valuations seen in 2007 for some trophy properties,” said James Grady, managing director at Deutsche Asset Management. “While that often makes people feel encouraged and emboldened, it’s really when valuations are high that risk is highest.”
Another troubling sign is rising LTVs. Tad Philipp, director of commercial real estate (CRE) research, said CMBS issuers today are underwriting CRE loans at LTVs around 70 typically, similar to LTVs in 2005. At that time, though, Moody’s methodology was calling LTVs on those same loans between 100 and 110.
Philipp said the Moody’s LTVs (MLTV) correlated much more strongly to expected losses than the underwriter’s LTV, and today the average MLTV is at about 100. Philipp added, “We believe this level is an ‘inflection point,’ and should MLTV increase further from here the risk will be magnified.”
At a MLTV of 100, equity has shrunk to a thin level on a historic basis compared to the appraised value. As the MLTV continues to rise, more losses are likely to follow.
“We’re back to the 2005-ish level,” Philipp said, adding, “We’re saying that in 2006 and 2007 underwriting got significantly off track, and while we’re not there yet we’re getting uncomfortably close.”
Also problematic is the increasing use of interest-only (IO) structures, which were prevalent before the CRE market collapsed during the last cycle. The Kroll IO Index measures the interest-only exposure of CMBS transactions, and it has increased steadily over the last year and a half, measuring 12% in first quarter 2012, 19% in the second quarter, and jumping to 29% so far this year.
“Some deals have their IO index approaching 40%, which in conjunction with [an increasing Kroll-calculated LTV] is leading to increased credit risk,” said Eric Thompson, a senior managing director in the structured finance group at Kroll Bond Rating Agency.
IO loans provide very low—and attractive—debt-servicing obligations for sponsors today. The more back-ended amortization is, however, the greater refinancing concerns become, especially if interest rates rise—as they are likely to do—and rental income is uncertain. Thompson said that roughly half of the CMBS deals so far this quarter have IO components, and about 20% are fully IO.
“Fortunately, many of the full-term IO loans aren’t levered above the weighted average of the transaction pool’s LTV,” Thompson said.
Stacey Berger, executive vice president at Midland Loan Services, a master and special servicer and a division of PNC Bank, described current underwriting as no longer conservative but “appropriately documented and not speculative.” However, his firm is seeing more properties fitting that description in secondary and tertiary markets, where performance in terms of values, rents and the liquidity of those assets falls behind property in the primary markets.
“When you have a property in a third-tier market that may be leased to a major tenant, and that tenant goes bad, it’s much more difficult to replace the tenant than if the property were in New York or another primary market,” Berger said, adding, “The markets are smaller and there are fewer alternatives.”
While rising property prices, LTVs and IO components may be starting to raise concerns, investors can gauge those risks. Perhaps the most distinguishing feature of the commercial real estate bubble that began deflating in early 2008 and resulted in numerous defaults was the use of so-called pro forma cash flows, in which deals are underwritten with aggressive interpretations of rent and frequently unrealistic expectations of future cash flows.
No CMBS deals today contain loans approaching the pro forma assumptions behind the debt supporting the highly leveraged acquisition in 2006 of the Stuyvesant Town/Peter Cooper Village apartment complex on Manhattan’s East Side, where the underwriting assumed conversion of rent-stabilized apartments to higher market rents. Nevertheless, underwriting assumptions based on little supporting data are increasingly appearing in CMBS loan pools.
Grady said that there have recently been occasions when a newly constructed or repositioned property, without a demonstrable long-term track record, has found its way into a conduit CMBS transaction. During past periods when conduit CMBS investors were more selective, such properties might have remained on a bank’s balance sheet until they were more seasoned.
“It is troubling when we see transitional properties or relatively new construction loans find their way into conduit CMBS transactions,” Grady said.
One such loan was underwritten by J.P. Morgan Chase for Grand Prairie Premium Outlets, in the eponymous Dallas suburb. The $120 million loan was the largest in the recent J.P. Morgan Chase Commercial Mortgage Securities Trust 2013-LC11 deal, making up 9.1%. Comprising premium retailers including Brooks Brothers, Gap Outlet and Saks Fifth Avenue off 5th, the property’s primary trade area has a 25-mile radius in which 3.9 million people live, with average household income of $69,345 in 2012, according to the Moody’s presale report.
The property opened for business in August 2012, and by late February it was nearly completely occupied.
Moody’s notes as one of its concerns, however, that “the availability of historical information is limited due to the property’s recent development in 2012.” As such, investors in the CMBS must rely on projections, without historical data backing them, that the local market can support the property’s more than 100 tenants.
Moody’s also notes that the loan “does not benefit from amortization during the first 36 months of the 10-year loan, and while MLTV is 90.4%, six of the 10 largest loans in the CMBS pool have MLTVs over 100%, with two of them over 110%. In addition, the lenders’ recourse to the sponsor, known as the “bad boy guarantee,” is limited to 10% of the loan, reducing its incentive to support the loan in troubled times—a still early trend Moody’s will be detailing in an upcoming report.
In some cases loans are clearly relying on pro forma income, but they’re for highly sought after properties that are unlikely to default no matter what the economic conditions.
The loan for the Seagram Building, at 375 Park Ave. in Manhattan, exemplifies the increase in CMBS that securitize a single loan as well the inclusion of overt pro forma income. In the case of the Seagram deal, the pro forma cash flow was nearly 40% higher than the property’s $54 million in 2012.
Huxley Somerville, head of Fitch Ratings’ CMBS group, said that $10.2 million of the pro forma income is assumed by increasing currently below-market rents to market level; $7.8 million by increasing occupancy to 96.7% from the 90.2% over the last two years; and $2.2 million from a re-measurement that increased the property’s area by 3.5%.
Somerville said Fitch, which published a one-page opinion on the deal but did not officially rate it, sees little chance of the loan resulting in a loss, but such assumptions heighten the risk of a downgrade.
“Our concern is that, if you’re an ‘AAA’ or ‘AA’ bondholder, you shouldn’t be relying on a bet that the property is going to achieve the projected rental income,” Somerville said.
Moody’s argues that trophy assets carry additional credit protection, and in the case of the Seagram Building its analysis anticipates currently below-market rents rising, but not to the level at which the landlord is currently signing tenants and is assumed by the deal’s underwriters. “We recognized some of the increase, but we built in a cushion relative to where leases are currently being signed,” Philipp said, adding Moody’s considers pro forma income to be income above what it views as sustainable levels.
Berger said that as a general trend Midland has seen more pro forma cash flows being underwritten into CMBS deals, but generally it’s been around the biggest and highest quality assets. “We certainly aren’t back to where we were in 2007,” he said.
Nevertheless, the rating agencies all note the increasingly borrower-friendly terms of the loans entering CMBS deals, including forms of pro forma cash flow. Clancy at Trepp acknowledges that LTVs and IO periods moved up but says they’re not yet frothy. “What’s seemingly frothy at this point is the skimpiness of spreads, whether for legacy or new-issue paper. That’s where we’re really back to 2008 levels,” Clancy said.
Central banks show little sign of easing their stimulus programs—Federal Reserve Chairman Ben Bernanke reiterated that stance last week—and the resulting low interest rates will continue to be a boon to commercial real estate. Clancy notes “a bit of a virtuous cycle going on now,” because low rates have prompted the market to view properties considered cuspy and likely to stumble a few years ago as now likely to be refinanced without a loss.
“The lower rates and spreads are forgiving a lot of sins,” Clancy said.
Grady noted that today’s relatively steep yield curve and strong investor demand resulting in comparatively tight credit spreads practically ensures profits on loans originated today. But when central banks begin to reduce the liquidity they’re providing and the curve starts to flatten, lenders usually seek to offset decreasing margins by increasing the volume of loans they underwrite, and the loosening of underwriting standards accelerates.
“The part that concerns us the most is that in most underwriting cycles, the most egregious stretches occur not during the central banks’ accommodation phase, but during the period when they start tightening,” Grady said, adding, “That’s really when the worst of the worst [underwriting] starts to occur.”
