Just as the industry began to feel comfortable about the re-emergence of CMBS financing and CMBS 2.0 began to take off, the CMBS market started getting ahead of itself this summer and then certain issues cropped up.
What has emerged as the industry made changes so as to render CMBS viable again by attracting a broader investor base is the so-called "CMBS 3.0" version.
Even as 3.0 emerges, uncertainty in the U.S. economy, combined with market volatility as a result of the European sovereign debt issues, have tempered the outlook for CMBS.
Emergence of 3.0
The turning point for the CMBS market came about with a $1.48 billion deal from Goldman Sachs and Citi that was supposed to close in July. Standard & Poor's pulled its ratings on the deal at the last minute, which meant the deal could not go through.
The offering had an aggressive capital structure that did not sit well with investors. While most other 2.0 deals had credit enhancement in the range of 17% to 18%, this deal was initially marketed at a 14.5% enhancement.
James Grady, a managing director at DB Advisors, said that there was significant pushback by investors. This meant that the deal had to be restructured with a 20% credit enhancement. Even then, the deal was not able to close because S&P discovered an issue with their criteria and did not provide final ratings for the deal.
Grady believes that this action has further lowered the credibility of S&P with investors.
"From an investor standpoint, S&P has taken a variety of actions during the crisis, and since then that has been troubling to market participants," he said. "Coming out with 14.5% credit support for the transaction to begin with strained their credibility, and then not providing final ratings due to discrepancy in their criteria further lowered their credibility."
While the immediate fallout is that S&P isn't the preferred ratings provider for any new CMBS issuance, it is not clear if there is going to be any long-term fallout for the rating agency.
Marc Peterson, CMBS portfolio manager for Principal Global Investors and an investor in the Goldman/Citi deal, said that while S&P's action was a negative event for the market, additional capital markets-related events kicked in that led to the emergence of CMBS 3.0.
"S&P's action was a primary reason," he noted. "The other was the market volatility and the need to broaden buyer base. The deals had to go to 30% (credit enhancement) and go public in order to attract core buyers. It's all about supply and demand, and the demand was from a new type of buyer that would support the market."
Additional Credit Enhancement
What is new with the 3.0 deals, compared to the 2.0 deals, is that they have embraced additional credit enhancement of 30% for a 'AAA'-rated super-senior class.
In comparison, 2.0 deals typically were structured with just one senior class with the enhancement levels in the mid-teens to high-teens range.
"Those deals were getting done, but anticipation of the deals was not as robust as the market had hoped," Grady said.
The additional credit enhancement for 3.0 offerings is similar to that for the super-senior class that was more common with the pre-crisis 2005, 2006 and 2007 vintages of CMBS.
With those earlier vintages, given that underwriting was getting stretched during those boom times and leverage levels were high, transaction structures were likely to include this sort of super-senior 'AAA' class with 30% credit enhancement.
The earlier deals also had a 'AAA' mezzanine senior class with 20% credit support and a junior 'AAA' class with 12% to 15% credit support.
However, while the pre-crisis deals had higher loan-to-value ratios, the 3.0 deals continue to be cautiously underwritten, with LTVs in the 60s, according to Peterson.
Another difference he sees is that the 3.0 deals include fewer high-profile properties. "The tradeoff to a lower leverage is properties in tertiary markets. The quality of loans is better, but the quality of properties is not," he noted.
While credit enhancement was one issue for investors, another impediment to the 2.0 deals was that they were getting done through 144A private placements, which meant that the investor base for the deals was not broad.
Considering that CMBS issuers did not want to take on the additional costs of public issuance, and given the regulations relating to the information issuers can provide to investors, they had opted to take the private route with 2.0 deals.
However, "As the deals started to struggle since they didn't have broad sponsorship, issuers decided it was in their own interest to issue the senior classes at least as public issues and undertake that cost," Grady noted.
Another advantage to going public, although that was not the primary objective of the issuers, is that these 3.0 deals are eligible for inclusion in the Barclays Capital U.S. Aggregate index, a benchmark index that does not include private placements. That further broadens the investor base for the deals.
CMBS 3.0 deals include the revived Goldman Citi transaction, which got pushed up to $1.7 billion with the inclusion of additional loans.
Michael Gambro, a Cadwalader, Wickersham & Taft partner who worked on the Goldman/Citi deal, noted that there are securities laws limitations on what kinds of information CMBS issuers can provide to investors on public deals.
"It's led to making determination as to what additional information can be made available to the public buyers, in contrast to the flexibility in providing additional information in private deals." Gambro said.
He added that the recent public CMBS 3.0 deals have a more detailed disclosure on the loan representations and warranties, as well as exceptions to the representations and warranties.
Essentially, he noted, "There continues to be a focus on additional disclosures to satisfy investors."
Deutsche Bank and UBS came out with another 3.0 deal, a $1.4 billion offering.
According to a Bloomberg report, this was originally slated to be a $2.2 billion offering but was pared down after the market volatility kicked in.
The 3.0 issuance also includes a $1 billion deal from JPMorgan Chase and a $1.5 billion offering from Morgan Stanley and Bank of America.
CMBS issuance expectations for 2011 are now down to about $25 billion, taking into account the pipeline, compared with estimates for CMBS conduit issuance of about $40 billion earlier in the year.
The recent market volatility, and widening of spreads, has rubbed off in the form of a bleak pipeline, considering that there has been a slowdown in loan originations for conduits.
Considering that originators are not sure about the levels of loan pricing, they've pulled back on quoting loans. This has caused the deal pipeline to pretty much dry up, according to Grady.
"We don't expect that to start up anytime soon once stability hits the market. You're likely talking about anywhere between three to six months to build a viable pipeline for transactions and then bring it to market," he noted.
This means that there is likely to be little issuance in the fourth quarter, except for the one or two deals that are already in the pipeline.
One deal the market is waiting for is from Wells Fargo and Royal Bank of Scotland, which is a $763.8 million CMBS that is supposed to price the week of Oct. 31. Market players also expect a deal late in the year from Deutsche Bank and UBS, and possibly another one from Cantor Fitzgerald, making for a total pipeline of about $3.5 billion.
Another reason for the bleak pipeline is that CMBS financing is less favored in today's market. Peterson noted that the additional costs related to the higher levels of subordination on the 3.0 deals, the costs of public security issuance, as well as the need for a higher return to account for the volatility, are likely to be passed on to borrowers, rendering conduit lenders less competitive today compared with insurance company and bank lenders.
Amidst the uncertainty, Credit Suisse is even considering shutting down its CMBS origination unit, according to various news reports.
Looking Toward 2012
Continued volatility in the capital markets might mean that there is less availability of financing for the CMBS loans coming due for refinancing in 2012. This could cause commercial property prices to decline further.
"We are likely to see more difficulties in refinancing (if volatility persists), which in the best-case scenario will just result in extensions and modifications until the financing environment improves," Grady said.
In the worst-case scenario, there is likely to be a further uptick in CMBS delinquencies and defaults at maturity if the loans cannot be refinanced.
Grady anticipates CMBS issuance of about $25 billion to $30 billion for 2012, based on stability returning to the market.
"That would require a good amount of stability and the need to have it relatively soon, given the timeline to ramp up these assets," Grady said. "To the extent we have further carryover of the European situation, to the extent we continue to post weak macroeconomic figures, we expect that number not to be met."