A pickup in CMBS issuance is giving the market a much-needed liquidity boost, but underwriting standards are slipping as sponsors scramble to find enough collateral for deals, which are drawing investors looking for extra yields.
Just a few months ago, CMBS deals were relatively scarce — $11.6 billion of securities were issued last year, according to Trepp — and they had to be underwritten pretty conservatively to entice investors. This week alone, two deals worth a combined $3.6 billion came to market, and market observers expect this year's issuance to total $35 billion to $50 billion.
Much of the collateral for these deals is expected to come from loans used as collateral in older deals that are maturing and need to be refinanced. But market participants say some of the best properties are being refinanced by insurance companies and international banks, which do not always resell their loans into bonds. Also, loans on some of the highest-quality multifamily properties are finding their way into the portfolios of Fannie Mae and Freddie Mac.
To compete with these other financing sources, Wall Street's CMBS conduits have to offer borrowers at least as much leverage as they could get elsewhere. "We're not back to '06-'07," in terms of underwriting criteria, said Julia Tcherkassova, a CMBS strategist at Barclays Capital, "but we're halfway there."
The latest transactions include junior, or B-note, tranches and many other features that characterized deals underwritten before the financial crisis. The collateral includes IO loans, loans on properties with mezzanine financing in place (or provisions allowing the borrowers to get such financing) and reserve accounts that are not fully funded when the deals close.
The first transaction to price this year, a $2.1 billion offering from Deutsche Bank and UBS, had a stated LTV ratio of 62.3% — a relatively mild increase from the sub-60% levels of last year's deals. But after taking into account other forms of leverage baked into the deal, Fitch Ratings put the "stressed" LTV ratio at 91.9% in a presale report issued last week. The average stressed ratio for fixed-rate transactions Fitch rated last year was 82.7%.
Five of the deal's loans, representing 18.2% of the pool of collateral, pay only interest for the first five years before they begin paying down principal. Two other loans, representing 1.6% of the pool, do not pay any interest until they mature.
What's more, some of the properties securing the loans are being used as collateral for additional debt. Two loans, representing 7% of the pool, have additional mezzanine financing, and five loans, representing 7.3% of the pool, have additional subordinate debt. Three others, representing 25.7% of the pool, allow mezzanine financing to be obtained in the future.
A $1.5 billion offering being marketed by Morgan Stanley and Bank of America Merrill Lynch has a Fitch stressed LTV ratio of 92.6%. (The stated LTV ratio is 61.6%.)
None of the loans in the pool of collateral are interest-only until maturity, but four, representing 31% of the pool, pay only interest for an initial period. Also, one loan, representing 11.6% of the pool, has additional mezzanine financing in place, and another loan, representing 3.5% of the pool, has additional pari passu debt (which would have equal rights in collection). Six other loans, representing 14.7% of the pool, allow mezzanine financing to be obtained in the future.
Huxley Somerville, group managing director and head of Fitch's U.S. CMBS credit team, said the deals that came to market last year were "unusual in that they had such low leverage," and he had not expect that to last. Higher leverage "isn't necessarily a negative," Somerville said. "Investors tell us they often prefer more leverage on higher-quality properties than lower leverage on lesser-quality properties."
Fitch has made some changes to its ratings criteria over the past 18 months. For example, it has increased the probably of default for loans that drop below 1.0 debt service coverage. The agency has also increased the amount of credit enhancement it requires at various ratings levels for concentrations in pools by loan or borrower.
This stricter ratings criteria has resulted in additional credit enhancement on recent deals, which, in addition to having more leverage, are backed by fewer, larger loans than was typical before the financial crisis. For example, the largest loan in the deal Morgan Stanley and Bank of America Merrill Lynch is marketing, a $235 million mortgage on the Christiana Mall in Newark, Del., represents 15.2% of the total pool. (It pays no principal for the first five years.)
And Fitch is no longer taking into account "pro forma" income. In the past, if a property were 60% occupied and the average occupancy rate for the market were 80%, the agency might have taken into account the potential for the property to reach an 80% occupancy rate. "Now we only take into account what rents are in place at the date of securitization," Somerville said.
Bill Bemis, a portfolio manager who oversees $3.5 billion of CMBS investments at Aviva Investors, said the increased stated LTV ratios on deals he has seen so far are "mild" and "not a concern" for him. Given the lending environment, "it's probably not too surprising" that leverage in deals is on the rise, Bemis said. He would be concerned if he started seeing other features that were common before the financial crisis, such as pari passu loans that were so large they had to be split between two, three or four deals, or deals with a lot of mezzanine financing.
But right now, "the supply we're seeing is well below where demand lies, so it's a definite positive for the market," Bemis said. In addition to providing new bonds with loans underwritten at current market values, as opposed to the peak values of 2006 and 2007, the new supply "highlights the relative value of current secondary bonds, which are still trading materially wider than new issues," he said. "We'd need to see a pretty material increase from here before supply starts to become a negative technical."
The bulk of demand for these deals is coming from CMBS investors "that just continue to see their portfolios mature and are looking to reinvest, whether its interest payments or principal payments, on a monthly basis, to try to hold the line on their current allocations," Bemis said.
Aviva's allocation to CMBS has been pretty consistent over the last few years, he said. In most of the portfolios it manages, it is "overweight" on the sector.
No one expected LTV ratios to stay at last year's unusually low levels, but Tcherkassova said investors expected it to take longer for underwriting criteria to deteriorate as much as they have. "That's one of the reasons some were sitting on the sidelines in 2010. They thought standards would continue to be very solid."
Some of last year's deals were structured to give investors in the highest-rated tranches a say in how loans in default were worked out or liquidated. However, Barclays analysts do not expect issuers to offer this feature in many of this year's deals; that's because, as the leverage heads higher, the junior-most bondholders, who are typically the first to bear losses, will demand more control of resolutions with borrowers.
