The Dream Downtown hotel opened its doors in June 2011 to much fanfare. Mermaids swam in the pools and stilt walkers and fire throwers mingled among the celebrities who attended the opening festivities. Its prospects appeared bright, given New York City's booming hotel business, the property's prime location in Manhattan's hip meatpacking district and the extensive hotel-industry experience of its owners.

Even so, including the property in a $1.3 billion CMBS deal launched this spring, when the hotel had officially been open less than a year, raised eyebrows among institutional investors and credit rating agencies. Adding to concerns, the loan backing the hotel carried a relatively high loan-to-value (LTV) ratio and an interest-only (IO) structure - features that were prevalent in CMBS offerings before the market's collapse in mid-2008 and have contributed to a jump in the delinquency rate of those so-called legacy deals this year.

The UBS Commercial Mortgage Trust 2012-C1 offering has become a measure of how far the CMBS market has come.

CMBS spreads widened markedly in the summer of 2011 as escalating concerns about Europe's sovereign-debt crisis and a sputtering U.S. recovery made investors risk-averse. Confidence in the market was further undermined by a ratings criteria snag that compelled Goldman Sachs and Citigroup to pull a deal that had already priced.

Spreads remain wide but have tightened sharply over the last few months, reflecting investors' need for higher-yielding assets amid a continuing environment of historically low interest rates.

"It's very hard for portfolio managers to add yield to their portfolios, and the new-issue CMBS market is a great way to do it," said Harris Trifon, research analyst at Deutsche Bank Securities. "That's especially true for super-senior bonds that provide 30% credit enhancements, effectively removing nearly all credit risk, and offer a spread of more than 100 basis points over comparable swap rates."

Trifon added that yields increase dramatically for lower-rated tranches of CMBS deals, exceeding alternative investments with comparable risk. In late August, the spread on 'AAA'-rated junior (AJs) CMBS offered a 500-basis point premium over high-yield bonds, compared to a difference of only 10 basis points in February 2011. Meanwhile, the credit enhancement that rating agencies require to protect investors in 'AAA' junior bonds was in the 20% range, well above levels between 12% and 14% in 2007, Trifon said.

RBS Securities published a report on Aug. 22 questioning whether CMBS has "rallied too far and too fast." The report noted that super seniors, 'AAA' mezzanine (AMs) and AJs are trading at or near their highest prices in nearly a year, increasing over the last three months by 2.4 points, 3.3 points and 4.1 points, respectively.

Meanwhile, spreads on super seniors tightened to 104 basis points on Aug. 23 from a recent high of 147 basis points on June 4, while spreads on 'AAA' mezzanine narrowed to 377 basis points from 481 basis points over the same period, and 'AAA' juniors narrowed to 1102 basis points from 1285 basis points, according to Trepp, a New York-based provider of commercial real estate and CMBS data and technology.

The subordinated B-piece market has seen a pack of mostly new buyers bid down deal spreads by 300 basis points since the market first began reviving in 2010, from around 21% to closer to 18% today, according to market sources.

Early this year, $1.7 billion hedge fund LibreMax hired Michael McLarney from Barclays and has been increasing its CMBS holdings, and $24 billion Angelo Gordon is planning a new fund that will invest in CMBS. In May, the Commonwealth of Pennsylvania Public School Employees' Retirement System agreed to invest up to $200 million in the Brevan Howard Master Fund, which was started recently by hedge fund giant Brevan Howard. It is expected to provide returns of 20% to 60% by the end of 2014, according to a letter to the pension fund's board by James Grossman, deputy chief investment officer.

With so many new investors piling into the market, observers expect issuance to approach and perhaps even exceed $40 billion this year, up from $34 billion in 2011 and just $11 billion in 2010. That's assuming no major external event, such as a sovereign default, sends investors scurrying for shelter again.

Approximately $10 billion of CMBS deals are in the pipeline and are anticipated to be launched over the next few months. An increase in volume should better indicate how strong demand truly is and where the market is headed.

"The post-Labor Day supply will be a good test for the market and will be a bellwether for credit quality at this point in the cycle, considering every conduit should be out with a deal in September and October," said Marc Peterson, managing director of portfolio management at Principal Global Investors.

Wall Street Beefs Up

The revival has prompted major Wall Street firms such as Morgan Stanley and Barclays Capital, as well as regional players such as KeyBank, to beef up their CMBS desk over the last year. Mid-size brokerage firms including Cantor Fitzgerald and Knight Capital have also started up desks to get in on the anticipated CMBS bandwagon, assuming commercial property prices will continue to recover. Cantor has teamed up with CIM Group, a real estate investment firm, to securitize loans that CIM originates.

"Everybody is looking at the next three years and where products are going to be built and who is going to be hiring," said Jeanne Branthover, managing director at Boyden Global Executive Search. She said the consensus appears to be that commercial real estate prices have hit bottom and the market is just beginning its recovery. She added, "Banks have to figure how to generate revenue, and this is a segment that should start generating money because of everything that's happening trend-wise in terms of real estate prices."

In July, Mitsubishi Corp. also announced that it will begin originating CMBS in the U.S. through a joint venture with Five Mile Capital Partners, an asset management firm specializing in real estate debt and related products. The business, called MC-FMC Commercial Real Estate Finance Management, will be executed via Mitsubishi's U.S. alternative asset management subsidiary named MC Asset Management Holdings.

Deal Terms Loosen

Inevitably, the CMBS market's revival has been accompanied by a loosening of underwriting standards. No one interviewed for this article is predicting a return of the raucous years leading up to the market's collapse, when investors desperately seeking to put capital to work annually purchased more than $200 billion in CMBS, often of questionable credit quality. Not only were deals highly leveraged, but many were based on "aspirational" cash flows that issuers and their underwriters projected occurring as the bonds matured.

Still, the cash flows of some loans in the latest CMBS deals may not be as predictable as investors might want. As one investor noted, the Dream Downtown hotel's income stream was far from "stabilized" when the loan was securitized, so investors could not be sure it would consistently hit income targets.

"The ideal [stabilized] CMBS loan has a three-year operating history, so investors have context for current rents and expenses, as well as the ability to see how the collateral performed during the downturn. We've recently seen an increase in not-yet-stabilized loans contributed to CMBS deals," said Tad Philipp, director of CRE research at Moody's Investors Service.

The Dream Downtown loan makes up 9% of the $1.3 billion UBS Commercial Mortgage Trust 2012-C1 offering, and it's the largest loan in the pool. Moody's calculated its LTV at 9.95%, which is in fact lower than the LTV of the second-largest loan in the pool for Chicago's Civic Opera House, at 113.5% and six of the other top 10 loans in the pool.

Moody's said in its presale report that the pool's aggregate Moody's-adjusted LTV ratio of 101.9% is lower than the 2007 conduit transaction average of 110.6%, but it is "the highest level Moody's has calculated for conduit pools since 2009." In addition, the pools' 9.2% debt yield is the lowest debt yield for a conduit transaction since the financial crisis, the rating agency said, adding that properties "with lower debt yields indicate [inherently] higher leverage and higher probability of default."

"The market is vastly improved from where it was back in 2007, but as things have accelerated over the past 18 months or so, there has been a natural loosening of credit that comes with more deals getting done," said Kevin Donahue, senior vice president at PNC Real Estate's Midland Loan Services. "It's critical that we remember the lessons gained from the [legacy loan] collateral that caused problems in the past."

Midland has been appointed special servicer for more than half of the new-issued CMBS securities since the market began reviving in 2010. The special servicer is appointed by the B-piece buyer who acquires the subordinated first-loss position of CMBS offerings. Consequently, those investors tend to closely scrutinize the commercial loans making up CMBS loan pools, often tapping Midland to perform the due diligence. That's given Midland a first-row look into loan quality since the market sputtered back to life in 2010.

Another indication of the decline in the composition of loan pools, according to Donahue, is the disproportionally high percentage of loans backing retail properties. He attributes this, in part, to the Freddie Mac K-Certificates program and other agency programs, which have gobbled up a significant portion of higher-quality multifamily loans that might otherwise have further diversified property types in private-label CMBS.

Also re-emerging has been "moment-in-time" underwriting, making debt yields and coverage ratios appear reasonable based on today's net operating income but may become less sustainable over time as tenant leases rollover or expire without proper structure around the risk.

Most commercial mortgages today mature in 10 years and amortize over 30, resulting in a property partially amortizing by maturity and making the loan easier to refinance. Donahue said loans are increasingly adopting either full or partial IO structures that require a higher amount of the loan to be refinanced at maturity - typically harder to do. "In most investors' minds it's a way to increase proceeds to the borrower and also potentially increase risk because of the lack of pay-down," Donahue said.

Eric Thompson, a senior managing director in the structured finance group at Kroll Bond Rating Agency, said the agency is seeing more CMBS deals structured to result in "credit barbelling," in which the pool contains several loans with very high LTVs and several with very low LTVs, potentially resulting in a moderate LTV average. The comparatively high portion of highly leveraged loans can bump up credit problems later on.

"I wouldn't exactly call it barbelling," Philipp said, "But there has been a notable drift toward loans in the most highly leveraged categories over the past few quarters. Another way of looking at it is about 5% of current loans are underwritten to about what the average Moody's adjusted LTV was at the peak" in 2007.

Other loan areas that have seen some slippage, Donahue said, include less structure around capital expenditures, and lower tenant improvement/leasing commission reserves based on lease rollover risk. In addition, "cash-out" loans have returned, when a property has increased in value and the lender refinances the loan at a higher level and the borrower pockets the difference. Donahue said such loans can have their place, if the borrower has owned the property for a significant amount of time and has enhanced its value. But it reduces the borrower's cash-equity in the property, and based on what "we have seen in the 2006-7 vintage loans, that becomes problematic if the property declines in value," Donahue said.

"One of these issues may not be problematic, but if I have a loan that has IO provisions, the borrower is cashing out, and I have no escrows - that can create a problem," Donahue added. "We're seeing that in a number of instances. The trend started when the market re-emerged, and it's been increasing in those areas."

James Grady, managing director at Deutsche Asset Management, said rising LTVs have been offset in part by other improving parameters such as debt-service ratios. And while yields have become more aggressive, "[Spreads are] still at levels we're comfortable with," Grady said, adding, "Compared to other markets CMBS is attractive on a nominal basis, and it's likely to get a lot of focus from investors."

Huxley Somerville, head of Fitch Ratings’ CMBS group, noted that debt service ratios decreased from 2010 through 2011 and credit enhancement increased. Debt service ratios in the first half of 2012, however, were similar to 2011 and Somerville said Fitch saw few concerns emerging through the rest of the year.

"From our view, we're not too concerned about declining credit standards in 2012. We said credit enhancement will increase if we see deterioration in LTV and debt-service coverage," Huxley said. He added that it was "amazing" how spreads have tightened over the last eight weeks, but he attributed at least part of that tightening to a false sense of security as political and financial news has slowed over the summer holiday

Others are less sanguine. Thompson at Kroll said, "In terms of credit deterioration, it's fair to say we've had some this year." He added that deals launched early in the year carried Kroll-adjusted LTVs in the low 90s, but that levels had crept up to the mid-90s by summer. "We've seen some deals recently where we've given preliminary feedback that had LTVs reaching or at 100," he said, adding that LTVs in excess of 100 were the norm in 2006 and 2007

Legacy Market Hurdles

Loans with high LTVs in the 2006 and 2007 vintages are haunting legacy CMBS today. Loan delinquencies on CMBS jumped 18 basis points in July, to a record 10.34%, according to Trepp. They are up 97 basis points since February. The jump came as many of the loans made during the real-estate boom that were structured to require payment of principal and interest in five years were unable to make these so-called balloon payments. These loans were made when commercial real estate prices were much higher and assumptions about revenues were much more aggressive.

Investors in legacy bonds analyze the subperforming and nonperforming loans backing those deals, and especially their LTVs compared to cash flow. If the former is high and the latter low, a workout at par or a refinancing in the bank market becomes unlikely, and the asset is more likely to reach maturity and default, unless borrowers or third-party investors can inject additional equity.

Mission Capital Advisors steps in at that point to determine whether a workout is possible, find investors and help structure the investments. "Our business has probably never been better," said Will Sledge, managing director of sales and trading at Mission. "We expect a significant uptick in liquidation across the board at every special servicer for those higher LTV loans."

Borrowers that are in good shape can refinance on very favorable terms, and these new loans can be repackaged into new CMBS deals, a trend that is anticipated to grow.

B-Piece Market Changes

An important brake on deteriorating credit quality in CMBS is the market for B pieces, which are the subordinated, first-loss portions of CMBS offerings. Investors in subordinated B pieces five years ago would recognize the names of only a few firms actively investing in that market today, although they would be familiar with many of the professionals working at those firms.

Rialto, which has been the most active B-piece buyer recently, was formed in 2007 by executives who moved over from several Wall Street firms' commercial real estate departments. Bill Landis ran Deutsche Bank's syndicated and principal-side financing business before joining Rialto in 2008 as its chief operating and investment officer, and he left earlier this year to form Raith Capital, along with Nelson Hioe and Michael Suchy.

Eightfold Capital is another new entrant that was spawned by executives who left long-time B-piece buyer, LNR Property, which remains in the market but is less active. Other players include BlackRock, Torchlight Investors, H2 Capital Holdings and CBRE Commercial Real Estate Services.

Although spreads have tightened in the B-piece market, observers noted that the number of active investors remains at about half a dozen, and because they take the first loss, they are exceedingly careful with their due diligence. Donahue said Midland has performed the due diligence on numerous B-piece transactions. "We think it's important to take the time and physically visit each property involved and re-underwrite each loan if necessary," he said.

Peterson said that one structural market change that should reassure investors in higher-rated tranches is the disappearance of the CDO market, to which B-piece buyers sold their subordinated bonds. "B-piece buyers can no longer finance through CDOs, so their returns today are coming through the B-piece bonds, and they experience losses much more directly than they did five years ago," Peterson said.




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