Attendees at the Commercial Mortgage Securities Association's (CMSA) Fifth Annual Open Convention in New York City last week grappled with many issues facing the current commercial mortgage-backed securities market, but a common thread throughout all of the discussions was the changing options for structuring deals in the current CMBS environment.
Topics as varied as low-leverage mezzanine financing, preferred equity structures, parri passu participation and "A/B" structures informed many of the sessions, eliciting questions from both panel members and observers alike regarding the most efficient and cost-effective methods for structuring CMBS deals. Participants also stressed how important it is for issuers and underwriters to foster good rating agency relationships.
"There is a certain slicing and dicing with loans that has taken place in many CMBS transactions recently, and we need to analyze the modeling and structuring issues involved," said Hugh F. Hall, a vice president in the private placement group at Credit Suisse First Boston. "There is the tried-and-true method of dealing with loans, and then there is the situation where loans are split into parri passu parts."
There are many advantages to creating an "A/B" structure on a loan individually - known as "loan stripping." When this method is employed, the issuer can put the investment-grade part of that loan into a transaction and therefore improve the credit enhancement levels significantly.
"Basically what you have is someone else who will take the risk of that loan on the subordinated side based on their view of that loan, rather than taking a subordinated piece of a whole pool, where they may like some loans but may not like others," added Joseph Franzetti, head of Salomon Smith Barney's conduit operation.
This scrutiny and separation of the subordinated piece seems to be a phenomenon that is gaining in popularity. "We've definitely seen this more often," commented Donald S. Belanger, a director at Deutsche Bank Securities Inc., a company that has been both an issuer and a co-underwriter in the CMBS market.
John Van Tassel, a panelist and first vice president of Banc One Capital Corp., concurred: "We've seen many instances recently in which the subordinated piece is split outside of the deal," he said.
With this method, if an issuer can find a buyer who has got a preference for a property and is willing to take a little more risk, the buyer will end up buying a B-piece of a note "that is a better match and more efficient match than buying subordinated classes of securities where they have to go through every loan, where there is a greater likelihood they may not like something," said Salomon's Franzetti.
The overall benefit, therefore, is the addition of a deal piece that is lower leveraged into a transaction, which will result in improving the credit enhancement levels. Then, by the time the B-piece buyer will look at the transaction, the risk has been mitigated somewhat.
"You don't have any single loan of large concentration contributing risk down the scale," added Franzetti.
Of course, a rating agency's perception of such a structure determines the aforementioned credit enhancement levels, panelists added. "Rating agencies do look at the whole loan and look at the recovery of the senior piece," said CSFB's Hall. "To give the maximum credit possible, the rating agencies typically limit the rights of the B-note holder," Hall said, thus giving the B-note holder very little control.
"The rating agencies won't give as much credit as we would like to this structure," added Banc One's Van Tassel.
Another topic discussed at one of the sessions revolved around the pros and cons of mezzanine financing for CMBS transactions versus a preferred equity structure, in which there is an equity investment in the mortgage but no lien on the property.
From a borrower's perspective, more leverage is always better, so through a typical structuring the borrower only has first mortgage debt to contend with. One can talk of the loan-to-value (LTV) or debt service coverage ratio - two of the most important indicators of the credit quality of the collateral backing a CMBS deal - in and of itself.
However, from a lender's point of view, mezzanine financing is typically more risky because lenders want to limit the amount of leverage that they have. "If you can find a mezzanine lender, they are taking on more risk, and they have to get more comfortable with both the borrower and the property," said Salomon's Franzetti.
Additionally, since rating agencies typically prefer the most liquid paper for the subordinated piece, mezzanine financing is often penalized by both rating agencies and investors, said CSFB's Hall.
"The market is much more focused on liquidity recently," Hall said. "A piece of advice that I can give is to deal with each rating agency separately."
Other structure-related topics discussed at the CMSA convention included: appraisal reduction, sequential-pay deals, defeasance, the importance of the relationship with the special servicer, first-loss buyers, IO buyers and whether or not a B-piece buyer should also act as servicer.