Even as the Trump Administration moves to loosen regulation, commercial mortgage bonds are enjoying a different kind of relief: Investors like risk retention so much that they are willing to pay up for it.
The first few deals to market since the rules took effect Dec. 24 have been so well received that it is making CMBS more competitive with other kinds of commercial real estate financing, such as loans from commercial banks and insurance companies.
Participants are particularly enthusiastic about a deal in which both of the sponsors, Citigroup and Deutsche Bank, as well as a third-party investor, a fund controlled by private equity firm KKR, all kept “skin in the game.”
This structure seems to address several constraints that the market was grappling with. On the one hand, sponsors did not want to keep a large volume of mortgage bonds on balance sheet for an extended period of time. It would tie up too much of their capital.
There is an exception to risk retention rules, unique to the CMBS market, allowing a third-party investor to hold the risk in a deal. But investors who typically buy a “horizontal” slice of the riskiest tranches were not accustomed to buying a 5% stake, particularly one that they could not sell or hedge.
“If you sell 5% of ‘fair value’ of the deal to a third party, that reaches up into the triple-B, or investment grade tranche of a deal,” said Patrick Sargent, a partner in law firm Alston & Bird’s finance group. “The B-piece buyer only wants unrated, single and double-B paper. They don’t want to have to buy investment grade that they can't trade. The economics don’t work for them.”
In the $1.3 billion CD 2017-CD3 Mortgage Trust, the three parties split the difference. Citi and Deutsche are holding on to a 1.9% vertical strip consisting of a portion of each class of securities issued. And KKR is holding on to a 3.1% horizontal strip. This combination is known as the L" strategy.
The deal priced so well that the secondary market, where previously issued mortgage bonds change hands, rallied in response.
“I think the L strategy, seeing how it priced, could in fact be the structure a lot of people gravitate toward,” said Joseph Franzetti, senior vice president, capital markets at Berkadia Commercial Mortgage, a mortgage brokerage.
“When there are multiple issuers buying a piece of the Vertical strip, they keep each other honest,” Franzetti said. “Citi is comfortable with Deutsche Bank’s collateral, and vice versa.” Investors feel comfortable that “no one’s either deliberately or inadvertently putting in poorly underwritten loans.”
“You’ve also got KKR buying a 3.1% horizontal strip, that’s an affirmation by a third party that’s holding a first loss position,” Franzetti added. “You create, from an investors’ perception, the best of all worlds: issuers who will discipline themselves and are going to make a market in the bonds, and the stamp of approval from a horizontal B-piece buyer. “The other thing that’s an advantage is the issuers don’t have to take [the full] 5%.”
Importantly, according to Sargent, the three parties also came to agreement on compliance and indemnity allocation issues that hampered prior attempts at using a third party to meet risk retention requirements.
“To the extent this structure has generated enough investor interest to bring down spreads, it’s ultimately passed on to borrowers," he said. "So the CMBS market becomes a more attractive alternative to borrowers, rather than a life company or bank.”
New issuance is off to a slightly stronger start that last year. Some $3.0 billion of private label mortgage bonds priced through Feb. 3, up 6% from $2.8 billion in the same period of 2016, according to J.P. Morgan.
So far, the Citi/Deutsche deal is the only one to employ the L strategy for risk retention. Another deal from Morgan Stanley, backed by five Marriott branded hotels owned by Ashford Hospitality Prime, relies on a third-party, an affiliate of the Blackstone Group, to hold a 5% horizontal slice. And the sponsors of third deal, a conduit CMBS, hold a 5% vertical slice. Both were very well received by investors as well.