A select group of investors that buy the riskiest slices of commercial mortgage securitizations have lost their appetite for the very worst offending loans.
Buyers of the B-rated tranches of CMBS are paid the highest interest rates but are first in line to take losses when loans used as collateral go bad. While they typically represent no more than 8% of the investor base, deals can’t get done without them. This gives B-piece buyers the power to blackball individual loans that they don’t feel comfortable with.
For example, six months ago, a loan that represents 75% of the value of a property and pays only interest and no principal for its entire term would have easily found its way into a CMBS pool, according to Mike Riccio, senior managing director and co-head of national production for CBRE Capital Markets.
Today, he said, the loan isn’t available because investors don’t want it.
Borrowing that heavily against an office building, shopping center or apartment building is just too risky unless some of the principal is paid off before maturity. Otherwise, the chances that real estate prices will fall, leaving the loan underwater, are too high.
“Investors are definitely more assertive about what they like and what they don’t like,” said Steven Schwartz, Managing Director of Acquisitions at Torchlight Investors.
He said that, over the last 90 days, Torchlight and other B-piece buyers have exerted more control over how pools look by influencing which loans close as well as which loans that have already closed are removed from the CMBS pool.
This pushback did not occur the last time commercial mortgage underwriting was this loose, in the run up to the financial crisis. It is all the more notable because the ranks of B-piece buyers have expanded. There are now nearly twice as many as there were in 2007.
Riccio said that the lack of certain loan availability, such as the 75% LTV, full-term, interest-only loans isn’t “because CMBS shops have decided to get more disciplined. It’s because they are having a tough time selling those bonds with that security in them. ”
While this pushback can make it harder for conduit lenders like CBRE to compete against other kinds of lenders, such as banks and insurance companies, Riccio said that from an overall financing capital markets perspective, the pushback by B-piece buyers is “a very good thing.”
“From our perspective the watchful eye and the discipline is [something] that we didn’t see in 2007, where you could get an 80% loan that paid only interest for the entire term — none of these loans were ever kicked out,” he said.
Huxley Somerville, managing director and head of U.S. CMBS at Fitch Ratings, says that he first heard rumblings of a pushback in January at a Commercial Real Estate Finance Council conference.
“We were told to be pleasantly surprised because we would see a stabilization in credit in 2015,” he said. According to Somerville some of the early 2015 conduit Fitch rated did show some improvement in the transaction pool but it was short lived and by the end of the first quarter, the pools reverted to riskier credit.
Rating agencies have also been pushing back against weaker underwriting. Moody’s Investors Service, in particular, has been increasing the amount of investor protection required to assign a triple-A rating to senior tranches.
And both Fitch and Moody’s have ramped up required levels of credit enhancement for subordinate tranches. Beginning in the fourth quarter of 2014, Fitch has required enhancement above 8% in order to assign a BBB-, the lowest investment grade rating, to class D tranches.
These higher requirements often resulted in a rating agency not being hired to rate a deal, or at least part of a deal. Moody’s hasn’t rated the class D tranches of any conduit this year, or in the fourth quarter of last year.
(Standard & Poor’s S&P has agreed to a ban from rating conduit CMBS until Jan 21, 2016 as part of a settlement with the U.S. Securities and Exchange Commission.)
It’s not unusual for the composition of a pool of collateral to change before a deal is finalized and rating agencies have no way of knowing why a particular loan was rejected. Still, Somerville says that if B-piece buyers weren’t kicking out the worse offending loans “then credit enhancement would be even higher and it’s certainly higher than what it has been for a very long time.”
There is certainly some interplay between the loans that B-piece buyers will accept and subordination levels required by rating agencies.
Sean Barrie, an analyst at Trepp, says that increased subordination requirements “yields more parity to B-piece purchasing.”
Schwartz believes that, over time, the pushback from B-piece buyers could reduce the subordination requirements for these tranches. “We could see it move from 8% to 7.75%or 7.5%, but that will take three or maybe six months to really show up in a big way,” he said.
For now, however, the proactive move by B-piece buyers is only occurring on the margins and does not reflect a wholesale improvement in the credit quality of CMBS pools. The pushback, says Schwartz won't stop overall leverage levels from creeping up, but it will cull the weakest loans from the deal.
“There won’t be an ah-ha’ moment, when all of a sudden we see a massive reversal of credit,” he said.
What’s more, “B-piece buyers can’t reshape an entire pool,” said Schwartz. “As B-piece buyers, you focus on what you believe are the toughest loans and those might only be 5% or so of the deal. If the loan hasn't closed, you can work with the originator to improve the loan structure, but if it has, you might ask for it to be removed.” However, focusing on that 5% hasn’t suddenly caused credit underwriting to immediately improve, or by extension, subordination requirements to immediately drop in deals.
Reshaping the collateral pool would require a wholesale reduction in LTVs and an increase in debt coverage service coverage ratio, a measure of the amount of cash available to meet interest and principal payments.
In fact, the opposite is happening.
As credit conditions loosen, average LTVs in conduit CMBS pools have moved upward. Fitch stressed LTVs, for example, have steadily increase to 110.2% in 2015 from 91.6%% in 2011. The share of high stressed LTV loans has been increasing, as more than 80% of loans in recent deals have Fitch-stressed LTVs greater than 100%.
Stressed LTV’s utilize a full cycle methodology which for example takes long term averages for cap rates rather than strictly current market cap rates. This methodology moderates the effect of the dramatic rise in prices without the corresponding cash flow growth by literally discounting the cash flows by historical averages rather than the subsidized low discount rates of today.
Nationally, lodging loans saw the largest increase in average LTV, while the other major property types remained fairly constant to slightly higher.
And capitalization rates, which are a measure of real estate income relative to a property’s value, have compressed over the past five quarters ago, in each property type. Lodging cap rates have staying the most consistent (hovering at 8.5%), while industrial property cap rates have fallen the most, to 7% in the first quarter of 2015 from 7.5% in the first quarter of 2014, according to Trepp.
“Continued property appreciation and competition for loans can drive cap rates lower as lenders require less income per dollar of property value to write a loan,” Trepp stated in an April 2015 report.
The increasing proportion of loans that pay no interest for their entire terms is another red flag. This has been steadily increasing in conduit pools over the last five year, according to Fitch, to 70.2% in 2015 pools from 25.1% in 2011 pools.
For now, however, the market is likely to continue on the same trajectory for two reasons. One is the continued demand for these loans, both from the CMBS investors and from banks and insurance companies.
The first quarter earnings conference calls of real estate investment trusts were rife with commentary about the high level of competition for borrowers.
The other reason is that, relatively speaking, the CMBS market still looks healthy. Although credit has slipped from where it was three years ago, loans are still well underwritten. “Those loans made over the last several years were exceptionally secure, in due to a rising market, the best loans that we’ve seen in a generation,” said Riccio.
“The market is working really well right now. CMBS lenders are winning deals they should be winning. Lenders are comfortable with the overall supply and demand fundamentals in real estate,” he said.