The long-awaited reemergence of CMBS may present opportunities for the commercial real estate industry and structured finance investors.
Over the past 25 years, the commercial mortgage–backed securities (CMBS) market has established itself as a critical component of the commercial real estate industry. A wide array of commercial real estate market participants have come to rely on CMBS for efficiently priced commercial real estate exposure, as well as liquidity, matched financing, and ancillary income opportunities.
After the dramatic shutdown of the CMBS market in spring 2007, these securities have begun to reemerge as a potentially viable source of commercial real estate debt capital, albeit with simpler deal structures, lower leverage, and an increased emphasis on underwriting in-place income at increased debt service coverage ratios and lower loan-to-value ratios. With an expected $1.4 trillion of commercial real estate mortgages maturing over the next four years, as reported by National Real Estate Investor, the reemergence of CMBS, dubbed by market participants as CMBS 2.0, has been welcomed by the commercial real estate debt and equity investment communities, as well as by other fixed-income participants.
The rise of CMBS traces its roots to the hyperinflation and resulting credit crises of the late 1970s, when interest rates rose from 9.6 percent in October 1979 to 15.7 percent in September 1981. Portfolio lenders, including banks and life insurance companies, who were caught lending long and borrowing short, quickly found fixed-rate five- and ten-year commercial real estate mortgages unpalatable and stopped the flow of capital to commercial real estate.
The first CMBS transaction was priced in December 1983, when Fidelity Mutual Life Insurance, focused on generating liquidity, issued $60 million of commercial mortgage–backed securities to three life insurance companies. By 1985, total annual issuance of CMBS reached $3.7 billion and the market established itself as an effective financing mechanism for commercial real estate.
The growth of the CMBS market paralleled the dramatic growth of the commercial real estate market in general. According to research provided by Commercial Mortgage Alert, by 1995, there was $1 trillion in outstanding commercial loans, of which 5.4 percent was originated through CMBS. By early 2007, CMBS reached its pinnacle of dominance as the broader commercial real estate markets peaked, with roughly half of all new commercial real estate debt originations intended for CMBS execution, funneling enormous amounts of liquidity into the commercial real estate market and driving debt pricing down to historic levels.
In spring 2007, structured finance investors began to analyze more closely the risk inherent in CMBS after significant delinquencies and defaults began to paralyze the residential mortgage-backed securities (RMBS) sector. After evaluating the underwriting of these loans, and the deterioration in the residential real estate and structured products markets in general, bond buyers generally lost confidence that CMBS credit risk was appropriately assessed by the major credit rating agencies. Further, additional challenges were presented by a deteriorating U.S. and global economy. As a result, bond buyers devalued these securities, driving CMBS spreads to very high levels, subsequently leading to rapid inflation of the cost of capital for commercial real estate borrowers and the effective shutdown of the entire commercial real estate securitization market.
After the initial and sudden dislocation in the commercial real estate capital markets, commercial real estate seemingly went into free fall. According to Real Capital Analytics, a New York-based global real estate research and consulting firm, from 2007 to 2009 the number of commercial real estate transactions fell 92 percent, representing a drop in dollar volume from $421 billion to $17 billion. Meanwhile, due to a lack of transaction activity, legacy CMBS became increasingly difficult to value and price. At the bottom of the market, we observed super-senior CMBS tranches trading at 50 cents on the dollar, reflecting the dire expectations of default and substantial principal loss, as well as the astronomical yield requirements demanded by the severely reduced pool of active commercial real estate related structured finance investors.
In March 2009, the Term Asset-Backed Securities Loan Facility (TALF), was opened to CMBS. Soon after, the Public-Private Investment Program (PPIP) plan was made available to CMBS investors. While these two policies did not fundamentally change the credit quality of CMBS, they did kick start demand for the product, driving credit spreads down to more normalized levels in the upper sections of CMBS capital structures. Indeed, in the six months following March 2009, the spread over swaps for AAA-rated ten-year CMBS fell from 1,150 basis points to 500, representing a 56.5 percent decrease in the risk-adjusted spread associated with the highest rated CMBS credits.
With credit spreads quickly falling to levels close to current commercial mortgage offered rates from life insurance companies and commercial banks, dealers of new-issuance CMBS began to sense an opportunity to reenter the market. In the first transaction since the market collapse, Diversified Developers Realty Corp. in the fourth quarter of 2009 issued a $400 million offering backed by one loan collateralized by 28 retail properties. While this single-portfolio single-borrower offering lacked diversity, it exhibited a 50 percent loan-to-value ratio and an exceptional 2.04 times debt service coverage ratio, according to the transaction’s offering documentation. The offering was well-received by the market, with the AAA-rated class pricing at swaps plus 140 basis points and, by some reports from market participants, it was ten times oversubscribed. Notably, most buyers of the offering did not even take advantage of the TALF financing in their purchase of the securities; and as CNN Money observed in a recent analysis, the mere perception that the U.S. Federal Reserve vetted the transaction ahead of the offering was enough to create a deep market for the transaction.
Soon after the Diversified Developers Realty transaction, major investment banks issued $14.65 billion of CMBS through December 2010, according to data provided by Bloomberg, LP. While the structure of CMBS 2.0 continues to evolve, it appears that today’s new-issue CMBS is generally characterized by higher debt service coverage ratios, lower loan-to-value ratios, fewer tranches, transparent legal structures, more subordination, and additional loan documentation.
Development of the CMBS 2.0 market can be viewed as beneficial for two major components of the commercial real estate market—the commercial real estate equity investment market and commercial real estate related structured products.
The commercial real estate equity market should benefit from the opening of an expected $45 billion of commercial real estate senior mortgage capital, as estimated by market participants. However, with today’s focus on debt yield and increased debt service coverage ratios, maturity refinance risk could remain.
Despite the fact that all-in interest rates on CMBS senior mortgages have fallen 125 basis points from the first quarter of 2007 to the first quarter of 2011, there appears to be a renewed focus on sizing commercial real estate debt based on in-place property level cash flow, rather than value and prospective net operating income. We have observed that average office-secured CMBS loan maximum loan-to-value ratios have decreased from 80 percent to 70 percent, debt service coverage ratios have increased from 1.20 times to 1.30 times, and a renewed focus on debt yield may be constraining financeable senior mortgage proceeds. In fact, holding all other variables constant in this analysis, financeable proceeds have decreased by about 25 percent.
While an element of maturity risk may still remain for borrowers with legacy commercial real estate debt exposure, we observe that 25 commercial mortgage-backed securities lending desks have now emerged, either as part of traditional issuance platforms within major investment banks or as independent originators who issue new commercial real estate mortgage loans for immediate sale to CMBS issuers. This increase in the number of active lenders in the commercial real estate market is expected to drive pricing competition and diversify available capital structures for a range of commercial real estate borrowing needs. While this trend is beneficial for the borrower community, CMBS market participants are cognizant of maintaining rigor in their underwriting standards in order to help prevent deterioration of credit quality of CMBS as a whole.
From a structured finance investment perspective, the reemergence of CMBS provides an opportunity for investors to diversify away from legacy CMBS vintages and capitalize on strengthening CMBS fundamentals. Generally the investment community believes that, on a relative value basis, CMBS provides an attractive return compared with other fixed-income alternatives. Given the generally strong credit characteristics prevalent in the current new issuance environment, money managers, life insurance companies, proprietary trading desks, macro funds, and major broker/dealers continue to apply substantial demand for the asset class.
The emergence of CMBS 2.0 has various ramifications for the commercial real estate equity investment markets through an increase in liquidity, as well as on the fixed-income markets, by providing bond buyers with access to commercial real estate fundamentals through asset-backed securities. Due to additional debt capital liquidity, commercial real estate investment sales volumes could continue to increase and price discovery could occur throughout the commercial real estate asset class spectrum and various property types. Given the resurgence in CMBS, and at a notably faster pace than its seemingly more regulated residential cousin, it appears that the product is likely here to stay and that CMBS should continue to evolve into its role as a central component of the commercial real estate debt and equity finance landscape.
This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
