The managing director and U.S. head of real estate investment banking at Barclays Capital discusses the state of the commercial mortgage-backed securities market, including new programs and how to recognize real values.
Sheridan “Schecky” Schechner is a managing director and U.S. head of real estate investment banking at Barclays Capital, based in New York. Schechner is a trustee of the Urban Land Institute and a member of the Real Estate Roundtable.
Where does securitization go from here for the average borrower? Is there any chance for new programs? What sort of underwriting, spreads, and tranche levels will we see?
Currently, there are at least ten firms that are trying to ramp up their securitization and lending capabilities. The terms today are as follows:
- Size: $20 million to 75 million;
- Term: Five or ten years;
- Rate: Swaps plus 225 to 275 basis points [bps];
- DSCR [debt service coverage ratio]: 1.25 x;
- Maximum loan to value [LTV]: 70 percent; and
- Amortization: 25 to 30 years.
For loans that are investmentgrade quality [typically 50 percent LTV ratio or less], the rates are even lower, maybe even under swaps +200 bps.
What these terms mean for borrowers with the proper refinancing metrics is very attractive financing. The problem is, however, that many borrowers can’t refinance their existing loan amount. The drop in cash flows and the higher cap rates used in valuation lead to a proceeds shortfall that is too big for the borrower to fund with other sources of cash. As a result, many loans are getting extended.
That being said, I would not be surprised to see the following loan terms being offered in the fourth quarter of this year: 80 percent LTV, 1.20 x DSCR, ten-year term, 30-year amortization, and two to three years of an interest-only period.
When and how will they refinance all the currently overfunded loans, both securitized and bank loans?
Currently, most lenders are willing to extend their existing loans provided they deem the borrowers to be creditworthy and adequate property managers. Whether the extension is for 90 days or three years, lenders are willing to extend if the current borrower is doing an adequate or even better than adequate job managing the properties and there is no reason to change the situation, provided the property is cash flowing. A lot of extensions are getting done right now with a 1 percent extension fee or a de minimis [i.e., extremely minimal] paydown. This situation will change once the proceeds gap mentioned above narrows. Once lenders believe there is a viable alternative source of refinancing proceeds, then the number of extensions will drop.
What are your thoughts on the banks’ current “extend and pretend” policy, and how do you think it will affect them?
From the banks’ perspective, any “extending and pretending” they have done over the last 12 to 24 months has been the appropriate strategy because the values of real estate have rebounded, and they have ameliorated their potential loss significantly. Banks are assuming that the upward trend in valuation is going to continue, and as long as they continue to have a low cost of funding—due to historically low interest rates—it seems like a good strategy to them. In addition, banks have taken significant loan loss provisions and will continue to do so in 2010.
At some point, banks will have enough loan loss provisions to handle the loss due to a foreclosure because the gap between the loan balance and the market value of the asset will have narrowed and they will be feeling “deal fatigue.” When that occurs, we will see many more foreclosures and sales of nonperforming loans and bank-owned real estate [REOs].
What will be done to recognize real values versus the old 2005-to-2007 values for lending?
As transactions occur, people will gain clarity on the new cap rates and that will help reset expectations. Some borrowers have been trying to get great deals in terms of loan writedowns and have been asking for unrealistically low valuations. However, many lenders have been holding out for unrealistically high valuations, so having transactions completed will inject some facts into the negotiations.
As far as securitization and the refinancings being 70 percent of the 2010 values, where will the equity come from to make up the difference?
It will come from either existing borrowers or pools of capital already raised for this type of rescue funding.
Since many smaller borrowers don’t have the equity, and servicers will be hitting their three-year maximum extension in another year, will they start to take back more assets just like the hotel servicers are already doing?
The three-year maximum extension will cause many more foreclosures. However, I expect some servicers will attempt to amend the three-year extension limit so that people can continue to extend their loans rather than throw them into default.
Will the servicers perform renovations and otherwise spend money to upgrade assets before resale, or will they just dump them?
For the preponderance of the situations where the servicer has foreclosed and money is needed for an upgrade, I think the servicers will not put in money, but will sell the assets.
What is going to happen to the small borrowers, since even if commercial mortgage–backed securities [CMBS] should return next year, it is unlikely they will find loans for perhaps two or more years, since they will still be underwater?
The small borrowers are going to get extended if they are in CMBS pools now. Additionally, CMBS lenders are currently focused on loans over $20 million. There are two sources of financing: life companies and, more importantly, local and regional banks—but much more recourse is required.
Will there be enough bond buyers by 2011 to absorb all the paper that could be originated?
The most recent transactions have been significantly oversubscribed. Many buyers of securities are price sensitive, and, given the lack of yield in other sectors, CMBS looks like a promising investment. Lastly, even if the market ramps up, we have a long way to go before we achieve the $20 billion-per-month origination we saw in 2007.
If the CMBS market takes time to reset, there is around $700 billion to refinance, so where will the capacity come from for new loans?
First, currently, for many borrowers, the best lender is the existing lender. So, many loans will be extended. Second, either through IPOs [initial public offerings] or through sales to existing REITs [real estate investment trusts], some assets will move into public hands. There, the loans will be refinanced with new equity being injected. Lastly, there are pools of capital waiting to act as sources of rescue financing. So, you will continue to see notes split into A and B notes, with new capital being inserted in between.
Will there ever be collateralized debt obligations [CDOs] again?
Yes. With investors seeking yield, more and more exotic products are coming back to life. Who will hold the B-piece risk on new originations since the government wants the banks to hold 5 percent of the risk? It seems unlikely that the government proposals will become law. In addition, the CMSA has lobbied quite successfully that the construct in CMBS of having a third party own the risk is an acceptable alternative. So, we will see no change from precrisis with respect to which type of entities hold the B piece.
What other new regulations are going to come that may affect CMBS issuance?
Who knows what is going to come from Washington. One area of focus is Fannie [Mae] and Freddie [Mac]. Is Congress going to restrict their multifamily lending, stop them from making any loans at all, or keep the status quo? One can only imagine the impact on the multifamily market and the CMBS market if Fannie and Freddie stopped making multifamily loans.
