CMBS Update

Tuesday, June 12th 2018
New York

The CMBS market bubble, whose inflation took years, popped just more than 10 years ago. Following a nearly two-year hiatus after that, the sector made its return and has been plodding along for roughly eight years.

What’s surprising is that securitized lenders continue to show discipline. There’s nary a sign of the frothiness that was so visible last time around.

CMBS issuance volumes have slowed and bond investors have pushed back on certain deals. There simply aren’t as many investors interested in the sector as before the Great Financial Crisis, so issuers have to tread carefully. Structured investment vehicles, proprietary trading desks and collateralized debt obligations that bought up bonds before the crisis either no longer exist or don’t ply the CMBS waters.

For the most part, lenders continue to underwrite loans based on existing collateral cash flow. That’s particularly true now that risk-retention rules are in place.

At the same time, property investors continue to stick with their property underwriting practices. Owners, meanwhile, have held firm on their pricing demands, which has resulted in a steady decline in investment sales volumes since late 2016. While the first quarter saw an uptick in volume, part of that could be attributed to Google Inc.’s $2.4 billion purchase of the 1.2 million-square-foot Chelsea Market in Manhattan.

Rating agencies might argue that underwritten leverage levels aren’t necessarily the best measures of discipline, but they’ve flattened in recent years, after topping out in 2014. Leverage levels might have remained stable before the crisis, but they often were based on expected collateral financial performance, as opposed to actual performance.

Take the most notorious CMBS financing written before the crisis: the $3 billion mortgage against the massive Stuyvesant Town/Peter Cooper Village apartment complex in Manhattan. The loan, senior to another $1.4 billion of mezzanine debt, ended up being securitized through five CMBS deals.

When the financing was originated, the thinking was its collateral would generate $336.2 million of net operating income, nearly triple the $113.1 million of NOI that actually was generated in 2006. The property at the time was appraised at a value equal to its $5.4 billion purchase price, placing a leverage level of less than 56 percent on the CMBS financing.

The property’s owner, a venture of Tishman Speyer and BlackRock Realty, had planned to rapidly move units off the city’s onerous rent regulations, increasing cash flow.

While offering material for each of the CMBS deals that included pieces of the mortgage highlighted the risk that the Tishman/BlackRock plan might not pan out, investors still ate bonds up. The benchmark bond class of Wachovia Bank Commercial Mortgage Trust, 2007-C30, a $7.9 billion conduit deal that held a $1.5 billion piece of the StuyTown debt – the largest piece held by any of the five CMBS deals – priced at a spread of 26 basis points more than swaps. That was in line with other conduits at the time. The deal’s BBB- class priced at a spread of 130 bps more than swaps. It had 3 percent subordination.

But the Tishman/BlackRock strategy didn’t pan out and rents never got to the levels expected. The property’s value at one point was as little as $1.5 billion. The CMBS debt defaulted, the property was taken through foreclosure and ultimately sold in 2015 to Blackstone Group for $5.3 billion. That deal included certain city tax incentives and financing. Fannie Mae also provided $2.7 billion in financing. By then, the property’s NOI had increased to $210.9 million.

While pro forma loans are no longer commonplace, they’re not extinct. Early on in the recovery, Nomura Securities found that 30 percent of conduit loans originated since 2010 were written based on expected cash flows. But many of those cases involved recently constructed properties, so they lacked full financial histories.

CMBS Spread Movement Through the Years

In early 2002, benchmark CMBS bonds – those with 10-year average lives and the highest possible ratings – were selling for prices resulting in spreads of 44 to 46 bps more than swaps. As market conditions got heated, those levels tightened. In early 2007, they tightened to 21 bps more than swaps. By July of that year, bond investors started running for the hills. Spreads blew out to more than 300 bps more than swaps. A brief tightening then ensued, but by late 2008, they had ballooned to 1,150 bps more than swaps. That would have provided investors with a yield of more than 15 percent for the highest-rated CMBS. At the time, such bonds were structured with 20 percent subordination, or credit protection.

After more than a year of hyper volatility, spreads started narrowing steadily in June 2009. By the end of the year, they had tightened to just more than 500 bps more than swaps. They fell for the first time below 200 bps more than swaps in early 2011, but remained volatile and didn’t start stabilizing until early 2013.

Since then, secondary market spreads for CMBS issued since the crisis – the so-called CMBS 2.0/3.0 eras – have ranged from 69 bps more than swaps to 165 bps more than swaps.

For further information call John Sauro 877-794-5363.

Source: R.E. Direct