The Return of the Rise of CMBS
Underpinning gains in transaction activity, credit markets have eased significantly over the course of the last year. In Manhattan and other gateway markets, a surfeit of lenders now compete for opportunities to finance acquisitions of prime assets and to refinance maturing debt.
This marked shift in borrowers’ access to credit has facilitated a critical mass of trades, supporting a degree of price discovery that was absent just a year ago; it has also allowed mortgage rates to remain near their cyclical lows even as long-dated treasury prices have fallen and yields have risen.
Among the re-emerging sources of credit, year-to-date CMBS issuance is approaching the $10 billion milestone, already within range of last year’s $12.3 billion total. Projected issuance in the range of $40 billion during 2011 is just a fraction of the peak levels that preceded the financial crisis. Nonetheless, current CMBS activity represents a significant share of overall lending in today’s more deliberate marketplace.
The re-emergence of this key credit source has been welcomed by a range of market participants who remain cognizant of persistent imbalances in borrowers’ access to financing. Still, there is a need for sobriety in assessing the implications of a resumption in securitization market activity. While CMBS can play an important role in leveling the credit landscape, its continued growth faces challenges from cautious investors, policy makers and its own structural inertia.
Democratization of Credit
While insurance and foreign bank lenders have generally focused their activities in gateway markets, CMBS lending is observable across a much broader geographic area. In a report released last week by Real Capital, CMBS lending is shown to have captured a significantly larger share of mortgage-origination activity in secondary and tertiary markets.
Across all markets, securitized loans accounted for 15 percent of mortgage originations in the second half of last year. In primary markets, where competition among lenders is most apparent and credit constraints have eased to the greatest extent, CMBS accounted for 8 percent of loans; in secondary and tertiary markets, it accounted for 15 percent and 22 percent, respectively.
Reliant on well-diversified collateral, conduit lenders are necessarily growing more active outside of gateway markets, in locations where the lender landscape is more thinly populated and competition in lending more subdued, and where spreads are higher. The less conservative geographic and property mix has raised questions about the quality of assets being bundled into new issues and concentrations in the largest loans. Stressed measures of loan risk have risen, though the stress-testing calculus warrants additional scrutiny.
In an upcoming Goldman Sachs-sponsored deal, for example, one ratings agency reports that the largest 10 loans account for almost 60 percent of the deal. As with several other recent deals, the newest deal is weighted toward retail properties, with assets in Texas and Pennsylvania accounting for almost of a third of the overall pool.
Absent are the trophy office towers and high-rise apartments that have formed the bedrock of the investment and lending recovery. Instead, the geographic and property mix corresponds with market segments that remain relatively underserved by other lenders.
While the mix of loans and underwriting standards embedded in forthcoming deals may weed out more risk-averse investors, there are other reasons to be cautious in welcoming a resurgence of CMBS activity. Aside from the record-high volume of loans in special servicing, many of the structural issues that were material contributors to the CMBS market’s crisis-period collapse remain unaddressed or unresolved.
The Commercial Real Estate Finance Council has made some progress in addressing investors’ desire for a more transparent and well-functioning market. The recently released CMBS 2.0 standards are evidence that progress has been made on this front. Among the key provisions, the new guidelines standardize lenders’ representations and warranties to investors regarding an issue’s loans and the due diligence performed on properties and borrowers.
The guidelines also establish a mediation framework for breach claims, outline underwriting principles intended to minimize the risk of loan non-performance and further standardize issues’ Annex A files.
The industry’s progress in enhancing its capacity for self-regulation is laudable. However, serious questions remain open for investors and regulators. In the near term, policy uncertainty related to methodological standardization across ratings agencies and risk retention requirements have fueled a divergence of expectations about deal flow. Opponents of across-the-board risk-retention requirements for CMBS argue that it will unnecessarily raise costs and inhibit issuance.
But the motivation behind the retention requirement reflects that the CMBS market has performed relatively poorly as compared to other sources of commercial real estate credit. Non-performing rates on legacy CMBS issues are much higher than for other lender groups, even after controlling for observables such as seasoning. The elevated rates of CMBS delinquency and default are consistent with structural weaknesses in the securitization market that are not replicated elsewhere to the same degree.
One of these weaknesses presents a challenge for the nation’s banks, where the incentives to scrutinize long-term loan performance are stronger at the time of origination. Rising competition from conduit originators can ultimately undermine loan quality among its competitors, including regulated institutions.
CMBS may be underwritten more carefully now than a few years ago, but this cyclical focus on risk fails as a substitute for measures that will ensure the long-term health and sustainability of CMBS.
Constraints on regional and community banks’ capacity to extend credit in support of smaller markets’ commercial property sales and refinancing needs are likely to persist for some time.
Particularly in cases where the bank lender has significant exposure to development and in cases where the management of legacy distress has proven unwieldy, regulatory and supervisory pressure may require a drawdown of exposure to the commercial property sector. Given a relative paucity of alternative credit sources in these markets, liquidity should be significantly enhanced as conduit lending ramps up.
Nonetheless, bond investors and policy makers have good reason for circumspection. Differences in the incentives and competitive constraints of bank and conduit lenders can result in a deterioration of loan quality on the balance sheets of the former. At the same time, many of the structural weaknesses of the CMBS market—including conflicts in the incentives of the various parties facilitating each issue—have yet to be fully addressed.
A rare opportunity will be lost if efforts to reform are set aside in the broader market’s now rising tide.
Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.