The New CMBS and the Question of Risk
Tom Acitelli April 28, 2011, 1:23 p.m.
The industry was abuzz last week following news of the first delinquency of the re-emergent CMBS market. Looking past the large type of the headlines, it was readily apparent that market participants could afford to keep their seats.
According to the report from RBS that announced the delinquency, the U.S. Geological Survey’s regional headquarters in Austin, Texas, backs the problematic loan. Notwithstanding the fiscal challenges being debated in the nation’s capital, the Government Services Administration remains a reasonably credit-worthy tenant, and, after an administrative delay in lease payments is addressed, there is every reason to believe that the delinquency will be remedied.
If a real issue arises, it might follow from a $14.3 million loan–bundled into the same CMBS issue–backed by the Ivyridge Shopping Center in Philadelphia. The shopping center’s largest tenant is a Super Fresh, the grocery chain owned by now-bankrupt A&P. The Ivyridge Super Fresh is not scheduled for closure, but the loan is being tracked as a measure of prudence.
For the time being, all’s quiet on the CMBS 2.0 performance front.
Why the Fuss?
The first delinquency of the post-crisis generation of CMBS issuance is a matter of concern, but not because of the peculiarities explaining the government’s missed lease payments. Rather, the delinquency coincides with assertions that recently minted loans are showing signs of weaker underwriting.
For market skeptics, the absence of a comprehensive structural overhaul of CMBS–covering issues ranging from rating agency compensation to the potential for special-servicer conflicts of interest–means the current bias in favor of conservative underwriting will ultimately give way to greater risk-taking as the market normalizes.
Attention to risk is cyclical, as we have seen many times before. In a late-February report from Standard & Poor’s, “15 Months Later … the Caution Flag is Out for CMBS 2.0,” the rating agency offered that “compared with late-2009 issuances, the newer multiborrower deals have higher leverage, less debt service coverage, and somewhat looser underwriting.”
Of course, the first CMBS to come to market after the market hiatus were inordinately conservative. Some loosening of standards was inevitable and appropriate. Whether things have gone too far or too soon is the question upon which various constituencies disagree.
Are standards loosening in a way that is not fully captured in credit ratings or is beyond the scope of investors’ ability to discern? Across the broad swath of institutional investors for whom CMBS may be of interest, there is considerable variation in the depth of real estate credit analysis. Some investors inevitably buy the rating and not the underlying properties. For those investors wary of CMBS or the informational advantage of issuers, the scope of the market’s recovery will be circumscribed.
From an economist’s vantage point, information asymmetries–real or perceived–can be as damaging to the market’s viability as any deleterious regulatory effort or financial market correction.
And so the question of CMBS quality does not simply relate to market participants voting with their pocketbooks, choosing whether to invest or not depending on their level of comfort. Rather, our industry’s ability to signal variation in quality efficiently and transparently is a necessary element of a CMBS recovery.
In the alternative case, where quality is difficult for buyers to observe, we slide into Akerlof’s market for lemons. As a case in point, recent press reports have focused on stressed measures of debt service coverage and loan-to-value ratios. But a deterioration of a loan’s stressed metrics may not reflect lower loan quality at all. It could just as easily reflect changes in modeling assumptions that, for any given loan, are known in principle, not with specificity. On their own, stressed measures offer an incomplete picture at best.
Credit, Credit, Everywhere, But Not a Loan to Make
While our capacity to measure risk is evolving, we must also ask why and how CMBS loan quality might deteriorate at this early juncture. Even if attention to risk is only cyclical, many investors remain highly risk-averse–or at least cautious–in their assessment of the commercial real estate market. Herein lies the challenge.
CMBS has returned as a source of credit with gusto. Estimates for issuance levels in 2011 now tend to be closer to $50 billion than $35 billion or $40 billion. CMBS issuance is projected to remain a fraction of its previous peak levels but has already captured more than 15 percent of recent origination volume, according to Real Capital Analytics. This is generally viewed as a positive development for a marketplace in need of diverse credit sources to meet demands for new financing and from a historic volume of maturities.
But in the same way that buyers have brought equity to major markets in abundance, driving prices higher, CMBS lenders have fomented greater competition for lending opportunities across an even wider geography. For the large number of conduit originators that have re-engaged with the market, there are simply not enough high-quality lending opportunities to sustain the collective appetite. And so, at least on the margin, some lower-quality loans are introduced to the pool.
There is room for this, as long as the risk metrics properly convey the exposure. The challenge for the CMBS recovery is that debate will continue on the question of whether quality has adjusted downward. For the investor outside of our space, it may only reinforce that our understanding of structured risk is still maturing.
Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.