“Only when the tide goes out do you discover who’s been swimming naked.”—Warren Buffet
There is a plethora of consternation in the real estate capital markets about the new risk-retention rates, and how this could roil the commercial mortgage-backed securities markets. Beginning in 2017, all CMBS lenders will now be required to retain either a vertical or horizontal (first loss) tranche of a CMBS security which will subsequently raise the cost of the security to the borrower since the issuers will have to hold reserves on their balance sheet. So, simply add 10 to 20 basis points to the spread and it will be business as usual? Maybe. However, there are clearly other factors in play. CMBS shops have used this pause to relook at their entire business in an attempt to determine where they fit in the marketplace.
The largest players are generally the issuers, the behemoths that both securitize their own loans and take in loans from “contributors.” J.P. Morgan Chase leads a cast that includes Deutsche Bank, Bank of America, Wells Fargo and CCRE. These five groups will likely be the big winners as they have the large balance sheets in which holding a slice of a CMBS loan is merely a rounding error. As issuers, they can cajole a B-piece holder more effectively since they can use pay-for-play leverage if a B-piece buyer tries to kick out a particular loan. They can also originate some loans at break-even to simply add to the size of the securitization, effectively undercut their competitors, mainly contributors. Contributors need the issuers to take in their loans to ultimately be part of the issuers’ securitization, so these contributors need to add a small buffer to insure that their loans are not kicked out of the pool. As smaller shops, they cannot afford to either pay the roughly 100 basis point retention fee (about $100,000 on $10 million) or to have multiple pieces of loans sit on their balance sheet, the cost of which would exceed the profit on the deal.
Some contributors have left the business, namely MC-Five Mile and Walker & Dunlop, and many of the three dozen or so in the marketplace will follow. The survivors will be those lenders nimble enough to have figured out a way to absorb the risk. Bancorp is one such firm since, as a bank, they can afford to buy the vertical slice along with the competitive advantage of having arguably the smartest guys in real estate, Jonathan Kohan and Ron Wechsler, leading their CMBS efforts. Phil Miller and Macquarie Group were insightful enough to join forces with Principal Financial and the legendary Rob Dirks, who together will be a strong force. For those originators not blessed with such rainmakers, a bleak future may be in store as there will no doubt be fewer players in the market later this year.
As always, the CMBS market, however, is ruled by the B-piece buyers. They have proven fickle throughout the year with the only constant being their group disdain for Class B malls. Andrew Farkas’ C-III Capital has become a dominant force among B-piece buyers. For example, they purchased the entire junior tranche of Morgan Stanley’s 2016-BNK-2 issuance in November. This pool had a heavy concentration in New York and California (40 percent), which likely gave them comfort. While it was also overweight in retail (41 percent), it was of high quality with the largest asset being a $68 million tranche to the Gotham Organization in Harlem. Rialto Capital also continues to be the other large buyer of B-pieces as they took the whole of CSAIL’s 2016-C7 securitization, which consisted mainly of Credit Suisse and Benefit Street. Again, retail (40 percent) was the dominant product, but the two largest loans were trophy malls of Simon Property, so risk of default is extremely low. By the way, both of the preceding loans had risk-retention rules attached to them. And the world did not end.
While the various players are wringing their hands over the effects of risk retention, they should instead be ruminating about how $137 billion of CMBS (Source: Trepp) will be refinanced in 2017 as interest rates spike. An 85 basis point increase in the 10-year Treasury Bond since Labor Day (50 basis points since Election Day alone) is not much on an absolute basis, but it clearly is “bigly” on a percentage basis. For property owners that have cash reserves, they will be well positioned if interest rates continue to climb or if deleveraging becomes a theme for 2017.
Dan E. Gorczycki is a senior director for Avison Young New York who specializes in debt and equity financing, joint ventures and sales.