PRC Insights – 4 Reasons Why CMBS is Ready for a Refresh

4 Reasons Why CMBS is Ready for a Refresh

Last year, several credit ratings agencies were sounding the alarm that CMBS may be on the verge of a 2007-style downward spiral. Part of the reason for that worry is the uncertainty about the new risk retention rules that went into effect in December as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The news for CMBS over the last year has been for the most part troubling. CMBS is ready for a refresh. Here are 4 reasons why.

#1: Risk Retention Rules are Here
It’s easy to lose sight from a business perspective why the retention rules were made necessary. Immediately after the financial crash in 2007, credit was extremely tight. Deals made in the years following had to be disinfected with transparency and enough cash to cover losses. That was the impetus for the risk retention rule in Dodd-Frank which requires lenders and investors to hold a minimum of 5% of the value of each transaction to cover losses.

Those in the CMBS market have grumbled, but the rules are here now and all parties have to adjust. It will effectively force those in the market without the capital requirements out and will force those in to hold enough capital to stave off another collapse.

#2: Bond Issuance is Way Down

At the height of the collapse, the CMBS market was so hot that $250 billion from only 23 issuers was the norm. In December 2015, the number of issuers had fallen by 50% while the amount issued in funds had fallen to $130 billion.

By the close of 2016, CMBS heated up, largely in anticipation of the retention rule going into effect, but it still landed well short of bond activity from 2015; ending up at around $76 billion in 2016.

What’s worrisome is that there are signs that the CMBS market is heading towards the same overleveraged risk that caused the collapse a decade ago. Of the $370 to $500 billion dollars in bonds outstanding, there have already been over 5% in losses.

The market overall, according to Morgan Stanley is holding close to $3 trillion in outstanding mortgage debt. Losses like these are hitting second level investors hard, resulting in catastrophic losses. Rates are up, and the first quarter of 2017 only saw around $15 billion in U.S. CMBS loans issued.

#3: Refinancing is Going to Be Difficult for Many
Over this year, more than 60% of current CMBS loans are going to mature with one credit agency projecting a 50% to 60% payoff rate because most of these are overleveraged to the point that very few of them have an LTV under 80%. Refinancing these loans is going to be difficult.

Phillips Realty Capital president and CEO Stephen Shaw, Jr. recently spoke to the Washington Business Journal about troubled suburban properties in the Washington, D.C. region. He explained that higher quality properties have already been refinanced.

“I think the majority of what you’re going to see is suburban office. That’s been the problem child, and they were the most prolific receivers of CMBS,” he said.

#4: Finding B-Piece Buyers to Take the Risk Will be Harder
One of the go-to solutions for lenders and investors in CMBS is to find a way to pass the risk on. Likely the only place to find backers for these securities is among B-piece buyers and in the mezzanine debt market. However, they are not biting on these risks, especially for lenders who are not and have not adopted risk retention rules.

Compounding this are the Volker Rule and Basel II regulations that are weakening the secondary bond market.

On the Bright Side
Going forward, there are plenty of opportunities for a refresh in the CMBS market. First off, the economy is fairly stable and despite the lower number of issuances last year, this year shouldn’t fall too far below that number and in fact, may end up over $70 billion issued and sold by the end of the year.

Moreover, for those lenders willing to work within the retention rule, there are signs that investors are actually going to be more attracted to those investment opportunities over those that refuse to adapt. There will also be more creative use of alternative lenders to fill in the gaps created by B-Piece buyers.