Faster than anyone thought possible — and without much in the way of government help — the CMBS market has regained its vigor.
Deutsche Bank and UBS made waves right off the bat in 2001 when they revealed a $2.5 billion CMBS issuance that the firms were taking to the market. While CMBS issuance started picking up speed in the summer of 2010, the Deutsche Bank and UBS transaction is emblematic of the huge leap in lenders' willingness to tolerate risk over the past six months. The deal's size — it is one of the largest issuances of its kind since June 2008 — is only one of the factors.
When Goldman Sachs revived the CMBS market in late 2009, with a $400 million issuance, the particulars of the deal were such that it couldn't even be seriously considered a CMBS financing, says Richard Jarocki, managing director of debt and equity finance with Grubb & Ellis Co., a commercial real estate advisory firm.
“This was more of a single borrower, multi-asset deal,” he says. “Now, we have multi-borrower, multi-asset deals.”
The issue was backed by a portfolio of assets owned by a single borrower, Developers Diversified Realty, a publicly-traded retail REIT, and representing a single asset class in 28 stabilized grocery-anchored shopping centers. What's more, Goldman Sachs and Developers Diversified took advantage of the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF) program to finance a small portion (about 18 percent) of the issue's total price.
Issuances today are a much different animal, Jarocki says.
Issuance sizes grew throughout 2010, with deals averaging nearly $1 billion each by the end of 2010. And the deal size is still growing with the Deutsche Bank/UBS deal just one of a handful of deals in the works between $1 billion and $2.5 billion.
As a result, in December CMBS issuance in the U.S. totaled $4.5 billion — the busiest 30-day stretch in more than 20 months, according to Commercial Mortgage Alert, an industry newsletter.
In addition, the pools of assets now included in new securitizations involve multiple borrowers and multiple property classes (though most issuers still stick to some combination of retail, office, multi-family and, to a lesser extent, hotel).
On the lending side, leverage levels have risen from approximately 60 percent loan-to-value ratios 12 months ago to as high as 75 percent today. And while class-A assets in primary markets remain the preferred product type, new issues increasingly feature properties with some level of risk — centers positioned in secondary and tertiary markets and complexes with near-term lease rollovers or above average vacancy rates.
In December, for instance, Goldman Sachs and Citigroup began selling an $876.5 million issuance, much of which received AAA and AA ratings from Moody's Investors Service.
The larger part of the issuance comprised loans on retail and office properties (at 39 percent and 34 percent respectively). But hotel also accounted for 9 percent of the pool even though the sector is still considered a less desirable investment, according to Dan E. Gorczycki, managing director in the New York City office of Savills LLC, a real estate services provider.
Some of the properties were located in New York and California, but others were in Pennsylvania and Ohio, which might be considered by many investors as secondary markets.
“We are sort of in the middle range, where lenders are trying to see how far they can push the envelope,” Gorczycki says. “They'll go to a tertiary market if everything else about the deal is fine, or they'll do lease-up risk if everything else about the deal is fine. We are not at the point where they'll do everything, which is where we were at the peak of the market.”
Increasing risk tolerance
What's driving the appetite for risk is the increasing number of players in the CMBS space (as well as historically low interest rates). By the end of 2010, about a dozen or so firms had come back to doing CMBS issuance. As 2011 plays out, the number might swell to 25, notes Jarocki.
In addition to the usual suspects — Bank of America, J.P. Morgan, Citibank — there have been several newly formed funds that don't have any legacy issues from the peak of the market and so can afford to be more aggressive on loan terms, says Steven Yazdani, managing director with Lucent Capital, a Los Angeles-based intermediary that specializes in arranging debt and equity financing.
As a result, approximately $10 billion in new issuance has already been lined up for the first quarter of 2011, according to Alan Todd, an analyst with J.P. Morgan Securities LLC. By the end of the year, Todd expects to see up to $45 billion in new issuance. Issuance in 2010 totaled $18.3 billion, according to Commercial Mortgage Alert.
The catch is that most of that money will go to finance new acquisitions or to refinance loans with low original leverage ratios, industry sources say — in other words, the kinds of loans that could easily secure financing from traditional real estate lenders like banks and insurance companies. Borrowers looking to refinance riskier stuff will either have to put more money into their assets or look for mezzanine lenders to bridge the gap in funding, says Gorczycki.
Of course, as the months wear on, almost everyone in the industry expects that those standards will loosen.
“It's the human nature of Wall Street,” says Gorczycki. “Somebody will start underwriting deals others can't compete with, and that's sort of where the standards get overlooked. But that's several months away.”
Terms of service
Retail owners stand to benefit the most from the greater availability of CMBS financing since it happens to be a preferred asset class right now, says Steven Roberts, senior managing director of debt and equity finance with Grubb & Ellis.
Wall Street firms like multifamily and industrial product as well, but those properties get quickly snapped up by agency lenders and life insurers, he notes. Life insurers also get dibs on most of the class-A office buildings in large cities. What's left — suburban office space — is considered too risky of an investment by CMBS shops because of the stubbornly high unemployment rate, Roberts says.
In the last three deals of 2010, retail made up anywhere from 31 percent to 43 percent of the entire issue, representing the largest piece of the pie.
For the most part, the focus has been on grocery-anchored centers with good credit tenants, say industry insiders. Borrowers with unanchored strips in secondary and tertiary markets still have some trouble getting financing.
Or rather, if the asset doesn't involve too much risk, CMBS lenders will show a willingness to finance it, but they will offer such stringent terms that it would make more sense for the borrower to sign a recourse loan with a bank, says Yazdani.
“I think what we are seeing with CMBS lenders is class-B or better,” Roberts says. “It's got to be a well-situated property. The demographics in the area need to be strong. They are spending the time to underwrite it. Some community centers just never become class-A, but if they are class-B and solid, they get into the mix.”
At the same time, a borrower no longer has to be one of the largest publicly traded REITs in the country to be considered an acceptable candidate for CMBS financing, though a good credit history still helps. “The sponsor doesn't have to be pristine because in this environment everybody's had problems,” says Gorczycki. “As long as they didn't commit any bad acts, they will be okay.”
Lenders continue to pay careful attention, however, to borrowers' experience level with a particular asset class and knowledge of local markets. So that means a borrower that has always concentrated on Southern California would have a hard time securing financing for a property in the New York region, notes Yazdani.
Financing terms have gotten more favorable than they were 12 months ago. At the end of December, spreads over Treasuries on 10-year retail loans with leverage ratios up to 59 percent stood at 207 basis points, according to Commercial Mortgage Alert. Spreads on equivalent loans secured by office properties were at 214 basis points. That means interest rates on class-A 10-year deals have dipped as low as 5.4 percent.
But every deal these days gets underwritten on current cash flow, Yazdani says. Plus, the lenders have started paying a lot of attention to debt yields, something that was not even part of the equation in the mid 2000s, he adds.
Today, an acceptable debt yield ranges anywhere from 9 percent to 13 percent, to give the lenders some breathing room if the Treasury rates spike too much before the loans come to maturity.
“That's what people are now looking at — what's going to happen in the future, and they are trying to take a conservative view,” says Roberts.
Meanwhile, current debt service coverage ratios on CMBS loans range from 1.25 to 1.35 — they still haven't come back to 1.20. Plus, CMBS lenders have upped the average dollar amount of each individual loan that goes into the issue to approximately $15 million to $20 million, adds Jarocki.
The reason is that with fewer smaller loans in the issue investors feel more comfortable with their ability to analyze every loan. They no longer blindly trust issuers to do the due diligence for them.
“Before, the average loan sizes were very varied,” Jarocki says. “Now, we've seen the conduits not look at smaller loans. And that has to do with the investors who want to get their heads around the entire issue.”
Little hope for troubled borrowers
While the resurgence of the CMBS market is certainly good news for commercial real estate pros, they continue to worry about the billions of dollars in loans coming due over the next several years.
In 2011, for example, approximately $54 billion in CMBS loans will reach maturity, according to Trepp LLC, so the $45 billion in new issuance will be almost “entirely offset” by legacy pay downs, according to J.P. Morgan's Todd.
What's more, even if the market sees a greater level of issuance than expected, CMBS lenders will likely stick with new loans or with refinancing loans with conservative original underwriting.
It's unlikely they'll be able to help troubled borrowers who over-leveraged at the peak and have seen their property values plunge in the subsequent downturn, says Roberts.
“You have to remember that depending on the year a lot of that stuff was [originated], it's probably very difficult for the new financing to take out the old financing,” he notes. “Property values have dropped, things were very aggressively underwritten and many owners are going to have to make a decision [if] they want to put more equity into their properties. That's going to drive where we are going to be.”
At the beginning of January, the 30 days+ delinquency rate for CMBS loans on all commercial properties stood at 9.2 percent, according to Trepp LLC, almost three percentage points higher than a year ago and the highest level in the history of CMBS. The delinquency rate for retail was at 7.86 percent, up from 5.5 percent at the end of 2009. Before the end of 2011, the 60 days+ delinquency rate (considered to be “serious delinquency) on fixed-rate CMBS loans will likely reach 10 percent, according to Todd.
“There are two wild cards right now — interest rates going up and the loans that come due where the special servicers won't extend,” says Gorczycki. “That means there will be an active financing market, but it might be the case where people can't refinance their loans. Will mezzanine lenders be able to fill that void? Otherwise, we'll be stuck with the haves and have nots.”
On the Sidelines
While Wall Street firms view the current market as providing the perfect environment for an uptick in financing transactions, traditional lenders are having a more difficult time, industry sources say. The problem is not lack of funds — many life insurers, for example, could not spend all of their real estate allocations in 2010, according to Grubb & Ellis' Richard Jarocki. That's because unlike conduit lenders, life insurers almost never loosen their underwriting criteria, he explains. So while they have upped their loan to value (LTV) ratios to 65 percent from 50 percent over the past year, they still only want to do business with owners of class-A properties in primary markets. That has restricted the pool of assets available to them in 2009 and 2010.
They remain hopeful, however. Based on his recent conversations with life insurance company representatives, Jarocki expects that most life insurers will try to increase their real estate allocations in 2011. Altogether, the industry might increase its allocations by 25 percent, says Savills' Dan Gorczycki.
“Simply because they have a lot of money to put out, and they are hesitant to put it into the stock market,” he notes. “It has to go somewhere where they feel they can get a decent yield.”
Through the third quarter of 2010, life insurers originated $20.32 billion in commercial/multi-family loans, according to the Mortgage Bankers Association (MBA). The figure represented an increase of more than 75 percent from the $11.56 billion in originations completed by life insurers for the whole of 2009.
Commercial banks have been willing to get more aggressive on their real estate loans than life insurers. For example, Lucent Capital, a Los Angeles-based firm that specializes in arranging debt and equity financing, is currently in the process of closing an acquisition loan for a multi-tenant retail center in Southern California that's set to feature a 4.75 percent, fixed five-year interest rate and 75 percent LTV, according to Steven Yazdani, the firm's managing director. But that kind of loan is only available for institutional grade investors who already have a relationship with the bank, he notes.
“Banks try to be more conservative than conduits because they are going to be holding those loans on their balance sheets,” says Jarocki. “A lot of banks we've spoken to really do everything on a relationship basis. If you are looking to do a one-time shot deal, I think it's going to be very difficult.”