In late April, Moody's Investors Service published a report on the commercial mortgage-backed securities (CMBS) market, titled “Another Warning Light on the Credit Dashboard.” It was the latest in a series of alerts from analysts decrying reduced safeguards in real estate conduit lending.
As early as November 2004, Standard & Poor's published a report voicing increasing concern over deteriorating underwriting standards, fierce competition among lenders and other developing CMBS trends that may portend higher risks to investors down the road.
“Loans made today are not of the quality of those made a decade ago, and we're encouraging investors to differentiate between the performance of CMBS over the last decade and expected performance going forward,” remarked Tad Philipp, managing director of the CMBS Group at Moody's, in late April.
But some lenders and originators argue conduit loan requirements were excessively rigorous when the CMBS industry was hatched in the early 1990s during a liquidity crisis, and today's reduced safeguards reflect a more realistic approach to risk.
Whether changing standards constitute a true deterioration, or simply an adjustment, is a matter of perspective, explains Ed Padilla, CEO of Minneapolis-based financial intermediary NorthMarq Capital. “Real estate lending had been paying for the foolishness of the late '80s for over a decade in the form of restricted capital,” Padilla says. “In recent years, real estate has outperformed alternative investments and has earned the status of favorite investment class, with the result being a flood of capital chasing deals.”
A comparison of investment indices shows the strong performance of real estate investments. For the 12 months ended March 31, the National Council of Real Estate Investment Fiduciaries' property index, which tracks institutional-grade properties, showed a 15.55% return compared with an S&P 500 return rate of 6.67%. The National Association of Real Estate Investment Trusts' Equity REIT Index posted a 9.17% return for the same period.
The capital pouring into commercial real estate isn't limited to conduit loans, but the industry at large can't afford to ignore changes in CMBS standards because securitization has evolved to influence nearly all commercial real estate lending.
According to Dottie Cunningham, CEO of the New York-based Commercial Mortgage Securities Association, CMBS originations represent approximately 25% of commercial real estate debt outstanding in the nation today compared with 1% in 1993, and most of the remaining 75% of loans reflect a CMBS influence.
“Even the deals that aren't necessarily being securitized are being underwritten as securitized deals because that gives the lender the ability to free up capital by putting the deal into a CMBS transaction later on,” Cunningham says.
From fear to fervor
Those lenders originating the first CMBS loans were fresh from the 1980s real estate crash, in which capital pumped into new construction flooded the nation's major metros with excess office space. Fear of default inspired those underwriters to require significant amortization as well as reserves for taxes, insurance and maintenance.
Now those 10-year deals are rolling over and being replaced by loans underwritten in a very different environment, one in which competition to place capital is pressuring lenders to forego pay-down of the principal with a growing frequency of interest-only loans.
Today's lenders also are approving higher loan-to-value ratios, which may leave borrowers more vulnerable to falling behind on loan payments or even defaulting in the event of a tenant loss or other difficulties, analysts say. Moody's found that conduit loans averaged 95% of the asset's value in the fourth quarter last year, up about 10 percentage points from five years ago.
Other signs of frothy lending, according to Moody's, include an all-time high percentage of interest-only loans in fixed-rate conduits (56% in the first quarter, up from 45% in the last quarter of 2004); and an increasing use of master leases in which a borrower agrees to cover lease payments on vacant space in a property until a tenant is found.
Moody's has suggested the latter practice can mask a property's true performance. “In the current vintage of deals, there's less amortization and less reserves, so the quality of underwriting has deteriorated somewhat over the last 10 years or so,” Philipp says.
Money pouring in
After publishing her November 2004 report outlining areas of concern in the CMBS industry, Kim Diamond, a managing director in Standard & Poor's Global Real Estate Finance Group, said competition to place capital is pressuring lenders to forego requirements for reserves and other safeguards. She and other analysts worry the fervor to place capital in the current high-volume marketplace will lead to riskier lending.
Domestic CMBS issuance established a record volume in the fourth quarter of 2004 and first quarter of 2005, including a $32.7 billion first quarter that was 72% ahead of last year's pace. And with a pipeline of $38.5 billion in deals set to close by June 30, tabulations likely will reveal the second quarter set yet another volume record. Analysts expect this year's volume to breach the $100 billion mark and surpass 2004's all-time high of $93.1 billion.
Global volume has accelerated this year as well, promising to double 2004's record $127.6 billion issuance, according to the CMSA's Cunningham. “Non-U.S. issuance (year-to-date) is at about $22 billion right now compared with $11 billion at this time last year. That's remarkable to me,” she says.
Global CMBS is just hitting its stride, with the United Kingdom about 18 months into regular CMBS trading and Germany shifting recently from a unique deal format to more conventional conduit deals that will trade better internationally.
Commercial real estate debt accounted for 14.4% of the U.S. Gross Domestic Product at the end of the first quarter, according to Moody's, well above the long-term average of 11.2%. The last time real estate debt reached current levels was the late 1980s, when frothy lending by S&Ls fueled a construction boom that preceded the credit crunch.
Matching risk to rewards
Those lenders originating the loans for today's crop of CMBS issuance acknowledge some increased risk compared with loans made a decade ago, but they argue that market performance justifies those changes. “That willingness to take more risk is directly related to the excellent performance of the investment,” says NorthMarq Capital's Padilla.
Lenders have applied more aggressive standards, such as higher loan-to-value ratios and lower capitalization rates (the initial return to an owner based on the purchase price of a property), in order to place loans in a competitive environment, Padilla says. While that brings some increased risk to the investor, those practices will continue “as long as real estate continues to perform.”
Contrary to conventional wisdom, Bill Green, managing director and head of real estate capital markets at Wachovia, believes that loan underwriting hasn't changed. As has been historically the case, each loan application must stand on an analysis of an asset's cash flow.
What has changed, he says, is the willingness of investors and rating agencies to accept higher loan-to-value ratios in light of the CMBS market's years of strong performance. Today's market also places less emphasis on amortization “in nearly every asset class.”
Green says the CMBS market has proven to be a safer investment than analysts ever expected when the market was new. “The fact that CMBS has dramatically outperformed all expected default scenarios … is quite telling,” he says.
“It speaks to the strength of real estate markets during this time and the limitation on leverage in the early years.” Indeed, Standard & Poor's found a default rate of only 5.56% among commercial mortgage loans issued between 1993 and the end of 2005.
Loan performance is up
Despite concern over lending standards, Standard & Poor's reports U.S. CMBS delinquencies hit a four-year low of 1.04% in the first quarter, down from 1.18% at the end of 2004 and down from a peak of 1.96% in the fourth quarter of 2003. Even multifamily loans broke a trend of increasing delinquencies that began in 2000, dropping 16 basis points to 1.7% in the first quarter, and down from the year-end 2004 rate of 1.86%.
Moody's Philipp chalks up some of that delinquency reduction to the powerful boost borrowers received from falling interest rates, which lessened debt-service burdens and enabled some loans to perform that might otherwise have slipped into default. It's also too early to see the effects of relaxed underwriting on the loans issued in recent years.
Over time, however, Philipp expects to see CMBS performance more closely reflect the credit ratings analysts provide to rate the various risk levels of CMBS bonds. “We've had fewer defaults than indicated by the ratings. We're now expecting a closer alignment.”
Matt Hudgins is an Austin, Texas-based writer.
| Total Return (%) | ||||
|---|---|---|---|---|
| As of 5/11 | Avg. Yearly Life | Month to Date | Year to Date | Since 1/1/00 |
| Investment-grade | 5.2 | 0.7 | 0.9 | 58.6 |
| AAA | 5.0 | 0.7 | 0.8 | 56.0 |
| AA | 6.3 | 0.6 | 0.7 | 66.0 |
| A | 6.5 | 0.7 | 2.2 | 71.8 |
| BBB | 6.7 | 0.7 | 1.7 | 76.7 |
| Source: Morgan Stanley | ||||
CDOs: The Next Big Evolution in Finance
With so much emphasis on risk reduction through diversification, commercial real estate collateralized debt obligations, or CDOs, promise to take the market spotlight this year.
A CDO resembles a commercial mortgage-backed security (CMBS) deal, but with fewer restrictions on the type of collateral used to generate income for disbursement to bondholders.
Unlike a CMBS deal, which relies on real estate loans to generate income for bond holders, a real estate CDO may derive its income from a package of assets that includes securities as well as loans. Those securities may include riskier forms of real estate loans like mezzanine debt, which carries a greater risk to investors but can bring greater returns than the senior loan interest common in CMBS deals.
CDOs have existed since the 1990s, but until recently they primarily consisted entirely of CMBS bonds repackaged as the collateral used to generate payments to investors. But today, CDOs include a variety of assets other than CMBS. CDOs introduced revolving transactions in 2004, enabling the manager to replace or add to collateral in the pool.
“Collateral can include pretty much the whole gamut of real estate finance, whereas CMBS is typically limited to loans and senior loan interest,” explains Tad Philipp, managing director of the CMBS Group at Moody's.
CDOs are quickly gaining popularity. U.S. CDO issuance hit $8 billion in 2004 and will likely double this year, according to Moody's. The Commercial Mortgage Securities Association (CMSA) plans to devote an educational session on CDOs during its national conference June 8-10 in New York. Says Philipp: “It's probably the biggest evolutionary step ever in real estate finance.”
— Matt Hudgins