By Poonkulali Thangavelu, Contributing Editor
Even as commercial mortgage-backed securities financing was slowly starting to make a comeback as a source of multifamily financing, U.S. and global macroeconomic issues, as well as micro-level CMBS-related issues, have come together to stall the CMBS sector.
Based on the recent market developments, it seems that the CMBS 2.0 version that emerged post-financial crisis is undergoing another retooling process as it readies for what market watchers are cautiously starting to call a CMBS 3.0 version. As Gary Mozer, principal and managing director, George Smith Partners, notes, “We saw them getting very lax [toward mid-year], and we saw the market getting crazy again. Then the market crashed and everybody got religion again.” He expects the CMBS market to be very conservative in the next go-around.
According to multifamily industry sources, even though major CMBS lenders such as Goldman Sachs and JP Morgan are interested in financing multifamily loans, they are not able to compete with Fannie Mae and Freddie Mac, the life companies and banks in today’s environment.
Mitchell Kiffe, senior managing director/co-head of production with CB Richard Ellis’ debt and equity finance group, notes, “Until late July and early August, when the CMBS market stubbed its toe, the conduits were becoming more of a factor in the multifamily business. But since that time CMBS lenders haven’t been much of a factor.”
Since August, macroeconomic issues relating to the performance of the U.S. economy and the wrangling over the U.S. debt ceiling issue have impacted capital markets. Markets have also been on edge and are watching for any fallouts from issues relating to the sovereign debt of European countries such as Greece and, to a lesser extent, Italy, Ireland, Portugal and Spain. According to Kiffe, the impact of all these factors “sent shock waves through the fixed-income markets and spreads in general blew out for all asset classes, including CMBS.”
At the micro-level, the sector has been impacted by concerns about the amount of CMBS issuance coming to market earlier in the year, and the question of whether there was enough demand to absorb it. According to Kiffe, bond buyers may also have been more in favor of public issuance rather than the private placements of CMBS that were common in the deals that came to market prior to August.
Ratings agency-related issues have also impacted CMBS market sentiment. A $1.48 billion CMBS offering from Goldman Sachs and Citigroup had to be withdrawn, just before the deal was due to close, in the last week of July, after Standard & Poor’s withdrew their ratings on the deal. The ratings agency said that it was going to review its ratings methodology relating to the calculation of debt-service coverage ratios on CMBS conduit/fusion transactions. S&P resumed rating new CMBS transactions in early August (and the withdrawn deal was brought back to market in September in a somewhat modified form) but the damage had already been done. “[The S&P action] was disturbing—certainly not a confidence builder,” Kiffe notes.
Fannie and Freddie rule
Even before these market issues cropped up, the GSEs had been gaining share in the securitization area at the expense of the conduit issuers. According to a report by Standard & Poor’s analyst James Manzi, in the pre-crisis days, multifamily made up as much as 15 percent of CMBS collateral pools by loan balance. However, in CMBS 2.0, multifamily loans have been much less in evidence, accounting for only about 4 percent of the pools.
Based on expected CMBS issuance of about $40 billion for 2011, Kiffe expects multifamily-backed issuance to be less than $4 billion for the year. In comparison, Fannie Mae and Freddie Mac have been securitizing about 90 percent of the loans they originate. According to Manzi, Fannie Mae and Freddie Mac’s multifamily-backed issuance has been at about $10 billion as of early September.
In addition to the advantage Fannie Mae and Freddie Mac gained as a result of having a consistent market presence in the period immediately following the financial crisis, when conduit lenders were absent, the recent capital markets turmoil has also made agency financing more competitive.
“The incremental cost of the dollars borrowers get from Fannie and Freddie versus CMBS is almost 25 percent,” according to Mozer. This means, “for all practical purposes, CMBS is right now the lender of last resort until the market tightens again. Right now you are not going to do a CMBS loan unless you have to because you have a loan maturity, Fannie and Freddie won’t touch it [and] the local bank won’t touch it.”
The multifamily loans held by GSEs also compare very favorably in terms of delinquencies, with delinquency rates of less than 1 percent as of mid-year according to Standard & Poor’s, compared with delinquencies north of 15 percent for conduit multifamily loans. The poor underwriting on conduit loans made during the boom years has caught up with these loans in the form of higher delinquencies.
As CMBS started reviving in 2010, lenders tightened their underwriting, taking into account the fallout from the financial crisis. One significant change in the CMBS 2.0 version is that lenders have been underwriting to actual cash flow in place on multifamily properties, taking into account actual rent income and expenses, rather than on a pro forma basis. Mozer recounts that in the pre-crisis days there was a lot more pro forma cash flow used to reckon both revenue and expenses. “I think that a lot more discipline has been brought to the market,” he notes. Another difference is in terms of the lower loan-to-value levels, which are now closer to a maximum of 75 percent to 80 percent LTV.
Other CMBS 2.0 changes include smaller pool sizes, which make it easier for bond buyers to underwrite the underlying collateral, as well as higher levels of subordination, or the levels of protection from potential losses, for the higher-rated CMBS tranches.
As well, Kiffe sees lenders underwriting to a debt yield, or the ratio of a property’s net operating income to the mortgage loan. This has come about as a way to avoid inflated property values that arose during the pre-crisis days because of factors such as the use of low cap rates. Lenders expect a debt yield of about 8 percent for multifamily properties, compared with a debt yield of about 10 percent for other property types. Kiffe sees more life company and conduit lenders, but not so much Fannie Mae and Freddie Mac, adopting debt yield as an underwriting measure.
Is CMBS making a comeback?
Even with all the issues that have stalled CMBS financing, the sector is not yet out of the game. Industry watchers are looking to see how much demand there is for the few securitizations that are coming to market later in the year. As well, market volatility has impacted CMBS pricing, which needs to stabilize too.
Kiffe expects that if the CMBS market gets through its recent issues, CMBS lenders will feel comfortable aggregating more loans on their books for CMBS issuance. Depending on how spreads shape up, influencing CMBS competitiveness, he expects conduits to get a larger market share going forward. “It is very small now, so it really has but only one way to go—up. It is really important for the conduits to come back because CMBS is an important source of capital,” Kiffe says.
Legislative issues loom
There are also legislative factors that could potentially impact CMBS financing. The Dodd-Frank risk retention proposals are expected to be finalized next year. The proposals call for 5 percent risk retention by CMBS issuers, except in the case of certain qualified mortgages. The proposals also impose other restrictions on CMBS issuers, including the need to set up a premium cash capture reserve account and to have an operating advisor oversee certain transactions.
Mike Flood, vice president, legislative and regulatory policy, CRE Finance Council, says that the way the risk-retention proposal currently reads, less than 1 percent of CMBS loans would qualify for an exemption from risk retention. The trade group is proposing standards that would push that up to about 20 percent of loans, as is the case with RMBS loans.
CRE Finance Council is calling for a laddered approach to risk retention, whereby if more loans in a pool meet high underwriting standards, the threshold for risk retention should correspondingly be allowed to be below 5 percent.
And Flood also points to the term that the ‘B’-piece buyer of lower-rated tranches is required to hold on to the investment for the life of the asset. The CRE Finance Council is proposing instead that ‘B’-piece buyers should be able to exit their investments after a defined holding period, considering that after a while market factors, rather than underwriting, determine investment value.
The risk retention proposals provide a further advantage to Fannie Mae and Freddie Mac, considering that they are exempt from risk retention while they are in conservatorship. Flood says, “The market is starting to rebound, but we need to make sure that these rules are written so that they create an even playing field. While we clean up the mistakes from the past, we also need to make sure that there is a viable marketplace with portfolio lending, CMBS and equity to make sure that we can handle refinances going forward.”