Regulatory Regime Dims the Mood in CMBS

The commercial real estate market has plenty of reasons to be optimistic about 2016: the positive fundamental drivers driven by steady job growth and robust capital flows into the sector are producing higher rents and property values.

The optimism, however, doesn’t extend into the CMBS industry, which faces a unique set of headwinds mostly stemming from new regulations coming into effect. CMBS prices fell sharply in the second half of 2015 as the industry begins to wrestle with how to retrench after Dodd-Frank and other regulations are fully in effect. The mood at the Commercial Real Estate Finance Council’s annual Industry Leader’s Conference in Miami this week reflected nervousness at how the market will handle the changes.

“It feels at this point that the deck is stacked against us,” is how one long-term industry executive put it.

While all lending segments have already felt the impact of a host of regulations, and are bracing for more to come, CMBS is likely to feel the brunt of regulations more than other lenders. Life companies are lending at record levels. The threat of reorganization looms over Government Sponsored Enterprises, but the change depends on the outcome of the next election, and for the time being they are also on a record pace. The agencies securitized a record $61.8 billion of multifamily loans in 2015, up more than 20 percent from 2014.

Commercial banks are a little more complicated, having been hit by higher capital charges for construction and redevelopment loans, which will cut into the share of many small- and mid-sized banks and push riskier loans to specialty lenders. Still, large banks are actively writing permanent loans, even if the market is evolving.

Conditions are not so favorable for CMBS at the moment, however, starting with the widening of spreads that began in the spring. Recently issued AAA-rated CMBS was priced to yield 135-150 basis points over Treasuries, up from about 85 bps in the spring. Wider spreads are caused by a variety of factors, including global economic instability, investor concerns about deteriorating loan quality and the impact of new regulations.

One new regulation involves imposing higher capital charges on the securities held by investment banks, which has led them to sharply reduce the amount of bonds they own. The new rules were meant to curtail trading of complex derivatives for the sake of profits, which got out of control before the global financial crisis (exemplified by AIG), but they also have limited banks holding of fixed-income products such as CMBS for the purposes of “market-making.” Investment banks used to be willing to buy securities from investors that wanted to sell in order to provide liquidity to the market. Today, the investment banks are less willing to take the risk of holding CMBS and other products on their books. Investors pay for more liquidity, so prices have dropped in an environment with less liquidity.

Lower bond prices are a problem for CMBS because the price that issuers can sell bonds is the cost of capital for securitization programs. Put simply, if the average coupon that a CMBS trust pays to investors is 4 percent, and the average loan coupon of the underlying collateral is 5 percent, the bank makes a 1 percent profit. If spreads rise and investors get a 4.5 percent coupon, the bank’s profits are cut in half to 0.5 percent.

Consequently, when spreads widen securitization programs have to increase the coupon that they offer to borrowers in order to make the same amount of profit. That makes the segment less competitive relative to life companies and banks, whose cost of capital is less volatile. According to Commercial Mortgage Alert, CMBS issuers floated $101 billion in 2015, a 7% increase from 2014, but the market disappointed expectations due to a slowdown in the second half when spreads were wider. If CMBS is less competitive, market players fear not only that they will lose business but that they will be seen as the lender of last resort, limited to lower-quality assets and secondary and tertiary markets.

Of course, it’s impossible to say exactly how much of the wider CMBS spreads are due to the liquidity issue and how much is about economic fundamentals and/or general bond market sentiment. Spreads are apt to change quickly depending on a host of factors, only some of which are related to real estate, so it’s too soon to declare that today’s competitive imbalance is a permanent feature.

The other major challenge for CMBS comes from the “risk retention” requirement of Dodd-Frank that takes effect in 2017. Developed to reduce the abuses mainly in the residential MBS market before the global financial crisis, the rule requires issuers of asset-backed products to retain 5 percent of the bonds they sell. The idea is that banks won’t knowingly sell bad bonds if they have to own some of them.

Alone among asset classes, CMBS issuers have the option to sell the 5% strip (which can either be a “horizontal” strip of bonds, such as the lowest rated 5 percent, or a “vertical” strip, which would be 5 percent of each tranche) to a third party. The CMBS industry lobbied for this change to keep with long-standing market practice to sell the below-investment-grade classes to investors known as “B-piece” buyers. These investors buy junk-rated CMBS at steep discounts, but they also take the most risk, since the classes they own are the first to be wiped out if loans default. B-piece buyers also act in tandem with special servicers to repair or liquidate troubled loans.

Under risk retention rules, the owners of the 5 percent strip are not allowed to sell the investment for five years. The constraint on liquidity is likely to depress prices further, which contributes to the worries about lower prices and competitiveness. What’s more, the regulations do not yet specify a remedy in the event the B-piece buyer–which is independent from the issuer–does sell the bonds it owns. That is one of the many scenarios that will have to be hashed out between the industry and regulators in coming years.

Given the constraints on the B-piece buyers, some worry that it will be difficult–if not impossible–to raise enough capital to buy the 5 percent strip. Market players estimate that some $3 billion to $4 billion of B-piece capital will be needed to keep the market fully functioning next year. Without that capital, the market could grind to a halt, since few banks seem willing to retain the bonds.

Not everyone is pessimistic about CMBS. The industry was formed in the wake of the Savings & Loan crisis in the late 1980s and has been adept at being reinvented to meet current market conditions. Asset-backed issuers have adapted to the risk-retention rules in other segments and other countries, so they might do the same in U.S. CMBS, even if they do so with some grumbling. The new rules are likely to lead securitization programs to become more conservative about lending standards to make sure that they can sell all of the loans they originate, but many would argue that is a good thing since the market has gotten in trouble whenever deals became more complicated with more aggressive terms.

Also, it is hard to imagine that raising a few billion dollars to buy the risky portion of CMBS deals will be too hard. The five-year prohibition on trading might not drive away too many investors, since many go into the investment planning to be a long-term holder. Over the market’s history, the B-piece market has evolved several times, and the roster of players has changed, but rarely has there been a lack of capital. In today’s global yield-constrained environment, where sovereign bonds of struggling European countries yield less than 2%, raising money for U.S. commercial real estate that potentially produce double-digit returns might not prove to be difficult.

Certainly the market will change in response to the regulations, and there will be a measure of uncertainty as to what regulators will accept, since many of the changes are still spelled out in generalities. Time will tell, however, about how much the change will be. The CMBS market fills a number of needs in the lending markets–such as properties in secondary and tertiary markets and large transactions too big for balance sheet lenders. As long as that remains the case, and real estate fundamentals do not sag, there will be demand for securitized loans backed by commercial real estate.

The more optimistic sentiment at CREFC was summed up by another long-term market player: “The challenge is not to say ‘woe is me,’ but to find ways to be effective in the marketplace,” he said.

Paul Fiorilla is associate director of research for Yardi Matrix.