Commercial mortgage-backed securities, one of the biggest sources of real estate debt in the last cycle, are back. But don't let the kinder, gentler, more transparent structure of today fool you, insiders say — the CMBS market really hasn't changed from its Wild West days.
Recovery of the real estate market is dependent on the availability of debt, and CMBS lenders provided billions of dollars worth of that debt before the financial crisis. The CMBS market is now in the process of a cautious comeback that is growing bolder. Following the recession, only the best properties are getting loans, and buyers are looking to the CMBS market to provide the debt for less-than-perfect real estate.
Competition is already stiff, which is forcing CMBS lenders to loosen the tougher, post-crisis requirements they adopted.
Underwriting on the underlying mortgages in the CMBS loan pools is once again of the “pro forma” variety and in some instances “valuations are questionable,” especially within larger loans for highly prized properties, according to recent reports issued by Standard & Poor's and Trepp LLC, a provider of commercial mortgage-backed securities and commercial mortgage data and analytics. This trend adds liquidity, but also adds risk to the deals as well as potential problems for the real estate market, industry insiders say.
“CMBS documents haven't changed from the peak of the market,” said Joe Smith, founding partner of New York-based real estate investment firm Glenmont Capital Management. “Most investors complained about flaws and issues with CMBS, and most of those flaws and issues have not been resolved. It's fairly amazing; the mechanism is still in place even though it led to issues in the marketplace.”
While there are fewer CMBS issuers today, more than 20 shops, including Goldman Sachs Group Inc. and Citigroup Inc., have reopened the lending windows in the past six months, said Randy Bramel, founding principal of Bridgeport Investments, a Tustin, Calif., real estate investment bank.
“Lending is very competitive in these types of markets, where insurance companies, pension funds, foreign investors ... and REITs could be bidding alongside CMBS issuers,” the S&P report noted. “The part that we believe should be most alarming to investors is that the appraisals appear to be building in upside in rents and occupancy” rather than using the actual rents and tenancy when the deal closed.
Real estate investment managers expect CMBS requirements to get even looser. New CMBS issues increased more than tenfold in 2010, according to a recently released joint real estate report of Deloitte, Real Capital Analytics and Real Estate Research Corp. citing Mortgage Bankers Association data.
“Eventually, as investors come back to CMBS, we will see CMBS be more active in secondary markets, not necessarily trophy properties but B to B-plus,” said Mike Kelly, managing director and head of debt capital markets for J.P. Morgan Asset Management, New York. “CMBS shops are being very aggressive because they can securitize (the mortgages).”
What's more, although the Dodd-Frank Wall Street Reform and Consumer Protection Act requires banks or CMBS issuers to own a stake in the securities, it also allows the so-called B-piece bondholder, the owner of the lowest quality debt, to take on that risk in the bank's place, lawyers say. Other contractual safeguards put into what is being called “CMBS 2.0” are advisory only with little actual authority.
For example, new CMBS contracts install a watchdog to represent all bondholders, but the watchdog can only recommend action and has no actual power. Only the B-piece bondholders can replace the special servicers — the firms charged with working out troubled loans held by the CMBS, such as by foreclosing or restructuring, said Christopher Brady, a partner in the Charlotte, N.C., office of law firm Mayer Brown, who works for CMBS issuers.