Has the CMBS Market Finally Turned the Recessionary Corner?

Deal Flow, Demand, Pricing and a Drop in Delinquency Rates Point To New Momentum
For the past 12 months, activity in the commercial mortgage-backed securities (CMBS) market has been ever so slowly building momentum. U.S. CMBS loan delinquencies declined last month for the first time in 33 months. The market is also finally seeing demand for new CMBS transactions as three CMBS deals went to market in the past couple of weeks, marking the most active period since the downturn.

It’s not all good news in the CMBS world, but the recent trends are being viewed as a positive indicator for 2011, when the volume of new deals is projected to more than double from this year.

“Recent CMBS figures indicate market improvement is beginning to show up but is yet still fragile,” said Howard L. Michaels, chairman of Carlton Advisory Group speaking at a Bloomberg Real Estate Briefing Report this past week. “CMBS issuance is expected to approach $15 billion this year and expected to reach $35 billion in 2011, after tumbling to $11 billion in 2008 from a record $234 billion in 2007. Spreads reached more than 15 percentage points in November 2008.”

The biggest positive by far was the news of the decline in CMBS delinquencies.

CMBS delinquencies dropped 88 basis points (bps) to 7.78% due largely to the resolution of seven loans (totaling $5.2 billion), according to Fitch Ratings. The resolutions included the $4.1 billion Extended Stay America loan, collateralized by a portfolio of 682 hotel properties.

At the same time, only $304 million of hotel-backed loans became newly delinquent. This led to a large drop in hotel delinquencies to 14.14% from 21.31% in September, the largest drop recorded of any CMBS asset type by Fitch Ratings.

“Whereas hotel-backed loans saw the most rapid performance deterioration, now the opposite is true,” said Fitch managing director Mary MacNeill. “Hotel loans are now well positioned to recover quickly when business and consumer spending resume and the economic recovery gains traction.”

Of the record $6.6 billion of resolutions from the index in October, $4.4 billion corresponded to hotel loans.

Current delinquency rates by property type are as follows: multifamily: to 14.57% (from 14.45%); hotel: 14.14% (from 21.31%); retail: 6.25% (from 6.10%); industrial: 5.83% (from 5.79%); office: 5.38% (from 5.48%).

Borrowers are also sensing an uptick.

“I can tell you that we have two mortgages that we are putting on two office buildings that are at 65% LTV, with great tenants. I expect to see the lenders put these into CMBS. So I would say the feed to the pipeline is growing,” said Charles Cecil, CEO of the Phoenix-based Southwest Fund, a commercial real estate hedge fund.

On the negative side, legacy CMBS loan prices dropped a bit in September and defaults on legacy loans are projected to increase in the coming year.

The aggregate value of commercial real estate loans priced by DebtX that collateralize CMBS decreased to 80.5% as of Sept. 30 from 81% a month earlier. Loan values were 77.2% a year ago.

“The recent trend of rising loan prices paused in September, but is likely to continue due to tightening loan spreads and improving real estate conditions,” said DebtX CEO Kingsley Greenland. “In September, however, an increase in delinquency rates and steeper yield curve impacted CMBS collateral prices.”

Also on the negative side, Michaels of Carlton Advisory Group noted that many commercial mortgage loans underwritten before 2009 will continue to experience term defaults and would be difficult to refinance today.

The amount of outstanding commercial mortgages is about $1.3 trillion, Michaels said. The amount scheduled to mature in the coming years is as follows: 2011 = $130 billion; 2012 = $164 billion; 2013 = $112 billion; and 2014 = $152 billion.

“Based on current information from research and servicers, more than 40% or $560 billion of outstanding commercial mortgages are in some sort of trouble,” he said.

“On the positive side,” Michaels added, “we are finally seeing demand for new CMBS transactions with AAA tranches pricing at tighter spreads than were available one year ago. Portfolio lenders (insurance companies and banks) are providing mortgage capital again as well, albeit with more conservative LTV (loan-to-value) and DSCR (debt service coverage ratios) margins.”

Issuances by Wells Fargo ($736 million), JP Morgan ($2 billion loan secured by Extended Stay America) and Goldman Sachs ($2.7 billion backing debt from Hilton Hotels) are currently being shopped with good initial response from investors, Michaels said

The Wells Fargo securitization is more diverse than other recent transactions, with retail making up just one-third of the pool versus 43% in the Deutsche Bank issuance and two-thirds in the JPMorgan deal.

The primary assets of the CMBS are 37 loans secured by 59 commercial properties having an aggregate principal balance of approximately $736 million. The loans were originated Wells Fargo Bank, Bank of America, and Basis Real Estate Capital II LLC.

The Goldman Sachs deal is unlike any that long- term investors have seen. It isn’t rated and Goldman Sachs is marketing only the most senior portion of the $8+ billion mortgage on Hilton Hotels. Pricing is LIBOR + 175 basis points for the senior tranche, Michaels said.

Annaly Capital Management Inc. this month compared this batch and a few others of new offerings this year — sometimes referred to as CMBS 2.0 — with the legacy CMBS of 2005-2007 vintage.

Annaly’s first observation is that CMBS 2.0 has a lower average loan count of 33.6 as compared to the legacy CMBS issuance that contained hundreds of loans. Not only are the pools more decipherable due to fewer loans but investors are also given more time to perform their due diligence. During the “go-go days” investment grade investors were given perhaps two to three days to review hundreds of loans.

Also, a smaller loan count creates smaller pools versus the legacy pools that averaged $2 billion with some pools topping $7 billion. While legacy pools reflected debt service coverage and LTVs similar to CMBS 2.0, those ratios included a significant component of pro forma underwriting.

Today, debt service coverage is calculated off in-place income with nearly all of the loans containing amortization from day one and reserves being funded for capital expenditures, Annaly pointed out.

Even so, rating agencies have assigned slightly higher subordination level to the AAA bonds of 17-18%, much better than the 11-13% attachment points for the legacy CMBS.

Finally, the new transactions contain fewer tranches, generally two AAAs supported by five to eight tranches beneath them compared to legacy transactions which had up to 29 tranches.

Regarding the asset classes, retail, office and industrial securitized loans currently comprise 59%, 19% and 9% respectively of the CMBS 2.0 pools, higher than the legacy composition of 30%, 30% and 4%, respectively.

More retail is being financed in the CMBS market because portfolio lenders have basically red lined all retail other than ‘fortress malls.’

Hotels would also typically comprise about 10% of securitized assets, but CMBS investors today have frowned on those assets as well.

Finally, multifamily loans historically comprised 20% of securitized loans; however, Fannie Mae and Freddie Mac dominate the multifamily finance segment today with low rates and generous leverage.

Source:  CoStar

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