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The Evolving CMBS Market - 2016 and Beyond

Written by Chris Martin, Investment Analyst

While the truism that “Real Estate is Local” remains such, the impact of national and global financial markets on both valuation and execution in the investment sales world cannot be overstated. The sale price a broker is able to generate on a multi-tenant retail property is generally determined by the return an investor can reasonably expect to generate on their purchase. The largest individual factor that determines the rate of return is the degree to which and the terms of the leverage they undertake. As the world of financing in commercial real estate continues to shift, it is prudent to evaluate where the market sits and what we should expect in the near to medium term future.

Commercial Mortgage Backed Securities (“CMBS”) are a creation of the era of financial innovation that swept the market in the 1980s. Conceptually, the securities operate under the premise of diversification of risk through the pooling of loans, allowing investors to accept a lower risk premium and borrowers to benefit from lower interest rates. The security is either made up of a pool of diversified, conforming loans, or a single, trophy-quality asset. Either type of security is then organized into several tranches, with AAA to BBB- representing the investment grade ratings. These tranches are then sold to a variety of different investors based on the level of risk they are willing to accept. The bulk of issuance in the CMBS market is done by large banks like Bank of America, Wells Fargo, Deutsche Bank, and JP Morgan, with the total number of issuers in the market currently in the high 30s. These issuers generally do not retain risk related to the securitized instrument but instead earn fees from the securitization and issuance process.

In the last few months, the CMBS market has experienced the most volatility and uncertainty since the financial crisis. The yields on each tranche of the security are generally evaluated by the spread of the issuance yield over the equivalent treasury swap. These spreads have increased dramatically over the past six months, with spreads on BBB- rated tranches increasing from the mid 300 bps a year ago to over 800 bps in March. The market has rallied somewhat in the last month, tightening spreads to near 700 bps, still well above last year’s lows. On top of the rapid increase in spreads, CMBS issuance has decreased by 32% in the first quarter of 2016.  Only 21 CMBS deals were issued in Q1 2016, versus 32 during the same period of 2015, with the total issuance size down by nearly $9 billion.  As real estate valuations continue to reach and surpass the peaks last seen in 2007, the uncertainty in the CMBS market can be seen as a sign of investor skepticism in the continuous march of asset-valuation growth that we’ve experienced since 2010.

While the capital markets are strongly affected by a variety of macroeconomic conditions, the single largest issue facing the current CMBS market going forward is the shifting regulatory regime. The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act has had a tremendous impact on the operations of Wall Street and the capital markets. For CMBS markets, the most impactful provision is the forthcoming rules regarding “Risk Retention”. Set to come into effect December 24, 2016, the rule will require sponsors of the securities to hold 5% of a CMBS issuance on their balance sheet, or the buyer of the non-investment grade “B-Piece” to hold the security for at least 5 years as a risk retention measure. While the exact impact that this rule will have is unknown, the requirement is likely to lead to a more conservative approach from issuers and reduced liquidity in the B-piece primary market, driving yields up.

Going forward, CMBS issuance into 2016 and beyond has many uncertainties attached to it. S&P reports that there are roughly $150 billion of CMBS maturities scheduled before the end of 2017, which includes the tail-end of the “wall of maturities” associated with the 10-year loans in the CMBS 1.0 market. While the bulk of CMBS 1.0 maturities have already occurred, the CMBS loans with the laxest underwriting standards were underwritten in 2006 and 2007, with a significant amount of secondary and tertiary market properties currently with the special servicer or in possession of the trustee. The historical low cap rates and high asset-price levels we’re experiencing should lessen the blow for some of these upon maturity, however a continued tightening in the CMBS market would likely lead a reduced ability to refinance and a notable increase in default rates. Overall, with the CMBS 2.0/3.0 loans generally underwritten to a stricter standard, and with even more conservative requirements forthcoming, the type of collapse seen previously seems unlikely. However, a tightening in the CMBS and related debt markets is likely to apply downward pressure on asset-price levels that will undoubtedly continue to be felt in the investment sales market.

Chris Martin | Investment Analyst
Mid-America Real Estate Corporation
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