Big, bad CMBS are back despite reform talk

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 warn. 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 of that debt before the financial crisis. The CMBS market is in the process of a cautious comeback that is growing bolder. Following the recession, only the best properties are getting loans, so 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 once again is 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 said.

ISSUES NOT RESOLVED

“CMBS documents haven't changed from the peak of the market,” said Joe Smith, founding partner of 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,” Mr. Smith said. Although there are fewer CMBS issuers today, more than 20 shops, including Citigroup Inc. and The Goldman Sachs Group Inc., have reopened the lending windows in the past six months, said Randy Bramel, founding principal of Bridgeport Investments, a real estate investment bank. “Lending is very competitive in these types of markets, where insurance companies, pension funds, foreign investors ... and [real estate investment trusts] 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 last year, according to a recently released joint real estate report of Deloitte LLP, Real Capital Analytics Inc. 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. “CMBS shops are being very aggressive because they can securitize [the mortgages].” What's more, though the Dodd-Frank 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 said. 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 CMBS, such as by foreclosing or restructuring, said Christopher Brady, a partner in law firm Mayer Brown, who works for CMBS issuers. But returns in the CMBS market are becoming more volatile. Traditionally, CMBS are correlated with the stock market, which has dropped recently. And this time around, CMBS performance also is moving in lock step with high-yield bonds, said John Dunlevy, managing director and head of the structured-products group at investment management firm PineBridge Investments. There is a big supply of CMBS right now, which is compounded by an increase in the issuance of new securities, he said. This oversupply of bonds is making CMBS investors nervous.

'LIKE BACK IN 2007'

“It has been a roller coaster time period this year,” Mr. Dunlevy said. “When you talk about underwriting, it is a pimple on the elephant, compared to what else is happening in CMBS.” But that pimple might be growing. Values are being based on the low cost of debt, not the true worth of the properties, Mr. Smith said. “It's like back in 2007. The biggest problem within the CMBS were that investors have passive rights and are ill-equipped to deal with distressed circumstances.” Sometimes, the company that serves as the special servicer also owns the most subordinate debt. This affects how special servicers treat the loans, Mr. Smith said. For real estate investment managers and institutional investors, this means that if they run into a problem and there is a default on the loan, the special servicer is more likely to default than restructure the loan, he said. “I've yet to restructure debt if they own the B piece,” the most subordinate debt, Mr. Smith said. For now, more commercial-mortgage-backed securities are a positive for the real estate market because of the added liquidity, he said. “We went through the same thing in 2004 to 2006,” Mr. Smith said. “CMBS was not hurting anyone; it was helping wealth creation,” Mr. Smith said “It was only in 2008 to 2010 that those flaws were more noticeable.” Arleen Jacobius is a reporter at sister publication Pensions & Investments.