CMBS Faces a Refinance Wave
Unlike its residential counterpart, the market for non-agency commercial mortgage-backed securities (CMBS) has rebounded from the 2007 crash and the outlook is for further expansion this year.
By Robert Stowe England
“Shops are back to underwriting levels that we saw before the crash,” says Sean Barrie, research analyst at Trepp LLC, New York.
After hitting $96.5 billion last year, now it appears the CMBS market is poised to expand further in 2015 to $115 billion to $120 billion for private-label, according to Deutsche Bank Securities Inc., New York.
"CMBS is a market that has come back to really pre-crisis levels,” says James Wiemken, head of structured finance ratings at Standard & Poor’s Rating Services, New York. “We believe, as do many other market participants, that 2015 will be another strong year. That’s being driven by both refinancings of maturing debt and strong fundamentals.”
The market is facing a huge wave of maturing loans from the boom years of 2005 to 2007. “The CMBS origination engine will have to pick up the pace” to refinance loans in deals that have 10-year mortgages with a balloon payment at the end, says Barrie.
That means 2015, 2016 and 2017 will be years when the need to refinance could drive up issuance volumes.
The CMBS maturity wave represents $635 billion headed toward the markets for resolution in 2015 to 2017. In the first year of the wave—2005--total non-agency CMBS soared to $177.5 billion from the $98.2 billion in the prior year, according to Inside Mortgage Finance. In 2006, issuance volume leapt higher still to $226.5 billion and then edged even higher in 2007 to $231.5 billion.
Current CMBS issuance volumes are well shy of those boom years and refinancings face tighter underwriting controls and closer scrutiny than they did a decade ago, according to Chris Datz, a principal at Washington Square Realty Capital LLC, Philadelphia.
“Ten-year CMBS loans were the financing method of choice and were loosely underwritten, based on extremely aggressive rent growth projections, low capitalization rates and high loan-to-value [LTV] ratios--and these loans will need to be refinanced in the next three years,” he wrote in a blog post for Region’s Business in Philadelphia earlier this year.
Datz is predicting a shortfall of more than $200 billion in the amount of new debt needed to refinance the maturing debt from 2005 to 2007. “Many borrowers will be shocked to find that even after 10 years of perceived growth and appreciation, the net operating income of the property will not underwrite to loan proceeds sufficient to repay the outstanding loan,” he wrote.
CMBS investors were initially slow to come back to the market after it crashed. Volumes languished at very weak levels for three years--2008, 2009 and 2010--before beginning a slow slog back in 2011 and 2012.
In 2013, the market showed some real life with $86.5 billion in new issuances before rising to $96.5 billion last year, the best year for non-agency CMBS since 2003, according to Inside Mortgage Finance.
Low interest rates “have been key to the sector’s return,” says Wiemken. For one thing, they lower the cost of debt service. They also make it more likely debt can be rolled over into a new CMBS issue, thereby providing liquidity to the market.
While underwriting and the structure of deals are more conservative than a decade ago, they are weaker than they were from 2010 to 2013. “We, as well as other market participants, have noted that competition among CMBS loan originators increased in 2014,” says Wiemken.
“We saw weakening in underwriting standards. We also noticed debt yields increasing and many loans are being securitized with a high percentage of hotel exposures, which can pose unique risks,” he adds.
The recovery of the CMBS market has been enabled in part by the willingness of key investors to purchase the non-investment-grade B-piece of new conduit CMBS deals. The B-piece is made up of high-yield bonds rated BB+ or lower.
In 2014, the top B-piece investor was Rialto Capital Management LLC, a division of Miami home builder Lennar Corporation. Rialto invested $15.8 billion in 13 deals or 27 percent of the $58.2 billion B-piece market, according to Commercial Mortgage Alert.
Rialto, the dominant player in the B-piece market since the private-label CMBS recovery began, was formed in 2007 by its Chief Executive Officer Jeffrey Krasnoff, former chief executive officer of LNR Corporation, Miami.
The second-largest B-piece player last year was New York-based Seer Capital Management LP, founded by Philip Weingord in 2008. Seer invested $11.2 billion in 11 deals or 19 percent of the market. Together, Rialto and Seer represented 46 percent of the B-piece market last year.
While the recovery in commercial real estate prices has been relatively strong overall, it has been uneven across various market segments and geographies. It is strongest in the major markets, in part because these are the markets that have attracted large inflows of foreign capital, according to Ashley Hooper, research analyst at Deutsche Bank Securities.
In a recent research report, 2015 Outlook: CMBS and CRE Prime for Liftoff, Hooper identified Canada, China and Norway as the largest foreign commercial real estate investors in the last three years, followed by Japan, Bermuda, Hong Kong and Germany. Foreign investment has favored most the New York borough of Manhattan, followed by, in order: Boston; Los Angeles; Washington, D.C.; Hawaii; and San Francisco.
Prices for major-market apartment buildings are 33 percent above their pre-crisis peak, while prices for central business district (CBD) office buildings are 28 percent above their prior peak, according to Deutsche Bank. Other market segments have not seen a full recovery, including the hotel sector (-24 percent), suburban office (-19 percent) and retail (-17 percent), according to Deutsche Bank.
Worries about the ability of the CMBS market to refinance the coming wave of maturities is complicated by expectations that the Federal Reserve will raise its key Federal Funds Rate sometime this year.
While the market could experience some turbulence, ultimately the CMBS expansion will forge ahead. “Rising interest rates aren’t likely to hurt property prices or affect the refinancing of maturing debt in a growing and stable economy, in our view,” says S&P’s Wiemken. "To the extent we see stability in economic activity, that bodes well for the sector.”
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