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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   December 2009

Giving the CMBS Market a Boost: 7 Steps

Recovery is possible after acknowledging how the securitization industry stumbled

Given the continued frigid conditions in the commercial real estate lending market, it's time to figure out how to jump-start loan originations. The major focus likely should be on loans that are part of commercial mortgage-backed securities (CMBSs). These accounted for almost 50 percent of all new commercial real estate loans in 2007, before the credit freeze.

Fundamentals across the commercial real estate industry continue to show signs of weakness. Recently, the Federal Reserve Board, legislators and U.S. Treasury Department officials have voiced concern about how the industry's weakness may impact the banking industry and the overall economy. Many real estate owners are taking dramatic action to deal with their operational challenges, which include declining effective rents and increasing vacancies. For many, however, their greatest challenge is in how to deal with the lack of debt capital available.

Without a healthy CMBS market to originate new loans for securitization, the commercial real estate lending markets likely will remain in turmoil. Commercial mortgage brokers should understand what happened to the securitization industry, as well as what steps we can take industrywide to help restart CMBS lending and give property-owners and mortgage borrowers hope for true market recovery.

Looking back

Data from the Commercial Mortgage Securities Association (CMSA) and other estimates indicate that in the second quarter of this year, there were about $650 billion in CMBS loans outstanding. That is about 25 percent of the total estimated $2.5 trillion in commercial mortgages outstanding.

Of these CMBS loans, it is estimated that about $70 billion will come due within the next two years. Who will be there to provide takeout financing for this maturing debt?

Because the banking industry is struggling with its own credit-portfolio problems, banks and insurance companies cannot make up the slack. With attention from regulatory authorities and with banks struggling to deal with substantial losses from other sectors, it may be years before they will increase their commercial real estate loan originations. At best, a number of banks recently have been working out existing loans as they "extend and pretend" that their loans will eventually pay off.

But this does not help the huge number of borrowers who have CMBS loans coming due in the next two years and whose prospects for extending their mortgage loans are limited, despite recent Internal Revenue Service-rule changes that give special servicers more flexibility in CMBS-loan workouts.

Compounding these issues is the fact that valuations of existing income-producing properties have been reduced significantly. Declining cash flows, stricter underwriting standards and greater expected returns have led to cap-rate decompression and ultimately to value declines.

Talking TALF

To help bolster the CMBS-lending market, the Federal Reserve this past March extended the Term Asset-Backed Securities Loan Facility (TALF) program to cover new-issue CMBSs and existing -- or legacy -- CMBSs. Then in August, the program was extended to last through this coming March for legacy CMBS and to June for newly issued CMBS.

As of this past October, however, no new-issue CMBS loans had been pooled under the program. There has been some interest in the legacy-CMBS TALF program, which is limited to AAA-rated CMBS tranches in certain bonds. After the extension to mid-2010, the industry appeared to show some interest, particularly on the part of borrowers and loan underwriters.

Initially, the new-issue CMBS TALF program most likely will be limited to large, publicly traded borrowers. These deals could take months to reach the stage where the Fed will even consider them.

In addition, although the new-issue CMBS TALF program is a good start, it likely is not nearly enough to jump-start the market because it appears targeted at large, single-borrower publicly traded owners with loan-to-value ratios (LTVs) of 40 percent to 50 percent.

There have been indications that some Wall Street firms are in the process of restarting their conduit-lending programs, though their traction is uncertain. Investors' appetites need to return to small and medium-sized private borrowers -- the traditional backbone of the U.S. commercial real estate industry.

7 steps for recovery

To stabilize the commercial real estate industry, many believe that the focus must be on reviving the CMBS-loan-origination market. The following seven ideas and suggested industry changes may help jump-start the market and help the industry avoid significant losses in the future:

  1. New underwriting standards are required. Commercial mortgage brokers and borrowers must accept that the days of high-leverage, low debt-service-coverage loans are over. In particular, interest-only or low-amortization loans are not appropriate for a future CMBS market. Loans that barely covered debt service with a 1.05 debt-service ratio previously will need debt-service ratios of 1.4 times, 1.5 times or even greater, depending on the market and the property type. Equally important, 50-percent to 60-percent LTVs will seem normal rather than conservative.
  2. The CMBS-investor base must be revived. Recently, several insurance companies have looked at spreads on vintage CMBS from the late-1990s and early 2000s and have concluded that they are attractive compared with U.S. Treasury bonds and corporate bonds. Despite this relative value, however, they are not buying CMBS because they are concerned about downgrades, capital-reserve requirements and a lack of liquidity in the market. The Federal Reserve and the Treasury must provide support and liquidity for the CMBS market until buying and trading is robust. The public interest in supporting this market is clear, and Federal Deposit Insurance Corp.-insured banks will remain constrained until they can see the CMBS market as a potential takeout for their own commercial real estate mortgage loans.
  3. Ratings agencies must improve their models and provide transparency. Issuers and investors should understand how ratings are determined, and they must be confident in the initial ratings assigned. 
    Eventually, there must be greater, healthier competition in the ratings-agencies business. A good start was the National Association of Insurance Commissioners' decision earlier this year to add a new approved ratings agency. 
    Further, this past October, the House Financial Services Committee approved a bill that would place more regulations on rating agencies; at press time, neither the House nor Senate had voted on the bill, House Resolution No. 3890 (updates: sctsm.in/HR3890).
  4. Loan structures must be tightened. A large shopping-center real estate investment trust's bankruptcy case this past April raised serious questions about the usefulness of the special-purpose-entity protection in the standard CMBS structure. A further complication has come out of a large hotel chain's bankruptcy case, in which the so-called "bad boy" provisions have been turned upside down. Lenders that want to be the new CMBS issuers must resolve these issues by placing new and firm restrictions on borrower malfeasance.
  5. Borrowers must be well-capitalized and demonstrate actual cash flows, not pro forma cash flows. In the boom years, lenders and CMBS issuers were virtually indifferent to borrowers' credit quality. Brokers and their borrowers should be ready for partial or full-recourse loans in certain circumstances. Borrowers with large portfolios must show lenders that bankruptcy filings will be unlikely for unrelated loans.
  6. CMBS issuers must set up internal structures that involve retaining some portion of the CMBS-loan pool. This issue has the attention of government officials, investor representatives and research analysts. For example, U.S. Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, has stated that future financial-services regulations will include some provisions requiring securitization issuers to retain some interest in the deal. Issuers have traditionally resisted this for return-yield reasons, but it appears to be inevitable. The originate-to-sell model will not work again and likely will only serve to keep investors away. Issuers must have skin in the deal to restore investor confidence.
  7. CMBS lenders and issuers would be wise to hire, train and retain experienced underwriters, brokers and risk officers who understand cycles and how loans must be structured to assure repayment. Too often during the boom years, CMBS-loan issuers hired brokers who were compensated for volume, not for loan quality. Their underwriters and brokers often were incentivized to create loans whose sources of repayment were based on the hope of increased future cash flows and values, rather than on in-place rents and loan structure. As a result, existing CMBS-loan delinquency rates continue to climb. Investors, regulators and bond insurers will no longer tolerate this mentality.

These suggested changes may take some time to achieve. If implemented, though, they may go a long way in jump-starting new CMBS-loan originations and the market.


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