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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2016

Special Report: Side Effects of Risk Retention

New CMBS rules may cause headaches and alter commercial lending

Special Report: Side Effects of Risk Retention

The risk-retention regulations that go into effect this December, requiring sponsors of commercial mortgage-backed securities (CMBS) loans to hold on to 5 percent of every new deal or assign the risk to a B-piece buyer, resemble a medication being administered this year for a disease that took hold in 2008. Like many medications, these “skin in the game” restrictions could have some side effects.

Although the penicillin is aimed at reducing systemic risk, side effects potentially could include an altered commercial-lending landscape and an increased risk of reduced revenue for CMBS players — not just deal sponsors but also property owners, conduit lenders, loan sellers and traditional bank lenders.

Understanding how CMBS players might consider changing their strategies as a result of the risk-retention rules is critical for everyone involved in commercial lending, including commercial mortgage brokers. With the implementation date creeping closer, the following trends are likely to emerge in the near future.

Balance-sheet lending

With CMBS issuance already down, will there continue to be even less CMBS financing available for loans coming due? If so, this poses the risk that it might become increasingly difficult for borrowers to refinance loans that had been previously securitized.

Take Simon Property Group, the largest U.S. mall owner and one of the top owners of securitized properties, which received more than $600 million in CMBS financing in the first half of this year, according to CrediFi data. Although owners like Simon may be concerned about refinancing CMBS loans in a post-risk-retention environment, many securitized loans do not remain in CMBS pools once they mature.

A CrediFi analysis of an $8.25 billion sample of CMBS loans in New York City found that more than 80 percent were refinanced as balance-sheet loans or private securitization. The sample examined the 2015-2016 financings of New York City commercial properties with loans that were at least partly securitized in Securities and Exchange Commission-registered conduit or fusion deals between 2005 and 2007.

The risk-retention rules can make capital markets’ involvement more
challenging for CMBS sponsors, conduit lenders and loan sellers.

In addition to posing a challenge to owners concerned about refinancing CMBS loans, the risk-retention rules also can make capital markets’ involvement more challenging for CMBS sponsors, conduit lenders and loan sellers.

After all, the regulations mean CMBS sponsors need more capital on hand because they have to hold on to 5 percent of the deal. If CMBS issuance continues to dwindle, partly because of that requirement, then conduit lenders might not originate as many loans. Loan sellers’ participation in the market could be reduced as fewer loans become available, with the sellers potentially deterred by the risk of being unable to pass those loans into CMBS deals — and therefore needing capital against those loans.

CMBS players that could face the risk of a reduced revenue stream include Cantor Fitzgerald and Deutsche Bank, both of which are active in CMBS lending.

Cantor Fitzgerald was the No. 7 public CMBS loan seller this past year and rose to the top five in early 2016, according to a CrediFi analysis of all conduit/fusion CMBS loans sold in that period. For instance, Cantor sold more than $500 million in loans for CFCRE 2016-C3 Mortgage Trust, a public CMBS deal with a pool of $701 million for 38 loans and 67 properties.

Traditional bank lenders like Deutsche have the option of originating loans and holding them on their balance sheet rather than securitizing them, with the cost now being additional capital requirements for the banks. Like deal sponsors, conduit lenders and loan sellers, traditional bank lenders also face the risk of a reduced revenue stream.

It will be interesting to see how things unfold for Deutsche Bank, which was the No. 1 CMBS loan contributor from first-quarter 2015 through first-quarter 2016, according to CrediFi analysis.

Deutsche’s proportion of the total conduit/fusion issuance was higher early this year than it was in 2015. One of the biggest CMBS deals in which Deutsche was involved during the period analyzed is COMM 2015-LC19 Mortgage Trust, a $1.4 billion deal for 59 loans and 139 properties in states including Missouri, New Jersey and Texas. Nearly half the total loan amount in the deal, or $676 million in loans, was sold by Deutsche Bank or its subsidiaries.

Deutsche, however, is facing challenges and might not have the additional resources needed to keep up the pace. Deutsche Bank Trust Corp., a U.S. arm of Deutsche Bank, failed the Federal Reserve stress test this year for “broad and substantial weaknesses” in its capital planning. In addition, Germany’s largest bank is one of the non-U.K. banks most exposed to any Brexit fallout. This past June, the International Monetary Fund stated that Deutsche “appears to be the most important net contributor to systemic risks” among the global systemically important banks.

Nonbank lending

The primary lenders for refinanced CMBS loans in our sample, not surprisingly, are banks. It’s important to remember that banks are not the only lenders out there, however. Insurance companies are the most prominent nonbank lenders in the analysis of New York City refinancings. CrediFi found that many CMBS refinancings are being issued by insurance companies, such as Metropolitan Life Insurance Co., Prudential and American General Life Insurance.

Traditional lenders may become more inclined to require a full-recourse
guarantees that would require borrowers to provide additional guarantees.

Take 1675 Broadway, a 35-story mixed-use building in midtown Manhattan that was partly securitized in 2006 but refinanced as a balance-sheet loan in 2015, when MetLife issued a $254.6 million loan. (The previous originator was an insurance company as well; Prudential originated a $180 million loan for the property in 2006, $155 million of which was assigned to a CMBS deal.) Tenants of the 1675 Broadway building include media and advertising giants Starcom Mediavest and Publicis Groupe.

Other options

Other rising options for commercial mortgage borrowers may include turning to mezzanine lenders. In addition, traditional lenders may become more inclined to require full-recourse guarantees that would require borrowers to provide additional guarantees such as letters of credit or additional upfront reserves. Lenders also might enter into syndications more often, as a way of spreading out additional risk if they reduce their involvement in CMBS deals.

Until now, we’ve been talking about alternative approaches to debt, but we should also consider that the ratio of debt to equity may change. Equity players such as Blackstone may take on an even bigger role, or borrowers may look for equity investors, meaning joint ventures.

•  •  • 

Although it is unclear what will happen when the risk-retention regulations go into effect this  December, we can speculate that this penicillin may contribute to increased balance-sheet lending to make up for a possible continued reduction in CMBS deals, increased nonbank lending to fill the financing gap  and the increased use of additional debt or equity options.

In the coming months, commercial lending professionals likely will continue to monitor the CMBS market closely. Everyone involved, including commercial real estate players, analysts and regulators, will attempt to determine how strong the side effects of the regulatory change will be — and whether they are contributing to the cure of the CMBS market’s issues or hampering it.


 


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