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CMBS outlook remains uncertain as market conditions falter

Developers and investors are still chasing after loans in an active commercial real estate market, but the outlook for commercial mortgage-backed securities (CMBS) remains mixed at best.

Office building(2)The CMBS share of overall commercial lending has fallen to the lowest level in six years, losing ground to the banks, studies suggest. The demand for CMBS loans fell sharply earlier this year as the costs for borrowers increased. Although the high yields demanded by CMBS investors have come down, market watchers say new rules that kick in toward the end of December — and require CMBS issuers and other sponsors to retain more risk associated with asset-backed securities — could lead to a tightening of underwriting standards and bring more pricing volatility, keeping borrowers on the sidelines.

In recent quarters, the market share of CMBS loans has fallen from 20.2 percent in the second quarter of 2015 to 5.2 percent as of mid-June of this year, Real Capital Analytics (RCA) said. Since the recovery, that share has been as high as 32 percent, but now stands at the lowest point since the first quarter of 2010, when the CMBS market share was 5 percent. At its peak in 2007, CMBS loans accounted for nearly three quarters of all commercial loan volume, but then dropped to close to zero during the recession.

Meanwhile, the commercial bank-lending share has gone in the opposite direction in recent quarters, rising 13.5 percentage points in one year to 51.1 percent as of mid-June, RCA reported.  

The recent fortunes of the CMBS market have followed the movements of the spreads, or the yields demanded by end investors over other investment vehicles, said Jim Costello, RCA’s senior vice president said.

At the beginning of the year, the spreads widened dramatically, which priced CMBS loans out of the market.

“The pullback is not driven by the same forces that were seen in 2008-2009,” Costello said. “The previous pullback was a function of the overall commercial real estate market faltering. Today, there is still an elevated level of transaction volume that needs to be financed. CMBS is pulling back today as all high-yield fixed-income investment types have been hammered.”

Over the past two months, the spreads have come down dramatically, making CMBS more competitive, lenders say. The current borrowing rate for a CMBS loan is roughly 4.25 to 4.5 percent, and the demand for CMBS has increased.

Risk retention muddies the waters

New risk-retention rules for CMBS issuers set to begin in late December, however, continue to create pricing uncertainty. Under the Dodd-Frank Act, CMBS issuers or other sponsors will generally have to retain a 5 percent stake in the value of the transaction for five years, a move intended to ensure that the loans are properly underwritten. Analysts say this rule could especially impact B-piece buyers, which are often hedge funds that are looking for high-yield investments and often don’t want to hold the bonds for five years.

“The concern is causing loans to not get priced quite in the sweet spot that lenders would like, so they are just warehousing their loans  and maybe waiting a little longer to get to the market,” said Sean Barrie, a research analyst with Trepp. “That, in turn, is creating a low issuance number, a sign that people aren’t jumping head first into the market.”

Trepp isn’t forecasting that the risk-retention rules will cause widespread disruptions, however.

“We do think that it is not all doom and gloom,” Barrie said. “There certainly are opportunities out there if people are willing to take some risks, and it is certainly nowhere near the dire straits of 2008 or so.”

Ann Hambly, chief executive officer of 1st Service Solutions, said the market is closely watching upcoming issuance that comply with the risk-retention rules. Wells Fargo & Co., Bank of America Corp. and Morgan Stanley expect to sell as much as $1 billion in CMBS debt by the end of July, Bloomberg first reported in June.

“There is still all that uncertainty that exists in the marketplace. The biggest looming uncertainty out there is how the risk-retention rules will work,” Hambly said. “That has everyone’s attention. Until that is addressed, the volatility will not be gone in my opinion.”

The uncertainty also has come at a bad time for the CMBS market, as more than $100 billion in CMBS loans are scheduled to mature next year. Many of these loans remain over-leveraged and were loosely underwritten during the bubble-era, and will not easily be refinanced, Hambly said.

“That is still very concerning,” Hambly said. “What is happening is that the sins, if you will, of ’06 and ’07 are now coming to just haunt us in ’16 and ’17.” 


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