CMBS Ups and Downs

Market Flux May Bring New Discipline to Commercial Mortgage Lending.

The commercial mortgage-backed securities market is relatively young, having yet to complete its first decade. The market began in the early 1990s when the Resolution Trust Corp. issued CMBS to enhance its proceeds from the bulk sales of commercial mortgage pools inherited from defunct savings and loans. The success of those early CMBS sales attracted a new group of issuers and, by 1993, a few investment banks set up origination networks — typically through mortgage bankers — and securitized commercial loans. Other players worked with life companies and financial institutions that were trying to liquidate existing loan portfolios. One of the largest such deals was the $1.3 billion securitization of Canadian Confederation Life Insurance’s portfolio of U.S. commercial mortgages in 1995.

As the market quickly matured, more private developers and real estate investors began to turn to loan securitizers, typically referred to as conduits, for long-term mortgage financing. As CMBS volume swelled and bond investors began to take note of the market, CMBS spreads shrank, which allowed the conduit originators to offer loans at more competitive pricing. Early pricing on conduit-funded loans rarely broke margins below 400 basis points over corresponding U.S. Treasuries; loans on many hard-to-finance properties such as hotels commanded even wider margins. From about 1995 onward, however, conduit-funded loan rates have been competitive with equivalent rates charged by other real estate lenders such as banks and life companies.

Attracting Lenders
The CMBS market also attracted some leading portfolio lenders such as Chase Manhattan and Wells Fargo. These banks, as well as Bank of America, Citicorp (now Citigroup), NationsBank (now merged with Bank of America), and First Union, realized early on that originating loans for CMBS securitization could complement their traditional portfolio-lending activities.

With origination networks already in place and regulators keeping a watchful eye on the concentration of commercial loans in bank portfolios, the movement of certain loans off the books via pooling and securitization brought a number of benefits. First, it provided a good fee income base. Second, it allowed banks to re-employ capital more frequently, thereby boosting revenue and, ultimately, return on equity. Third, it offered banks a legitimate balance-sheet management tool and delivered greater flexibility in strategic planning.

Through the involvement of Wall Street investment banks (Nomura Securities, Lehman Brothers, Goldman Sachs, Credit Suisse First Boston), major banks (NationsBank, Chase, Citicorp), and a host of mortgage banking originators, the CMBS market has become the dominant force in the commercial mortgage lending market. In 1997, the total volume of commercial mortgages originated, pooled, and issued as CMBS totaled $44 billion, up from $29 billion in 1996. As of November 1, 1998, issuance volume already had topped the previous year’s level at $60.7 billion and annual issuance volume was on a pace to reach $72 billion.

In terms of originations, one player stood out. By summer 1998, Nomura’s Capital Co. of America subsidiary had reached a reported funding pace of $1 billion in new mortgages a month, making it the clear leader with its closest non-CMBS competitor budgeting annual volume closer to $6 billion.

Market Change
After setting a blistering origination pace in the first half of the year, conduit activity ground to a halt during September 1998, stalled by events in the capital markets, specifically Russia. Yet the final impact involves fundamental changes in the way the CMBS market operates.

Conduits fund commercial mortgages at traditional fixed rates, pool loans, and once they have achieved critical mass, create securities in which payments to bondholders are covered by mortgage payments on the properties. It may take three to six months before a conduit has enough volume to bring a deal to market — a critical period during which it has to hold the loans. Most often, the conduits fund and warehouse these loans using lines of credit granted by other investment banks.

It’s a lucrative business with huge amounts of money being made on both sides of the street. But it’s also fraught with risk. Conduits holding a large volume of mortgages typically use some sort of hedging device to protect against losses on the value of their loans if interest rates should move in either direction. But hedging — an art form more than an exact science — protects movements in interest rates, not changes in market spreads. In mid-September 1998, CMBS market spreads widened overnight and many major conduits were left holding the bag. The value of loans held on their warehouse lines sunk overnight because their interest rates were far lower than yields demanded by CMBS investors.

In a five-day period, Capital America and CS First Boston dropped out of the market. Capital America’s founder, Ethan Penner, resigned, and its parent company, Nomura Securities, announced huge losses. CS First Boston pulled back from the market with its CMBS guru, Andrew Stone, commenting that it would remain out of the market until spreads had returned to levels at which the company again could make money.

Credited with dragging the real estate market out of the credit crunch of the early 1990s, the CMBS market was supposed to deliver some form of stability to commercial real estate lending by CMBS issuers feeding product to an investor clientele operating under the economic law of supply and demand. (Previously, financial institutions typically prepared a budget at the beginning of the year, and once the loan allocation was met, they left the market until the following year. As a result, borrowers often were swamped with loan offers from January through September, then left high and dry from October on.)

But that stability was rocked by the events of September 1998. The exit of many major conduit lenders threatened to hit borrowers hard, especially as lenders such as Capital America reportedly already were sitting on a pile of loans that couldn’t be sold.

Continued Investor Support?
Whether fed by conduits or traditional real estate lenders such as banks and life companies, the CMBS market successfully has established itself as a legitimate investment market. It could be argued that during the September "bloodbath," bond investors did not leave the CMBS market but repriced it dramatically. As a result, some active investor groups such as hedge funds and mortgage real estate investment trusts may have left the market permanently. Currently there are investors for AAA-rated CMBS and growing interest for the B-rated classes, but no investor base yet for A- through BB-rated CMBS.

In essence, the market had turned from a seller’s market to a buyer’s market: Investors still wanted to buy CMBS, but they have yield requirements that current originations did not reflect.

The true concern for bond investors is "take-out" risk — the risk that borrowers will be unable to refinance when their loans come due. Take-out risk is affected by real estate fundamentals, such as overbuilding; softening in the general economy; the capital markets; as well as other sources of financing being repriced at rates that do not cover the balloon payments due.

The quality of mortgage underwriting also has a direct impact on investors’ perceptions of CMBS. Mortgages underwritten too aggressively are far more prone to default, causing problems for issuers and panic among bondholders. Only a handful of CMBS deals have featured loans that are delinquent or in default.

The October 1998 Chapter 11 filing by one of the biggest special servicers, Bethesda, Md.-based mortgage REIT Criimi Mae, sent shock waves through the CMBS market. One of the key special servicer roles is to provide a buffer against default losses by workout and other means. The inability of a special servicer to act quickly in supporting an issue isn’t attractive to bond investors.

Back to Fundamentals
For these reasons, investors and issuers are likely to take a much more careful look at how CMBS loans are underwritten and may perform far higher levels of due diligence. Detailed analysis of credit factors and net operating income will be far more focused and greater attention will be paid to verification procedures for property income, borrower creditworthiness, and other key underwriting factors. Issuers and investors alike

will pay far greater attention to fundamental real estate market conditions, mortgage underwriting standards, property performance, additional leverage, and a wide array of ancillary criteria. Market participants agree that the heated competition among conduits did not have a favorable impact on underwriting standards.

While the CMBS market may undergo a period of light issuance as a result of widening spreads, the market itself is unlikely to evaporate. Undoubtedly there will be changes. Some originators and issuers may well be out for the duration. Conduits will undoubtedly face a period of consolidation as they search for the equity strength needed to withstand market changes. It’s extremely likely that as banks, life companies, and other lenders regain a foothold in commercial mortgage lending they will — in addition to funding loans for their own portfolios — pass through a large proportion of their originations to Wall Street for securitization.

Decidedly, the commercial mortgage market is better off with securitization than without it. The events of 1998 proved that exposure to a public market can, at the very least, bring discipline to commercial mortgage lending. This should bode well for the entire commercial real estate market by providing a natural brake to development and, perhaps, prevent the specter of overbuilding that seems to threaten the market into recession every five to seven years.

Phoebe Moreo

Phoebe Moreo is national director of real estate securitization for New York-based E&Y Kenneth Leventhal Real Estate Group. Contact her at (212) 773-2475.Conduit Loans: Borrower BewareTo establish the value of commercial mortgage-backed securities, nationally recognized statistical rating organizations rate the various tranches of CMBS certificates. Higher ratings result in greater marketability and pricing for conduit loan securities.Rating agencies have developed specific criteria for evaluating every aspect of a loan. While they focus on traditional lenders’ underwriting criteria such as collateral and property revenues, they employ requirements that place higher thresholds than traditional underwriting. For example, rather than merely assessing environmental or other property-specific risk, loan securitizers, typically referred to as conduits, may require reserves for environmental contamination cleanup or deferred maintenance or for debt service.Further, rating agency criteria go far beyond traditional underwriting. Potential borrowers should take note that the competitive price of conduit loans comes at a cost — far more complex requirements and higher legal fees than traditional loans. Although many borrowers find the rates competitive enough for the work and higher expenses involved, those who are not adequately educated prior to pursuing conduit loans will be surprised (and perhaps discouraged) by the process. This thumbnail discussion summarizes certain conduit "hot button" issues that borrowers will encounter.Servicers. Because a conduit lender’s goal is to sell the loan, it employs servicers to monitor the loan both prior to and, often, after the sale of the loan. Although some CMBS lenders have captive servicers, many do not. Consequently, the borrower may not have a personal relationship with its lender.Funding. Conduits typically do not have post-closing funding obligations for items such as renovations and construction. Instead, these monies are funded to a reserve and disbursed by the servicer. As a result, the borrower will bear the added expense equal to the difference between its loan rate and the rate of return on the funded reserve.Prepayment. Because CMBS investors rely on income generated from debt-service payments, conduits typically prohibit loan prepayments for a certain time period. Depending on the loan term, the lock-out period will range from one year from the date of funding for short-term loans to as long as seven to 10 years. Conduits also preserve the income stream in other ways. Conduits may permit prepayment if accompanied by a prepayment premium, which, when added to the principal loan amount and invested in Treasuries with a term equal to the remaining term of the loan, will give the lender an amount equal to the loan payments.In long-term loans, borrowers can obtain a release of the real property collateral if they purchase replacement collateral, typically U.S. Treasuries, that provide the same income stream over the loan term. In this situation, the loan remains outstanding until maturity, with Treasuries as the new collateral. Depending on the interest rate, the "defeasance" collateral usually approximates the loan balance and defeasance provisions severely limit a borrower from obtaining a release of the underlying real property collateral.Cash Management. These lenders often require sophisticated cash-management agreements that have three different aspects. The first aspect is the lock box — either tenants will pay their rents directly to a bank designated by the borrower or the borrower may collect the rent until the occurrence of a "lock-box event" (typically, default or failure to maintain a certain debt-service coverage ratio). The second aspect is the collection and segregation of cash — rents typically are deposited (by tenant or borrower) into a blocked account the lender sweeps periodically. The lender then segregates the cash into ledger accounts for debt service, taxes and insurance, and other required ongoing reserves, with the remainder distributed back to the borrower. The third aspect is the servicing — in addition to funding reserves established at closing, the servicer monitors the other accounts and makes sure that funds are dispensed according to an approved budget.Insurance. Insurance requirements extend to include the insurer’s economic stability and the deductibles. The borrower must obtain insurance from an A- or AA-rated (for larger loans) insurance company; deductibles can be as low as $25,000. In addition to general liability, business, and broad-based property insurance, a conduit will require business interruption and earthquake or flood insurance (depending on the property’s location).Borrower’s Legal Structure. Conduits almost always require that the borrower be structured as a bankruptcy-remote, single-purpose entity. A bankruptcy-remote entity usually is a limited liability company, corporation, or limited partnership that may not file for bankruptcy without the consent of an unrelated third party. Single-purpose entities are prohibited from operating any business other than that associated with the real property security.By requiring the borrower to be a bankruptcy-remote vehicle, the conduit lender restricts the borrower from using the threat or the act of filing for bankruptcy merely as a negotiating tool. Similarly, by requiring the single-purpose structure, the conduit minimizes the risk that the borrower will be subject to the bankruptcy of its parent or an affiliated company. In addition, by limiting the scope of its operations, the borrower theoretically is shielded from claims not related to the real property security.Property Management. Conduits often require the right to terminate the property manager employed by the borrower. Although often tied to loan defaults by the borrower, conduits also may retain termination rights if the property does not achieve certain debt-service coverage ratios.Higher Legal Fees. Conduits, especially those based in New York, may require that their state laws govern the interpretation and enforcement of the loan documents. Thus, in addition to standard legal opinions under the law of the property state, the borrower also must obtain the same opinions from lawyers in the governing state.Conduits also might require a "substantive non-consolidation opinion," which must affirm that the borrower and the borrower’s assets are not subject to the bankruptcy of its parent or an affiliated company. Conduits typically require these opinions only for loans exceeding $20 million, but they can add significant legal expense to the borrower.— by Adam B. Weissburg, a senior associate of Cox, Castle, & Nicholson, LLP, in Los Angeles, who specializes in real estate secured transactions, bankruptcy, and workouts. Contact him at (310) 284-2270 or aweissburg@ccnlaw.com.CMBS PrimerCommercial real estate brokers who are not yet utilizing commercial mortgage-backed securities as an alternative financing source for commercial properties are missing an opportunity. Using CMBS, borrowers can secure longer-term fixed-rate financing on a nonrecourse basis at extremely competitive interest rates. The process of converting debt into equity would seem to provide an unlimited source of inexpensive capital to fund the debt requirements of income-producing properties. However, brokers should consider the benefits, opportunities, and drawbacks of CMBS loans before proceeding.CMBS financing can be used for refinancing to free up existing equity for future acquisitions, acquisition loans to help purchasers maximize yield on equity, and disposition loans that benefit sellers by illustrating a sales price in the higher ranges of value. Each of these areas can be a source of revenue for a broker in the form of increased commissions and financing referral fees (depending on individual state licensing).Refinancing. Refinancing is probably the most underutilized source of business that brokers overlook. By understanding a client’s current holdings, brokers can free up existing equity to create capital for future acquisitions. Often they can tap this equity in a tax-deferred status. Acquisition. When working with clients in the acquisition of commercial real estate, brokers should solicit quotes on CMBS loans as part of the due diligence process. By having a reliable source for CMBS loan quotes, the buyer may be able to pay more for the property (in a competitive-offer situation) or at least may receive an enhanced yield based on utilizing the leverage of lower cost debt.Disposition. When presenting a property for sale, the availability of financing can be a decided advantage in achieving the maximum sales price. By having a solid quote in hand for financing, the broker is better able to illustrate the prudence of the offering price and the benefits of the acquisition.CMBS loans are an excellent source of financing, but offer both benefits and drawbacks compared to other financing sources.CMBS Benefits. Nonrecourse CMBS loan programs can fit virtually any income property type, geographical area, borrower, and loan size — in contrast to traditional commercial banks that require recourse and insurance companies that want A-quality properties and large loan balances. Risk vs. return is the primary analysis undertaken by conduit lenders; they can address borrowers with credit problems by increasing spreads, instituting lock boxes to manage cash flow, and requiring escrows for replacement and tenant turnover. Conduits can structure CMBS loans in almost every instance. Interest rates are extremely competitive and fixed for longer terms. Conduits price CMBS loans at a spread off of the Treasury bond instead of traditional source pricing tied to the prime rate. Not only is the base index much lower, but conduits can match the note term against the bond maturities, which typically are seven, 10, 15, or 20 years.Multiple time assumption of a CMBS loan is very advantageous: The loan can be assumed by a purchaser of the property multiple times during its term. It reduces transaction costs associated with a future sale and preserves the leverage benefits of historically low interest rates. Since CMBS loans typically are nonrecourse, converting recourse debt to nonrecourse debt when sponsor balance sheets are improved can re-open local lending sources.Drawbacks. Usually the transaction costs are higher and time frames for loan processing are longer than traditional commercial banks, closer to those for large-balance insurance company loans. Plan for a minimum of eight to 10 weeks to close a CMBS loan and inquire about all fees associated with the loan closing. Processing time and fees can be different for each conduit.Certain loan requirements, which make CMBS loans more profitable when converted to securities, limit flexibility with regard to prepayment, secondary financing, funded reserves/escrow, loan documentation changes, and collateral alteration. Brokers should attempt to negotiate all loan covenant changes at commitment, in advance of closing. Changes at closing and after securitization become increasingly difficult. (See "Conduit Loans: Borrower Beware" sidebar.)The CMBS market still is very immature and is subject to fluctuation in pricing and changes in participants. The recent lack of liquidity and increase in yield requirements for the sale of CMBS to bond buyers has increased the major loan spreads (retrading) and eliminated some of the conduits originating loans. Brokers should know their sources well.Understanding the CMBS loan product is essential to take advantage of this opportunity. Brokers should establish relationships with mortgage bankers who can help them identify the proper sources for their clients’ financing needs and present a clear picture of the issues surrounding the CMBS loan origination, processing, and closing process. Brokers may want to reference the Mortgage Bankers Association of America membership directory, available by calling (202) 861-6500. Knowledge about this financing alternative surely will present income-earning opportunities. — by David Eaton, CCIM, CRE, president of Eaton Partners, Inc., in Manchester, N.H., which provides commercial mortgage loans to conduits, commercial banks, and insurance companies, contributed to this article. Contact him at (603) 626-1964 or dbeaton@ccim.net.


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