By Malay Bansal

A revived CMBS market, with new deals getting done, is helpful to REITs and other commercial real estate owners as it has started making financing available again. Spreads had generally been narrowing which helped loan originators by reducing the hedging cost and has been good for owners of CMBS bonds. However, recent spread volatility has left some people concerned, and wondering about the future direction of spreads and how to look at spreads on the new CMBS 2.0 deals in the context of 2006-7 legacy deals.

I always find it useful to start with views of market participants, and historical data for some perspective. Also, for legacy deals, estimates of losses are an important element. Below are forecasts for spreads for 2007 vintage CMBS for June 2011 published by industry’s weekly newsletter, Commercial Mortgage Alert at the beginning of the year, along with some other data. Comments and thoughts follow.

CMBS Spread Forecasts For June 2011

Loss Estimates (%) by Market Participants

S e t

CMBX1 (2005) CMBX2 (2006) CMBX3 (Early 2007) CMBX4 (Late 2007) CMBX5 (Late 2007/ 2008)
1

6.7

7.2 10.3 12.0 9.9
2 6.6 8.3 10.9 13.9 12.3
3 4.2 6.2 6.9 8.8 7.5
4 6.8 8.4 11.8 15.6 13.3
5 7.0 10.1 12.7 14.0 13.9
Note: Loss estimates from market participants including sell-side research group, rating agencies, and advisory services. Periods for each CMBX series are approximate.

 

Recent Spread History

Spread Over Swaps

Dec 2010

11 Feb 2011

18 Mar 2011

1 Apr 2011

Generic 2007 A4

215

150

195

165

GG10 A4

245

190

240

190

CMBS 2.0 AAA

130

110

120

110

 

Historical Spreads
Average Spread Over Treasury 2003 2004 2005
CMBS AAA 78 72 74
CMBS AA 87 79 85
CMBS A 97 88 95
CMBS BBB 150 125 147
CMBS BBB- 200 164 196
Corp – Generic A Rated Industrial 88 69 74

Recent Spread Widening

To focus first on what had people worried most recently – widening of GG10 A4 bonds by 50 basis points from mid Feb to mid March, it is important to step back and look at the bigger picture. GG10 spreads are more visible because it is a benchmark deal and trades more frequently. As the table “Recent Spread History” shows, (i) spreads did widen out, but are generally back to where they were before widening, and (ii) even when they widened out, they were inside where they were at the beginning of the year.

Another factor to look at is where spreads are compared to market’s expectations. The table above shows average prediction for 2007 vintage A4 bonds to be 184 over swaps. Mid March wide was swaps + 190 and the current spreads are swaps plus 165. Again, not as alarming when looked at in that context.

CMBS 2.0 Spreads

Spreads for new CMBS 2.0 deals widened out too, but not by as much. They went from 110 over swaps at the tight to 120 and are back to 110, compared to swaps plus 130 at the beginning of the year. Spreads did not widen much, but where could they go now? One perspective is looking at the history. The underwriting, leverage, and subordination in the new deals are comparable to what they generally used to be 2003 to 2005. However, looking at spreads over swaps at that time will not be as helpful because of the impact of recent events in swap markets. A better approach will be to look at spreads over the risk-free rate, or the spread over treasury notes. In the 2003 to 2005 period, CMBS AAA bonds averaged around T+75, whereas generic single-A industrial corporates averaged T+77. Currently, new CMBS spreads are swap plus 110 or T+117 and single-A industrials are T+97. This back of the envelope analysis would suggest that new CMBS AAA spreads could tighten by 20 basis points from the current levels. The demand for bonds is there and there is not a big supply in the pipeline. So the technicals favor continued tightening.

CMBS 2.0 Vs Legacy CMBS

Legacy CMBS deals are a bit more complicated given the losses expected by market participants (see table above). In general, expectations of losses seem to average around 11.5% for 2006-8 deals. One simple way of looking at the deals would be to assume subordination remaining after expected losses. On that basis adjusted subordination for legacy A4 bonds goes from 30 to 18.5, which is similar to the subordination for AAA bonds in new deals. Subordination for legacy AM bonds with loss taken out goes from 20 to 9.5. That is roughly between single-A and BBB bonds in new deals.

This simplistic approach ignores several other factors that also come into play, but does the market see these as comparable? Market spreads for legacy AM bonds, at swap plus 280 seem wider than 190 and 270 for new deal single-A and BBB bonds. Similarly, legacy A4 spreads at S+170 are much wider than S+105 for new issue AAA bonds. However, if you look at yields, legacy A4 is around 4.65, close to the 4.60 on new issue AAA. Similarly 5.80 yield on legacy AM bonds is between 5.42 and 6.22 on new issue single-A and BBB bonds.

Logical inference from above is that, in this yield-hungry world, the legacy bonds are generally in line with the new issue bonds in terms of yield, and legacy bonds should tighten along with new issue. The choice between them comes down to investors preference for stability, hedging, leverage, duration, etc.

The above would suggest that a general widening in legacy but not in new issue bond spreads, unaccompanied by any deal specific news, as happened recently, may be an opportunity to pick up some cheap bonds if you can do detailed deal analysis and are confident in ability  to pick better deals.

 

 

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Restarting CMBS Lending

February 9, 2010

By Malay Bansal

The DDR deal, the first CMBS deal after nearly eighteen months, was ten times oversubscribed. The following two deals also saw good demand even though they did not allow for TALF financing. So, clearly, there is good demand for CMBS bonds backed by well underwritten loans. Also, borrowers clearly want loans if they can get a reasonable cost of financing. DDR loan, with about 4.25% all-in cost of financing for the borrower, showed that a low cost of financing is possible even in the current market. Yet, prospects of a conduit style multi-borrower deal seem bleak at the moment. Any CMBS deals that come to market are expected to be single-borrower deals, as in those deals the borrower takes the market risk and not the underwriter doing the deal. Securitization shops do not want to take the spread risk while aggregating the pool because there is no way to hedge that risk, and so are unable to originate loans even though many are eager to restart their lending operation. If they do originate loans without ability to hedge, they would require much wider spread resulting in higher cost of financing than borrowers would find attractive.

Inability to hedge loans while aggregating a pool for securitization is one of the biggest obstacles preventing restarting of conduit lending for commercial real estate properties.

In the past, the conduit originators were able to hedge loans while they were aggregating a pool big enough to securitize. So, they were not exposed to risk from changes in interest rates and bond spreads between loan origination and securitization. The hedging generally involved hedging the interest rate risk by selling interest rate swaps, and hedging the bond spread risk by using Total Return Swaps on Lehman or Bank Of America CMBS indices. These indices allowed loan originators to effectively sell their risk to investors who wanted to gain exposure to CMBS in their investment portfolio. They sold the risk when they originated the loan, and bought it back when they securitized the loans. The hedge worked because spreads on new CMBS deals moved in parallel with the spreads on existing deals.

The problem now is that those indices are no longer appropriate for hedging, especially for new origination loans, because of two problems. One, ratings downgrades have impacted the composition of the indices. Second, and more important, the spreads on new bonds with newly underwritten loans cannot be expected to move in tandem with spreads on old bonds with the old underwriting. This lack of correlation between the two spreads makes the old bonds or indices unusable as a hedge for newly originated better quality loans.

What this means is that to hedge new loans with better underwriting, originators need bonds with better underwritten new loans. In other words, to originate loans, you need bonds with new underwriting, and to create bonds with better underwritten loans, you need the better underwritten loans. That’s the chicken-and-egg type problem of loan aggregation. This is what has prevented loan origination from restarting once the spreads on old bonds widened out.

To solve this chicken-and-egg problem, back in February 2008, I made a suggestion to Markit, which administers the CMBX indices. My suggestion was to create a new CMBX type of index based on future deals that met minimum credit quality. Only deals which met pre-set criteria based on LTV, DSCR, and other credit parameters would be eligible to be included in the new index. Trading of the index would have allowed the market to determine spreads on bonds backed by good newly originated loans, and provided a hedging mechanism for loan originators, solving the chicken-and-egg problem.

Markit discussed the idea in a conference call with the trading desks, but it was thought to require too much work to create, when dealers were busy with the market volatility. Also, the idea was complicated, since it was based on future deals. Additionally, the CMBX is based on CDS (Credit Default Swap), and cash and CDS markets do not always move together, and so the hedge would not have been as good as Total Return Swaps on cash bonds.

Luckily, things have changed since then.

One, MarkIt has created new indices called TRX, which are based on Total Return Swaps on cash CMBS spreads, which will be a much better hedge for loans than a CMBX or CDS type of hedge. Total Return Swaps are what many originators used in the past to hedge the credit spreads.

Second, new deals with newly underwritten loans have been done and exist now. So, it is not necessary to base the index on future deals, avoiding a lot of complexity. That simplifies things considerably.

One solution to the hedging problem for newly originated loans is to create a new TRX index based on the new deals. It will allow the originators to sell risk, and will allow all the investors (many who did not get any allocations in the over-subscribed deals that have been done recently) to get exposure to new CMBS bonds.

Some may argue that three deals is not enough diversity to create an index. Admittedly, it would be better to have a more diverse pool of deals for the index. However, even with just three deals, the index will allow many originators considering starting origination to solve the chicken-and-egg problem. Also, this by itself will not solve all the problems the CMBS industry is facing. Yet, it will be better to have something, even if it is not perfect, than to have nothing at all.

I urge Markit and the dealers to make available a new index that will be attractive to both loan originators and investors, and just might help solve one of the major roadblocks preventing restarting of CMBS lending.

Note: This article was published on Seeking Alpha.

By Malay Bansal

Note: This write-up was published on Seeking Alpha website and was selected as an Editor’s Pick article.

Much has been written about the issues faced by Commercial Real Estate, extent of losses the CMBS bonds will sustain, whether the TALF, PPIP and other government programs will help, and if the commercial real estate market is showing signs of bottoming or is going to keep declining a lot more. There are various views which all seem plausible. If you are not professionally involved in real estate, or if you do not already have a definite view, how do you go about developing your own opinion? This article is an attempt to help with that process.

First step in the process is defining the problem being faced by the CRE market. It is a complex problem and yet the best description of it I have seen is a simple one sentence comment reportedly made by a panelist at a recent industry conference organized by CMSA:

“We have gone from a 6% Cap, 80% LTV world to a 8% Cap, 60% LTV world.”

That is another way of saying the CRE market faces a double-whammy of falling prices and reduced availability of debt, but the use of numbers in this short one sentence elegantly and succinctly captures the essence of the problem. A simple example will help explain.

Let’s take a commercial property, say an office. It is year 2006, property generates $600,000 in rental income per year, and cap rates are 6%. That results in value of $10 mm (600K/6%). In an 80 LTV world, Larry the Landlord buys the building for 10 mm, borrowing 8 mm (80% of 10 mm) for 5 years from a CMBS lender, and using 2 mm of his own money. Now fast forward to a time closer to loan maturity. In the new world, cap rates are 8%, so the new value is lower at 7.5 mm (600K/8%), and the new loan amount is 4.5 mm (60% of 7.5 mm). To refinance, Larry needs to pay off 8 mm, but can only get 4.5 mm in new loan. So, he needs to come up with 3.5 mm. If he has that money or can raise it from somewhere else, he can refinance the old loan and continue to own the property.

If Larry can not raise the additional amount, or if he does not think that it is economically worthwhile to do so, then the loan is foreclosed, and one option for the lender is to sell the property. Ideally, the property can be sold for 7.5 mm, the new value. In the worst case, there should be plenty of buyers at 4.5 mm (since one can buy the property no money down using the 4.5 mm debt available in the new world). The actual price will be somewhere between the two depending on how many buyers are there with cash available to buy, and what is their view of real estate prices in future.

By using the above numbers, we can quantify the range of expected losses in cases of sales:

Decline or Loss %Decline or Loss
Property Prices 2.5 to 5.5 mm 25% to 55%.
Borrower’s Equity 2 mm 100%
CMBS debt 500K to 3.5 mm 6.25% to 43.75%

If you layer in other factors, for example, if you assume that building’s cash flow decreases by 15% due to higher vacancy or lower rental rates (or the actual rent is lower than the assumed rent in aggressive underwriting), the numbers become worse:

New cashflow is 510 K, which results in new value of 6.375 mm, and new loan of 3.825 mm. With a new buyer paying something between 3.825 mm and 6.375 mm in case of a sale, the range of losses is:

Decline or Loss %Decline or Loss
Property Prices 3.625 to 6.175 mm 36.25% to 61.75%.
Borrower’s Equity 2mm 100%
CMBS debt 1.625 to 4.175 mm 20.31% to 52.19%

Broad ranges for sure, and you can quibble with the cap rates or LTVs,  or the fact that this simple analysis ignores other expenses and complexities, but these are back-of-the-envelope numbers, and give you an idea. For CMBS deals, you also need an estimate on how many loans in a given deal will default. If you assume approximately 40% losses on defaulting loans, then defaults on 20% of loans in the pool will result in 8% losses on CMBS deals, which is somewhere in the middle of the range of losses being predicted by many of the market participants.

Loan extensions can postpone the problem, but not necessarily avoid it, unless the property prices go back to the old levels quickly, which no one expects.

Looking at the example above, one can clearly see the importance and impact of availability of debt. If debt up to 80 LTV were to become available again, that will narrow the ranges above significantly. Clearly, programs like TALF and PPIP that help increase availability of debt are helpful and important. But, they do not solve all problems. They do not help with the decline in value. That pain has to be taken, even though many are trying to ignore it. The current low transaction volume environment reduces confidence in valuations, but eventually volume and clarity on new valuations will both increase. Those who own commercial real estate property with a lot of debt and can not carry it through the downturn will suffer losses they have not recognized yet. But those who have cash and can buy properties at cheap levels in distressed sales will benefit. As always, it will be important to analyze and understand not just the sector, but the individual investments being considered.

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