Cracking the CMBS Code

Posted on February 22, 2011

Bond issuers struggle to find the best deal structure for investors, borrowers and regulators.

In early 2010, the special servicer on the commercial mortgage-backed securities (CMBS) loan offered a reduced payoff amount of $5.4 million, but Boyd and his fellow investors were unable to obtain financing to complete the deal. As a result, the special servicer foreclosed on the property.

There simply aren’t enough lenders willing to finance small properties with vacancy in a secondary or tertiary market like Westminster, a Denver suburb, contends Boyd, president and CEO of North Coast Investors Group. The Scottsdale, Ariz.-based company owns 11 anchored and neighborhood shopping centers totaling nearly 1 million sq. ft. in California, Arizona and Colorado.

“I couldn’t find anyone who would consider a CMBS loan for less than $10 million,” says Boyd, who also applied unsuccessfully for loans from life insurers. The CMBS sector that enabled Boyd’s company to buy Country Club Village all but dried up during the recession. And with roughly $1.4 trillion in commercial mortgages coming due over the next four years alone, borrower demand to refinance loans that are nearing maturity remains high.

To attract capital and rekindle securitized lending, an array of investment professionals are introducing “CMBS 2.0,” an upgraded version of the securities and low-cost conduit loans that made CMBS the dominant source of commercial real estate financing just a few years ago.

“A lot of the issuers are experimenting with different structures to see what works, what’s receptive to the investment community sand what doesn’t work,” says Brian Olasov, a managing director in the Atlanta office of law firm McKenna Long & Aldridge. “These parties are trying to crack the code to figure out what is going to make CMBS successful.”


Delinquency rates for securitized loans scare off many potential bond investors. The percentage of CMBS loans 30 days or more delinquent increased to a record high of 9.2% in December 2010, according to New York-based Trepp LLC, a real estate analytics firm that tracks the performance of securitized loans. Forecasters expect delinquency to top out below 10% this year.

The new generation of CMBS seeks to address investors’ concerns over previous securitization practices pertaining to disclosure. New deals remove perceived conflicts of interest among the bondholders and shift authority over the special servicer away from investors in the riskiest class of bonds to those at the top of the capital stack.

The innovations seem to be working. CMBS issuance reached $11.6 billion in 2010 after a scant $3.1 billion issued in 2009 and $12.1 billion in 2008, according to the weekly newsletter Commercial Mortgage Alert. The consensus forecast calls for $35 billion to $45 billion this year, far short of the $230 billion churned out in the peak year of 2007.

A return to 2007’s frenzied pace of lending would be excessive, according to John D’Amico, CEO of the Commercial Real Estate Finance Council (CREFC). In 2012, issuance could range from a healthy $75 billion to $150 billion, he says.

At that level, CMBS loans will provide options for borrowers alongside lending from banks, life insurers and via the government-sponsored enterprises of Fannie Mae and Freddie Mac. The goal is a mix of lenders, not a CMBS sector that dominates commercial real estate financing.


Securitization simply didn’t pencil out for issuers during the height of the recession. CMBS spreads, or the number of basis points added to benchmark interest rates to compensate bondholders for risk, widened to record levels.

For example, the spread on AAA-rated, 10-year CMBS reached 1,400 basis points briefly in November 2008 and averaged 902 basis points in 2009.

In 2010, the spread on AAA-rated CMBS averaged a more modest 356 basis points and stood at 222 basis points at the end of December. With spreads reined in, CMBS issuers have been able to sell bonds at a higher profit than they could in 2009.

That’s encouraging because securitization is vital to the long-term health of the commercial real estate industry, according to Mike Syers, a partner in the New York office of accounting and consulting firm Ernst & Young.

“Lenders only have so much capacity on their balance sheets,” he says. “In order to really put capital to work and fuel transactions, there needs to be an active lending market. Securitization provides that.”


Structurally, the latest generation of CMBS isn’t radically different from the deals investors flocked to before the market peaked in 2007, according to Olasov of McKenna Long & Aldridge.

A frequent expert witness in securities cases, Olasov contends that the expression “CMBS 2.0” itself overstates the extent of recent changes to a model that was fairly sound to begin with. “If you take a look at the 10 or so deals that have come out to date, it’s really more like CMBS version 1.1,” he says.

There are key differences, however. Deals are simpler, with six or seven tranches rather than a dozen or more. Bondholders other than the B-piece investor have a greater say in the way servicers are appointed and overseen.

And temporarily at least, underwriting today is more conservative than it was before the recession. Loan-to-value ratios on CMBS deals today generally range from 60% to 70% compared with 80% or more four years ago. Lenders now calculate the value of property used to secure a mortgage based on current leases and rental rates.

Leading up to the financial crisis, cheap debt coupled with bullish rent projections contributed to high asset values that were unsustainable. The bubble burst in late 2008, leaving owners overleveraged as asset prices deflated. As of September 2010, commercial property values had fallen 42.7% from the peak in October 2007, according to the Moody’s/REAL Commercial Property Price Indices.


Perhaps the most striking difference between the latest CMBS transactions and pre-bust deals is a shift of power within the capital stack. Traditionally, the investor who bought the riskiest part of a CMBS deal, the B piece, wielded power to approve the special servicer or to appoint a new one if the existing special servicer didn’t perform well. In practice, the B-piece buyer often was the special servicer.

Being the first in line to suffer a financial loss when losses occur in the pool, the B-piece buyer would in theory be the most motivated to see that the special servicer derives maximum value from any troubled loans in the pool. Affiliations between the special servicer and B-piece bondholder, however, created the appearance of a conflict of interest, say experts.

Suppose the owner of an office building was unable to make the balloon payment on a mortgage that matured in 2009. And suppose the special servicer granted two one-year extensions, in 2009 and in 2010, rather than foreclose in a depressed market that was unlikely to produce enough sale proceeds to pay off the remaining principal.

This example shows how loan extensions force all of the investors in the capital stack to wait before the CMBS deal is closed out, which delays the top-tier investors from collecting a portion of their investment that might have been realized immediately through liquidation.

The B-piece investor in the example, who approved the special servicer, continues to receive another two years of yield payments at the high-paying coupon rate that compensates B-piece buyers for their risk. At the same time, the special servicer collects another two years of fees

“Whether or not these special servicers were acting nefariously, it just annoyed [investors] and made them suspicious,” says Brian Lancaster of the Royal Bank of Scotland (RBS). “It sets up the appearance of a conflict of interest.”

Lancaster is head of mortgage-backed securities, asset-backed securities and CMBS strategies at the RBS Americas headquarters in Stamford, Conn.

In a CMBS 2.0 transaction, the investment-grade bondholders, rather than the B-piece buyer, are more likely to have a say in appointing the special servicer.

A similar shift is occurring in regard to the mortgage loan purchase agreement, in which the seller of CMBS securities sets out its commitments, known as representations and warranties, for investors. In the past, only the B-piece investor had a say in what those promises should be, according to D’Amico.


Over the past six months, the Commercial Real Estate Finance Council has been developing a uniform set of representations and warranties that would take into account the concerns of investors with less loss exposure, he says. When completed, council leaders hope these representations and warranties will set a standard for CMBS transactions.

The newest CMBS transactions are designed to be more responsive and appealing to the investors who buy CMBS bonds, says D’Amico. “It’s also intended to be responsive to what the regulators have to do under Dodd-Frank. They’re charged with improving the securitization industry, and we’re doing our part to help them.”

The Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law last July, gives federal regulators an April deadline to determine how to increase the degree of risk retained by note holders in securitized lending. The industry is waiting to learn what, if any, new requirements they must meet under federal rules that would begin affecting new CMBS transactions starting in 2013.

Changes may be slight because the B-piece buyer in CMBS deals provides economic discipline in much the same way as a balance sheet lender with skin in the game.

Due to the B-piece buyer’s first-loss position, a CMBS transaction is essentially underwritten twice: once by the issuer and again by the B-piece buyer, who conducts a detailed review of the deal and its pool of loans to protect its investment.

A key to meeting government regulators’ expectations for economic discipline in CMBS will be to ensure that B-piece investors hang on to their part of new deals, according to Tom Fink, managing director at Trepp. Before the market peaked in 2007, many investors rolled their B pieces into collateralized debt obligations (CDOs) and recouped their capital by selling CDO shares to other investors.

“When the B-piece investors had a serious economic risk, they exercised as much economic discipline as they could to keep the credit pools at a higher standard,” says Fink. That discipline went away when the B-piece buyer was able to replace much of the capital spent on its B piece using dollars collected from CDO sales.

Under the Dodd-Frank Act, a B-piece investor can’t sell its part of a new CMBS deal. “As long as we can avoid that kind of excess leverage again, then I think that B-piece investor model works,” says Fink. “We were able to build a huge business on that and I think we can build it again.”


Some 3,256 CMBS loans totaling $48.8 billion are scheduled to mature in 2011, according to Standard & Poor’s. Even with greater access to financing from CMBS and other sources, properties backing many of those loans won’t qualify for replacement financing without additional equity.

That’s the prospect Boyd and North Coast Investors Group will have to face in a few years. Special servicers have foreclosed on two of North Coast’s properties, and some of the company’s remaining shopping centers are now worth less than the principal on their securitized loans.

“None of the properties I own are worth what we owe on them today,” laments Boyd. “As much as I hate it, all I can hope is that we keep enough tenants in the remaining shopping centers to keep up the payments.”

New CMBS Documents Enhance Clarity:

In an effort to boost transparency in securitized lending, the Commercial Real Estate Finance Council (CREFC) has teamed up with bond issuers and investors to develop standards and best practices that could soon help prospective investors make more informed decisions. But will the move stifle creativity in deal making?

Historically, issuers tended to customize commercial mortgage-backed securities (CMBS) documents such as prospectuses and pooling and servicing agreements, a practice that resulted in a confusing variety of formats. In the months ahead, the goal is to provide more uniform instruments that help investors make informed decisions.

Among its recommendations, CREFC urges issuers to give potential investors access to a transaction’s pooling and servicing agreement. In the past, issuers typically distributed these 100- to 200-page documents to investors only after a transaction closed. Standard terms and formats in these key documents would benefit investors.

In addition to boosting transparency for investors and improving market practices, the initiatives would provide government regulators with recommended ways to meet financial reform objectives, according to CREFC President Lisa Pendergast.

While CREFC doesn’t enforce specific standards, the issuers will likely emulate the best practices, says Pendergast. “If you’re an issuer and you’re not conforming to the basic information that CREFC says you need to provide, you would have trouble selling into the marketplace.”

Standards would trickle down to lenders and borrowers as lenders adjust their underwriting to meet new CMBS requirements. The challenge for the industry will be to balance the drive for consistency with the need for individual firms to stand out from competitors on loan terms, says Brian Lancaster, who heads up mortgage- and asset-backed securitization programs at the Royal Bank of Scotland Americas in Stamford, Conn.

For example, a lender may want to offer a higher loan-to-value ratio than an industry standard in order to win business from borrowers. But the greater the variety among CMBS loans, the more difficult the investor’s task becomes in understanding the risk in a CMBS pool.

“[CREFC is] trying to come up with standards people will adhere to so we’ll have more homogeneity in the market,” says Lancaster. “The issue with that is that sometimes the originators push back. If it becomes too cookie cutter, nobody competes.”

Matt Hudgins is an Austin-based writer.