As a result of new Dodd-Frank risk retention regulations that went into effect in December 2016, last year was widely considered to be a pivotal period for the CMBS industry. Formulated to hold banks more accountable for their own investment decisions and place a greater emphasis on collateral quality, the regulatory provision imposed higher capital charges on sponsors by requiring them to retain a 5 percent interest in an asset-backed securitization.
The mandate fueled concerns that CMBS would become less competitive compared with other commercial real estate lending sources, leading to speculation of a potential slowdown in interest among investors, a reduction in market liquidity and higher borrowing costs.
Catherine Liu, Trepp
In short, the rules require issuers to retain a portion of the credit risk in their own transactions. This is accomplished by setting aside additional capital that amounts to 5 percent of the value of newly issued bonds on their balance sheets.
There are three different methods of fulfilling the retained risk requirement, which take shape in the form of one of three structural options: a horizontal slice equal to 5 percent of the lowest bonds in the deal waterfall, a vertical slice that amounts to 5 percent of each tranche in the deal, or an L-shaped (also called hybrid) structure that combines the other two holding strategies.
Although sponsors can sell the horizontal slice to a B-piece investor, they are not allowed to hedge or transfer the retained risk throughout the term of the transaction’s life.
Surpassing expectations
Despite the new regulation, private-label CMBS issuance for 2017 ultimately soared well above initial projections and exceeded the prior year’s volume. New issuance was buoyed by an influx of single-borrower deal activity and capped off at roughly $90.5 billion.
Various factors contributed to a more energized CMBS market in 2017, such as interest rates remaining at historic lows, tighter bond spreads, and issuers’ growing comfort with risk retention rules.
Karina Estrella, Trepp
CMBS deals with the horizontal risk retention structure made up 44 percent of the year’s securitizations as the dominant structural type, with $40 billion across 60 deals. Vertically structured deals followed closely behind with $37.6 billion across 61 deals, or 42 percent of the year’s balance.
Deals under the L-shaped risk retention category comprised the remaining 14 percent.
Driven mostly by heavy deal flow on trophy skyscrapers in major metropolitan areas, office loans made up the largest portion of total issuance with $26.5 billion, or 29 percent of volume.
New hotel/lodging issues amounted to $25 billion, or 28 percent of the total volume, bolstered by the rising trend of consolidation and expansion strategies in the hospitality segment.
Unsurprisingly, the retail sector took a significantly smaller share than in previous years with just 13 percent of 2017’s issuance balance. Investor sentiment toward retail was particularly tepid after a turbulent year highlighted by a slew of big-box bankruptcies, struggling Class B and C malls, and shifting consumer fundamentals.
Rounding out the major property types, mixed-use loan issuance grew to $11.4 billion (13 percent of the 2017 total) while multifamily and industrial accounted for roughly 6 percent and 3 percent of the new issue pipeline, respectively.
Overall, total issuance in 2017 increased 28.1 percent over the prior year’s tally of $70.6 billion. Despite this significant growth, many believe that issuance is still running below the expected pace, considering that some $110 billion in CMBS loans was slated to mature in 2017.
Last year also marked the end of the “wall of maturities” period as the large wave of more than $300 billion in CMBS loans issued between 2005 and 2007 was scheduled to come due as part of the 10-year term structure.
Drop in issuance projected
As the amount of loans that will be up for refinancing winds down, 2018 will act as a major turning point for the sector since the maturing balance drops off to a total of $30.3 billion this year. Consequently, private-label CMBS issuance is expected to decline to an approximate range of $60 billion to $65 billion in 2018.
In 2017, roughly $86.6 million in CMBS loans were resolved or paid off in any manner, bringing the disposition total for the wall of maturities period to $294.3 million. A little more than 12.7 percent of the retired balance from loans liquidated in 2017 incurred a loss, translating to an average loss severity of 42.4 percent across all property segments.
With just $18.5 billion in 2017 loan maturities still outstanding based on underwritten maturity dates, the sector has made much progress in paying off or refinancing the large volume of maturing debt thus far and will continue to fulfill the capital needs of its participants.
When it became clear that risk retention was not going to serve as a major hindrance to CMBS activity, as many of the initial concerns surrounding it did not materialize, the regulatory requirement did introduce several profound changes to the securitization landscape following its implementation.
For starters, risk retention caused a number of smaller players that could not afford to hold large balance sheets or the costs of regulatory compliance to exit, which has reduced the size of the CMBS investor base.
As a result of the consolidation of CMBS market participants, lenders have also been increasing their use of single-borrower transactions and split loans to minimize leverage and their overall pool exposure to weaker performing assets.
This has led to greater dispersion of credit quality and pricing within a transaction, otherwise known in the industry as credit barbelling and price tiering.
The risk retention requirement did positively contribute to strong investor appetite and considerably tighter spread pricing on new issues. This has resulted in sizable yield rates for issuers, aided by a reduction in overall supply, minimal volatility, and the market perception that credit quality has increased with additional sponsor and third-party involvement.
Challenges, opportunities
Looking ahead, the CMBS industry faces several headwinds in 2018. Many of the concerns stem from rising interest rates and the Federal Reserve’s self-imposed downsizing of its balance sheet, which could further reduce liquidity.
Other hurdles include a lower volume of maturities in need of refinancing, signs of overbuilding in certain commercial real estate property sectors, slowing rent growth and property value fundamentals, along with the sustained pushback in reform efforts to curtail the regulatory burden of current Dodd-Frank rules.
On the other hand, borrowers seeking to lock in low rates should help boost the volume of CMBS issuance. Meanwhile, a growing number of yield-hungry investors tied to large projects too capital intensive to finance via other lending vehicles will likely turn to CMBS.
The lower tax rate stemming from the recently passed GOP tax legislation will provide additional incentives to partake in acquisition and development activity, while spreads are expected to hold steady. Meanwhile, CMBS will continue to distinguish itself as an increasingly attractive source of commercial real estate financing.
— By Catherine Liu and Karina Estrella, research analysts with Trepp LLC based in New York City. Founded in 1979, Trepp provides data, analytics and technology solutions to the global securities and investment management industries. This article originally appeared in the February 2018 issue of Heartland Real Estate Business magazine.