Have CMBS lenders learned from their mistakes that led to today’s high default rates, or will they lapse into making irresponsible loans again as the commercial real estate recovery gains momentum?
Brian Furlong, managing director of New York Life Investments, who oversees the company’s CMBS investments and structured whole loan activities, raised the question Tuesday during a panel discussion at MBA’s commercial/multifamily real estate finance conference in Atlanta.
The delinquency rate for CMBS multifamily loans in January stood at an unhealthy 15.39 percent, according to Trepp LLC. In sharp contrast, the delinquency rates were well under 1 percent for multifamily loans originated by life companies and loans held or insured by Fannie Mae and Freddie Mac.
“The question becomes what led to that difference among industries, and has it been addressed and has it been fixed?” asked Furlong.
There is no doubt that CMBS lenders are making more responsible loans today than they were at the peak of the real estate market in 2005-2007, said Furlong. He believes that’s largely because lenders are proceeding with caution during the early stages of this real estate recovery.
“But fundamentally some problems of the business — in terms of it being a throughput business without [lenders] having skin in the game — really haven’t been addressed in a serious way,” said Furlong. “In the next crash, I’m not convinced that we’re not going to see the same 15 percent default rate in CMBS and 20 basis points in Freddie Mac.”
The Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law in July 2010 calls for securitizers of all asset-backed securities to retain 5 percent of the credit risk of the assets in the pool. With the rule-writing process not yet complete, however, exactly how that 5 percent retention rule will work in practice is unclear.
Furlong also urged the industry to stamp out conflicts of interest involving special servicers. The practice of some special servicers providing relief to borrowers with troubled loans in exchange for large fees has made some investors furious, he said. The special servicer is supposed to represent the interests of the bondholders who hold the loans on the properties.
“Some of these conflicts of interest are maybe inevitable in a downturn because it is a complex system,” said Furlong, who acknowledged that the industry is working diligently to address some of these problems. “The bankers who make these loans want happy mortgage brokers, they want happy borrowers, they want happy investors.”
A different perspective
Dennis Schuh, managing director with J.P. Morgan Securities LLC, which originated $8 billion in CMBS loans in 2011, said the higher delinquency rate in the securitized lending universe needs to be put into the proper context.
“CMBS is supposed to perform worse than balance-sheet lenders and life insurance companies. As a rule of thumb, it’s at a higher leverage point,” he said.
“CMBS delinquency rates were like zero for a really long time,” stressed Schuh. The spike in CMBS defaults is largely the result of loans made at the peak of the market when underwriting standards were loose, he believes.
“There were some really big deals that got done that are certainly skewing some of those numbers, but the numbers don’t lie. I’m not going to try to sugarcoat the numbers,” said Schuh.
Zanda Lynn, managing director with Fitch Ratings, said that in the wake of the sharp commercial real estate downturn the word “pro forma” has been banned at her office. “That is a word that, quite frankly, all of us were using in 2007,” she said, referring to loan underwriting based on projected future rents.
The underwriting today focuses heavily on the cash flow a property generates, not a “pie-in-the-sky ” approach involving rent projections, said Lynn.
The delinquency rate on CMBS multifamily loans has always been relatively high compared to the delinquency rate on Freddie Mac loans, said Lynn. That’s the case even if some of the largest troubled securitized loans aren’t factored into the equation.
“Quite frankly, when a multifamily deal comes in a pool [of CMBS loans], we’re always asking, ‘Why didn’t they get Freddie financing?’”
Wild swings in issuance
To say that the CMBS industry has been on a roller coaster ride the past few years would be an understatement. After annual U.S. CMBS issuance reached a high of $230 billion in 2007, issuance plummeted to nearly $3 billion in 2009 amid the global credit crunch before rebounding to approximately $30 billion in 2011. The conservative estimate for 2012 is for volume to range between $40 billion and $50 billion.
“I think it will be a $75 billion business when we start to hit the refinancing wave in 2014-2016,” said Schuh of J.P. Morgan Securities.
Margie Custis, panel moderator and managing director with Principal Real Estate Investors, said that the importance of a healthy CMBS industry in markets big and small can’t be overstated.
“We have to make CMBS work for the overall real estate recovery to work. Otherwise, we’re going to have a handful of really good markets and a lot of markets struggling because you are not going to see the life companies and the banks real active in some of these markets,” explained Custis. “They are only going to be willing to do 50 percent loan-to-value, and that is going to leave a lot of borrowers in a pretty tough position.”
An expected increase in acquisition activity will prove to be a big boon for the industry, said Kevin Pivnick, panel member and director of Deutsche Bank National Trust Co.
“CMBS is really tailor-made for a highly acquisitive environment where people need to close quickly and use a lot of transparency in the process, and they want a little bit higher leverage,” explained Pivnick. “It’s our view that we will get an outsized portion of the increased acquisition activity that we know is coming around the corner.”
— Matt Valley