Choppy Waters: Uncertainty Looms for the CMBS Market

By Poonkulali Thangavelu

The market volatility early this year has taken a toll on CMBS as credit spreads have widened.

Mitchell Kiffe, Senior Managing Director & Co-Head of National Production, CBRE Capital Markets

“Widening of the credit spreads makes it very hard for a CMBS lender to know with any certainty how to price their money, what interest rates they should charge for their loans, because they don’t really have much certainty as to where the bonds will sell,” said Mitchell Kiffe, senior managing director & co-head of national production for CBRE Capital Markets’ debt and equity finance group. “It’s a very non-virtuous cycle right now.”

CMBS market participants expect further uncertainty as lenders and issuers start to feel the impact of new regulations.

Lower expectations

As global markets reacted to the Chinese slowdown early this year, spreads on CMBS widened as investors looked for a higher risk premium. Compared to the middle of 2015, spreads have moved up almost 100 basis points on AAA-rated tranches and even 200 to 300 basis points on BBB-minus rated tranches. This has slowed down new issuance as it becomes more difficult for CMBS lenders to set interest rates on their loans.

As a result, CMBS volume in early 2016 has been less than expected and lower than during the same period of 2015. Consequently, forecasters have lowered their projections for CMBS issuance this year from $115 billion to $130 billion to between $100 billion and $110 billion. Issuance for 2015 was about $96 billion.

“I think there is a potential impact in the second quarter and beyond,” noted Eric Rothfeld, a managing director with Fitch Rating’s U.S. CMBS group. “Even if there is a slowdown that is appearing in origination, it will translate into a slowdown in issuance one or two months later.”

Looming regulations

Eric Rothfeld, Managing Director, U.S. CMBS, Fitch Ratings

CMBS participants are also watching to see the impact of regulations such as the Dodd-Frank risk retention rules and Regulation AB, which calls for more disclosures from CMBS issuers.

While stakeholders have been preparing for these rules, they were still hoping that regulators would modify them in ways that would make them more favorable to the industry. Instead, Kiffe said,

“They made a couple of accommodations around the margin, but the fundamental principles of risk retention are the same.”

New risk retention rules promote the involvement of more permanent, longer-term capital and has introduced uncertainty about how CMBS lenders will structure and price capital. As a result, it seems likely that CMBS borrowers will encounter higher interest rates. That, in turn, could work to restrain asset prices.

The CMBS market is also starting to feel the impact of Basel III. For example, its Fundamental Review of the Trading Book provision will likely require banks and broker-dealers to hold more capital against secondary trading activities. Although this regulation is not expected to take effect until late 2017, the market is already taking its potential impact into account. The prospect of the new rule has contributed to the widening of CMBS spreads as market liquidity has declined.

As banks become more conservative in response to new regulations, they may be less willing to extend credit to smaller CMBS lenders who are funded with lines of credit. If so, the ranks of lenders could shrink considerably from today’s group of 40 or so. A number of those players entered the field earlier in the recovery when CMBS became more profitable. On the plus side, a big wave of CMBS loans due for refinancing is likely to provide more momentum in 2016.

Eye on underwriting

Joe McBride, Research Associate, Trepp Inc.

Even as regulators work to counter the excesses that preceded the financial crisis, CMBS underwriting is noticeably more lax than it was early in the recovery. Standards have by no means slipped to the levels of a decade ago, when underwriters would factor in future rents rather than in-place cash flow. Yet the change is unmistakable.

“People are keeping their eye on underwriting,” confirmed Joe McBride, a New York-based research associate with Trepp. “Because things are getting better and valuations are going up, lenders are willing to do a little bit more leverage.”

For instance, as the market became more competitive last year, Fitch Ratings discounted cash flows underwritten by CMBS issuers about 8 to 10 percent. By contrast, the haircuts administered by Fitch in 2013 and 2014 were in the 6 to 7 percent range.

One factor that is helping keep underwriting practices in line is the B-piece buyer. Investors like Rialto Capital Management and LNR Partners are willing to buy the riskiest tranches in CMBS offerings.

“B-piece buyers act as the adults in this business, and tend to keep things a bit more conservative and realistic,” explained Michael Riccio, a Hartford, Conn.-based senior managing director for CBRE Capital Markets. Together with Kiffe, he oversees production nationally for the debt and equity finance group. “Their influence comes from conservatism,” Riccio added.