CMBS Conundrum: Making Sense of the Market and What’s to Come

By Joseph Franzetti, Senior Vice President, Berkadia

The CMBS conduit market has experienced a significant amount of turbulence since mid-2015, with triple-A spreads widening dramatically. As a result, both investors and borrowers have been thrown into a state of consternation. Those who invested in triple-As during the summer of 2015 have witnessed a fair amount of value diminution in their bond portfolio. And the news is no better for borrowers, who have seen their cost of capital continually grow and been subjected to a tightening credit environment.

Little surprise that property sales are also being impacted. There’s hope that the recent rally will gain some traction and provide a pricing floor; however, the firming up of bond prices may have come at the expense of fewer deals in the market and greater credit scrutiny. If lending capacity has been decreased just to create a scarcity of bonds—with the hope of improving bond pricing—there will be an unjustified negative impact on liquidity for commercial real estate. If, on the other hand, this is a result of investor pricing preferences and prudence, then the market has determined what makes sense and what doesn’t. Pricing and values will then reach their market-driven equilibrium.

The hallmark of the CMBS market has always been that for each loan story, there’s a price to be had. Better credit will bring tighter pricing and vice versa, and rationally allocated liquidity is the ultimate determinant of cost and structure. Purposely reducing credit with the hope of increasing the value of a loan will have its own unintended consequences.

Navigating the Regulatory Environment

Aside from normal market fluctuations, there are regulatory cacophonies affronting the CMBS market, the effects of which will take some time to either dissipate or be digested:

• Reg AB II, which started last year, presents CMBS issuers with greater costs, potential liability and further administrative burdens. The result may be a disruption in the normal CMBS process, which will make lending execution less predictable. Additionally, costs incurred by issuers for these efforts will ultimately have to be passed on to borrowers, further driving up the cost of capital.
• The Risk Retention schema coming out of Dodd-Frank will have its feckless implications felt sometime in the latter half of this year. Risk Retention requires greater amounts of subordinate capital with mandatory holding periods and the inability to trade the position. Further, issuers are responsible for monitoring the subordinate investor’s compliance, with very little to no guidance being offered by the regulators on how to do so. Again, the end result is a more burdensome process and greater costs being passed on to the borrower.
• What’s more, Basel III carries the potential to render it uneconomic for broker-dealers to make markets in CMBS. Under the new guidelines of Basel III, capital requirements for holding CMBS would greatly exceed what currently exists. This new approach, called “Fundamental Review of the Trading Book,” will increase the amount of capital a bank would need to set aside if keeping CMBS on its balance sheet.

So the field of play remains interesting: a currently turbulent market, coupled with regulatory requirements further unsettling matters, all while the industry faces more than $200 billion worth of loan maturities within the next 24 months. Depending on which side of the trade you’re on, this is either a perfect storm or a unique opportunity.