2016 is starting out as a unique year in the CMBS space.
Given the market uncertainty that shaped the 2nd half of 2015, the ongoing refinance wave, and the latest regulatory developments, 2016 poses both significant opportunities and daunting challenges for market participants.
Comparable to a sailing vessel staring into a strong headwind, the Commercial Mortgage Backed Securities (CMBS) market is facing an environment with no shortage of obstacles.
However, the ability to effectively navigate through these obstacles will position the best equipped market participants to look back a year from now and be pleased with their results, whether they be volume, customer, or risk mitigation centric.
In sailing parlance, the phrase “tacking into the wind” refers to a scenario in which a sailing vessel can advance, despite facing headwinds.
That is an applicable analogy when looking at the means by which CMBS market players will have to navigate market waters in 2016.
Although there exists healthy optimism from commercial loan originators, issuers, and servicers, there is also a healthy dose of caution and uncertainty.
Sadly for industry participants, much of the uncertainty stems from factors outside of their control, but rather in the hands of macroeconomic and geo-political concerns.
In looking at CMBS issuance over the last decade, it is clear that the market has begun to stabilize from the post-recession lows in terms of origination volume.
However, to suggest that the issuance numbers will approach the $200B plus numbers of the pre-recession heyday any time soon would be irrational. Nonetheless, the origination and issuance stability is a positive trend.
While 2015 did not meet expectations in terms of volume, the approximate $90B of origination volume was a positive sign, albeit disappointing to the overly optimistic crowd that had pegged origination targets at $125B or better.
Sales activity soared in 2015, as investors, both domestic and international, sought the yield that the commercial real estate industry readily provides. Capital flows and property fundamentals have buoyed property values.
Source: CREFC, Morningstar data
What appears most challenging, however, particularly for originators, is that despite positive trends with property fundamentals, there is uncertainty regarding overall market conditions.
This uncertainty, which manifests itself in spread widening up and down the investment spectrum, coupled with new regulatory conditions, could have dramatic impact on the loan origination and securitization issuance numbers going forward.
Beginning in the 2nd Quarter of 2015, the spread stability that the market had grown accustomed to earlier in the year began to show signs of significant widening.
That trend continued through 2015 and into 2016, as bond investors continue to price in the uncertainty of global oil /energy prices, political turmoil, and anticipated interest rate increases on bond yields.
By way of example, 10-year, senior, AAA bond tranches that a year ago were trading in the swaps + 100 bps range, now regularly price in the swaps + 150 bps range.
The Refi Wave
Not long ago, the industry was struggling to grasp how the wave of approximately $300B was going to be refinanced.
These maturing loans were primarily 10 year debt deals, originated between 2005-2007, at pre-recession industry peaks -- the height of aggressive underwriting--, including higher LTV loans, and loans with interest only (I/O) periods for all or part of the loan term.
To date, the industry has responded well to this wave of refinance activity, which is testament to the resiliency of the capital markets.
Multiple factors are contributing to the CMBS market’s ability to respond to this refinance activity, including:
- Rising property values – The ability of today’s current borrowers to refinance their loans has been significantly aided by property value increases that allowed the loans to be refinanced at similar LTV’s as their original loans.
- Loosened Underwriting – Competition for origination volume has allowed loosened underwriting standards to once again creep into the market. This has supported refinance activity.
- New Participants – New entrants into the origination landscape have increased competition, adding to the options to borrowers.
Competition and Profitability
CMBS originators face intense competition from its peers in the commercial loan arena, mainly from insurance companies, and commercial banks.
Add to that the GSE’s, who continue to dominate the multifamily lending sector, and the competition begins to squeeze profitability.
Part of the problem is the cost of capital volatility for CMBS lender / issuers, relative to its peers in the GSE, life insurance, or larger bank arena.
This has slowed origination activity significantly, resulting in market participants deciding to exit the origination landscape entirely, given competitive pressures.
Redwood Trust, a REIT that originated into the conduit market, has recently decided to abandon it origination activities, and rather will focus their efforts on commercial loan bond investing.
It will be interesting to see how the landscape of originators and securitization entities changes in the near future given the profit squeeze that is being felt by all market players.
2016 also introduces new regulations that will have a significant impact on current market practices. The two most significant are Regulation AB II, and the new risk retention rule, which is set to be enacted in the 4th Quarter of 2016.
Reg AB II is the enhanced disclosure rule placed upon issuers of securities. The regulation mandates that executives from issuers certify as to the quality of underlying data in securities documentation, including collateral data contained in prospectuses.
The risk retention rule, part of the behemoth Dodd-Frank Wall Street Reform and Consumer Protection Act legislation, was designed to require issuers to retain 5% of the bonds that they sell.
CMBS issuers will be allowed to keep with market practice by selling the 5% strip to B-buyers, however, the ultimate owners of the 5% strip will not be able to sell that portion for a period of five years.
While we can look to navigate through troubled waters as a relevant comparison for facing down the CMBS market in 2016 and beyond, originators, securitizers, and servicers will be best served by taking a cautious, risk-based mindset to their CMBS activities for navigating through headwinds.
About The Author
William Vahey is a Senior Managing Director with RiskSpan, and leads advisory engagements for the firm and multiple financial services organizations throughout the country.