COVER STORY, FEBRUARY 2008

THE NEW CMBS
Experts discuss observations in the changed industry.
Interview by Gary T. Saykaly

Gary Saykaly of BridgePointe Advisors recently sat down with Danny Carroll, senior vice president, and Kevin Berger, president of Beacon Rock Advisors, to discuss what they learned during the CMSA Investors Conference held at the Loews Hotel January 6-8, 2008, in South Miami Beach, Florida. Beacon Rock Advisors is an Atlanta-based commercial real estate advisory firm that provides loan underwriting and collateral due diligence services to lenders throughout the U.S and Europe and regularly advises first-loss buyers of commercial mortgage backed securities (CMBS) regarding re-underwriting, credit and market issues affecting loans underlying CMBS. The results of the interview created several highlights from the conference, summarized below.

Change for CMBS in 2007 — The “CMBS Debacle of 2007,” variously described as a pause, malaise, correction, gridlock, collapse, or worse, was an equal-opportunity offender that materially, negatively impacted all players, large and small, lender and investor, veteran and greenhorn, from Wall Street to Main Street.

Attendee Reaction — It seems that most participants at the CMSA Investors Conference were genuinely surprised and deeply troubled by the events of mid to late 2007. Not by looser loan structures, aggressive assumptions, or collective lack of discipline, which were known and acknowledged, but by the pervasive and persistent slowdown and the stern rebuke by the CMBS markets overall. Some in the industry feel the CMBS market’s punishment is severe and punitive and the sentence exceeds the crime. Others disagree and feel the sentence is proportionate and fair. The industry has requested probation or house arrest, and credit for time served. Final judgment is not imminent, and may not be heard prior to the end of 2008.

Battle Scars — The depth and breadth of the CMBS market reversals is no surprise to our readers and clients. It is remarkable, though, that this hearty CMBS lot would so openly acknowledge collective pain and bear the scars resulting from the 2007 battles. That stated, however (to continue the metaphor), powder is being kept dry, there is no apparent retreat, and the war is not decided. Overall attendee sentiment for 2008 ranged from merely cautiously optimistic to outright bearish, although the attitude was generally more positive for 2009 and beyond (there were no confirmed bull sightings, and it was reported, anecdotally, that Goldilocks was buckled-in and wearing a helmet).

State of Normalcy — Leaving aside the question of when a CMBS recovery might occur, it was generally felt the CMBS market will be resuscitated and return to a state of normalcy. But “normalcy,” it seems to us, will be in the form of a new CMBS paradigm. One that is lesser in scale, more conservative, and less robust. To paraphrase an ad for Nuprin: “New CMBS: little, yellow, different, better.” There is universal resignation that the party is over for a while, and the lingering $64,000 question (perhaps a $64 billion question) is “When will the CMBS markets function again?” We feel the impetus initially will be several deals consisting of 2007 production overhang. While these deals might be significantly re-packaged or credit-enhanced to become more marketable, we feel they will, of necessity, come to market and price in the first quarter of 2008, and certainly by the end of the second quarter. We feel these early deals could be completely sold, clearing all paper in the respective deals. In fact, they may be oversubscribed and may achieve improving executions as successive deals are priced. Our opinion is based upon: (a) the psychology of the new year; (b) fresh allocations of capital by U.S. and international investors targeting real estate debt (and equity); (c) reduced supply of CMBS paper actually available; (d) reduced supply of CMBS paper anticipated going forward; and (e) investors willing and able to move up and down the curve in search of appropriate risk-adjusted returns.

CMBS Halted — CMBS lenders are paralyzed and simply cannot originate a loan that they cannot sell in the marketplace, as there is no more risk available on their balance sheets. Fundamentally, these lenders must determine whether they are in (or intend to remain in) the business of CMBS lending, and, if so, they must determine breakeven lending spreads.

Pricing and Deals — We expect the pricing of the early deals to provide current data that will inform CMBS lenders regarding revised, but appropriate and realistic, break-even spreads. The deals should also begin to restore lender confidence that there is still an exit for CMBS originations. In turn, lenders will be in a better position to provide accurate and predictable loan spreads, and more reliably close loans as committed. Similarly, these deals should reassure investors at all risk levels that there remains a functioning CMBS market (with reasonable “bid-ask” spreads) that appropriately reflects and prices risk.

Rating Agencies — At the CMSA conference, there was bitterness toward the rating agencies due to the uncertain reliability of ratings of residential mortgage paper, particularly sub-prime debt, which spilled over into the CMBS markets. At least one agency representative acknowledged that the agencies have a credibility gap that must be addressed regarding CMBS. Another defended the validity of CMBS ratings as inherently more reliable, since they are generated at the property level for every deal and are based upon income and leases in place, as opposed to residential ratings which are based upon statistical modeling and credit scores. We agree that CMBS ratings are much more reliable, based upon the extraordinary level of due diligence and analysis undertaken in every deal.

Conflict of Interest — It was suggested to us that there is a way to remove perhaps the largest conflict of interest inherent in CMBS debt vehicles. Currently, issuers select and compensate the rating agencies on a given deal. The suggestion is to revise the process to permit the B-piece buyer to select the agencies to rate the deal, while the issuer remains responsible for the agencies’ compensation. This seems like a good, simple solution to an obvious problem and a perceived, if not real, conflict of interest.

Back To Basics — Going forward we expect a committed return (for the foreseeable future) to old-world underwriting considerations, including lower overall leverage, higher DSCRs, 30- and 25-year amortizations (interest-only deals are gone, for now), collected escrows, cash management/lockbox, and other prudent/necessary loan structure. Specifically, underwriting improvements might include: trailing 12 months cashflow/EGI (at best, some property types may be rolled backed to the last sustainable year); more aggressive mark-to-market of in-place rents; higher UW vacancies for anticipated changes (above current market or submarket); higher underwritten cap rates (above appraisal conclusions); more focus on borrower creditworthiness, experience, and capitalization; and market-based capex, rollover and TI/LC analysis.

Committed to CMBS — Overall, market participants remained committed to the CMBS industry as a viable lending platform and are bullish on commercial real estate fundamentals, as long as there is no recession. It is not clear how many would actually predict a recession, but almost uniformly, comments and predictions would be invalidated in the context of recession and “all bets are off.”

CMBS Volume — For 2008 U.S. CMBS production, there is a consensus for materially reduced volume of deals, but still a respectable volume by historical standards. The average U.S. CMBS issuance since 1995 is $88.4 billion (the range is $16 billion in 1995 to $230 billion in 2007). Well-placed pundits’ estimates of 2008 U.S. CMBS volume range from $80 billion to $185 billion, with the average estimate of $113 billion (roughly 50 percent of the volume in 2007). Beacon Rock’s estimate for 2008 is $100 billion, with approximately 75 percent of the volume occurring in the second half of 2008. While below the consensus average, we note our prediction is only slightly higher than the two lowest estimates of 2008 U.S. CMBS production of $80 billion and $90 billion, respectively. Conspicuous by its lack of mention at the conference is the substantial volume of U.S. CMBS origination from 1998 and early 1999 (estimated $110 billion), of which the majority is 10-year paper, presumably to be refinanced in the next 12 months. Also, there is shorter maturity paper originated in the past 5 to 7 years that should add to the refinance demand (estimated $10 billion). Allowing for defeasance of a significant percentage of loans since 1998, and allowing for encroachment by bank, life company and GSE/Agency lenders into the CMBS space, we feel there is roughly $60 billion to $70 billion of refinance demand that should materialize in 2008. This provides some comfort that our $100 billion estimate of volume for 2008 is reasonably achievable.

CDOs — Although most exotic CRE credit debt obligations (CDOs) are not anticipated to make a return to the market, it is not clear that B-piece buyers’ CDO financing sources have dried up altogether. Many of the leading buyers cleared their inventories through CDOs issued earlier in 2007, and the issue of long-term financing of B-piece investments will be addressed by these investors as they aggregate substantial positions in new portfolios. In our view, the B-piece buyers will remain active buyers of quality collateral. Deal terms will be much less favorable to issuers, and B-piece buyers will insist upon stricter underwriting and loan structure as we evolve into the new CMBS paradigm. Loan kick-outs and B-notes will remain common until overall deal quality improves. It is our belief that current B-piece buyers remain committed to the CMBS market and, frankly, like their position.

Pioneers Get Slaughtered — For this reason, we anticipate a number of new partnerships, brands, ventures, vehicles, structures, co-ops and the like to emerge in 2008. This would include all participants from issuers, bookrunners and agencies to investors. Today, there is a survival mentality that we feel is prevalent over competition and which will result in strategic alliances even among the (formerly) fiercest of competitors, at least in the short run. Partnerships tend to legitimize hard decisions, and collaborators provide the illusion, at least, of spreading risk.

Mature Market — We believe the CMBS industry and its veteran players, particularly, have matured and they exhibit a healthy respect and genuine admiration for their peers. Really. There was a tangible sense of community in South Beach, beyond the parties, dinners and other social events. Despite the well-chronicled pessimism and resignation, it was apparent to us that there is an abiding respect and passion for the CMBS industry, and genuine optimism in the longer term.

In summary, to paraphrase the paraphrase: In light of recent events, the new CMBS is understandably a little yellow, but with temperance, experience and hindsight, we expect it will re-emerge different and better, indeed.

©2008 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.