COVER STORY, FEBRUARY 2011

THE RETURN OF CMBS?
After a two-year absence, CMBS loan issuance is increasing.
Coleman Wood

The CMBS debt market was nearly wiped out by the recent recession. According to Matthew Anderson, managing director with Foresight Analytics, the commercial real estate industry issued only $11.6 billion in CMBS financing in 2010. That number is expected to jump to $35 billion in 2011. For any other market, a more than threefold increase in business would be a cause for celebration, but the CMBS market has a rather large hole to pull itself out of now.

“If you compare that to the peak years in 2006 and 2007, where there was $200 billion in issuance each year, we’re not getting back to that anytime soon,” Anderson says.

This difficulty is further compounded by distressed CMBS loans that are slowly coming to term. Of the approximately $350 billion in commercial real estate loans that will come to term this year, approximately $87 billion is securitized. Broken down further, approximately $24 billion of those loans are for office properties, $5 billion of which is distressed — with a loan-to-value ratio of more than 100 percent and a debt service coverage ratio of less than 1. However, the office sector is not even close to the most troubled property type.

“The greatest proportion of distressed property is in the multifamily segment,” Anderson says, adding that 38 percent of the multifamily loans coming to term are under water. Right now, some of these loans are able to avoid the distressed label, but that could change quickly.

“Low interest rates are keeping a lot of marginal properties above water,” Anderson says. “Critical to the outlook would be at what pace interest rates pick up relative to economic recovery. If interest rates get ahead of recovery, we could see more problems developing.”

With so much debt coming to term soon, what can lenders do to assure that they are able to refinance their loans? Lynn McKee, vice president of CMBS special servicing for Trimont, has several guidelines that will help owners of troubled and non-troubled assets increase their chances of obtaining refinancing. The first is that lenders have to believe that the property will increase in value. Part of initial collapse of the CMBS market was caused by “extend and pretend,” a term for banks that would refinance loans without doing their due diligence on whether the financing made sense.

“’Extend and pretend’ came out of what a lot of banks were doing in the past couple of years, particularly when they were extending construction loans and land loans that had very little chance of increasing their recovery over time,” McKee says. “It was really a way to delay having to take REO, take write-downs and, in many cases, close the bank.”

Once the lender sees that the property stands a good chance of increasing in value, the borrower has to bring equity into the deal. McKee deduces that, much of the time, the reason the loan is underperforming in the first place is because there is not enough capital to fund tenant improvements, market the property to prospective tenants and pay broker commissions. Finally, the borrower has to be someone the lender wants to work with. McKee suggests borrowers can speed up the underwriting process if they come to the servicer with a plan and are open and honest. Hiding cash or facts, or being unreasonable with expectations, sends up red flags to lenders. If the borrower is hiring a consultant to help with the process, it is best to hire someone with a prior relationship with the lender.

“Put those three things together, and most servicers, particularly on larger loans, are willing to talk about loan modification that will benefit both the bond holders and the borrower,” McKee says.

Patrick Connell, managing director with CB Richard Ellis Capital Markets points to loans for transitional properties as currently being the biggest logjam in the workout process. Prior to the recession, these properties were financed by banks and credit companies with some recourse. Since then, these lenders have largely pulled back from financing commercial real estate, and non- or low-recourse financing is rare. In addition, the smaller the property, the less attention it will attract from lenders. Still, Connell agrees that if borrowers follow the guidelines McKee pointed out, they stand a better chance than not of obtaining a loan.

“It’s a very effective means of minimizing losses at the trust level and, in many cases, producing gains and producing an overall return that is going to get you closer to a par-value return on the note, rather than taking that asset back in today’s environment and liquidating it,” Connell says.

Michael Cohen, executive director with the Charlotte, N.C., office of UBS Securities, sees 2011 as the year that the CMBS market turns the corner. His company has already roared out of the gate after a temporary exit from the market caused by the recession.

“If you look at UBS, and the fact that from getting back into the business in the early third quarter of 2010, then contributing close to $1 billion in collateral into the next Deutsche Bank pool, we are a clear example of who is going to lead the way into CMBS 2.0,” Cohen says.

There is still steady investor demand for CMBS paper, but the market is not out of the woods yet. Cohen sees equilibrium in the market coming, however the market is going to have to work itself out at its own pace.

“As debt becomes more readily available, you are going to start seeing more trades in the market. When those trades occur, and those acquisitions get refinanced, those assets will be appropriately leveraged. For assets that are going to be refinanced, if they are currently too levered, there is going to have to be a payout to re-lever those assets,” Cohen says.

He adds, “The market today is significantly better than it was 1 year ago, and I expect it to be even better at the end of 2011.”

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