CMBS Approaching Point of No Return

The lending market cycle invariably turns to favor borrowers, but the commercial mortgage-backed securities (CMBS) market’s near miraculous turn around and the bonds’ plunging spreads, as well as indications of deteriorating credit quality, suggest buyers should beware.

The average spread on ‘AAA’ tranches is nearly half last August’s, falling to 75 basis points in mid-May from 143 basis points last summer, while lower-rated bonds have fallen even further, according to Trepp.

Spreads for CMBS rated BBB- dropped to 298 basis points from 614 basis points over the same period.
Meanwhile, if new issuance through the rest of 2013 follows the pace of the first quarter, total volume this year could top $100 billion, more than doubling 2012 volume and multiples above the $11 billion issued in 2010.

“It’s an amazing recovery in a short time, from the depths of the market to where we are now,” said Manus Clancy, senior managing director at Trepp. “Five years ago, people wondered whether we’d be back to $40 billion in five years, and now it could be $100 billion—it’s almost euphoric.”

CMBS is clearly benefiting from the liquidity central banks around the world are injecting into the financial system, which makes higher-yielding assets relatively more attractive.

A number of other factors also suggest CMBS could be headed toward troubled territory, including skyrocketing property prices in major markets, increasing loan-to-value (LTV) ratios and interest-only periods, the return of “pro forma”-type cash flows, and sponsors “pushing the documentation.”

Property prices in second- and third-tier markets have risen only marginally since their lows in 2009, the 24-hour cities—major metropolitan areas such as New York, Chicago and Seattle—have been on a tear. Moody’s Investors Service’s Real Capital Analytics now tallies prices in the major markets at a smidgen below highs reached in 2007, while prices in non-major markets are still 30% down.

“We’re now approaching if not above peak valuations seen in 2007 for some trophy properties,” said James Grady, managing director at Deutsche Asset Management. “While that often makes people feel encouraged and emboldened, it’s really when valuations are high that risk is highest.”

Another troubling sign is rising LTVs. Tad Philipp, director of commercial real estate (CRE) research, said CMBS issuers today are underwriting CRE loans at LTVs around 70 typically, similar to LTVs in 2005. At that time, though, Moody’s methodology was calling LTVs on those same loans between 100 and 110.

Philipp said the Moody’s LTVs (MLTV) correlated much more strongly to expected losses than the underwriter’s LTV, and today the average MLTV is at about 100. Philipp added, “We believe this level is an ‘inflection point,’ and should MLTV increase further from here the risk will be magnified.”

At a MLTV of 100, equity has shrunk to a thin level on a historic basis compared to the appraised value. As the MLTV continues to rise, more losses are likely to follow.

“We’re back to the 2005-ish level,” Philipp said, adding, “We’re saying that in 2006 and 2007 underwriting got significantly off track, and while we’re not there yet we’re getting uncomfortably close.”

Also problematic is the increasing use of interest-only (IO) structures, which were prevalent before the CRE market collapsed during the last cycle. The Kroll IO Index measures the interest-only exposure of CMBS transactions, and it has increased steadily over the last year and a half, measuring 12% in first quarter 2012, 19% in the second quarter, and jumping to 29% so far this year.

“Some deals have their IO index approaching 40%, which in conjunction with [an increasing Kroll-calculated LTV] is leading to increased credit risk,” said Eric Thompson, a senior managing director in the structured finance group at Kroll Bond Rating Agency.

IO loans provide very low—and attractive—debt-servicing obligations for sponsors today. The more back-ended amortization is, however, the greater refinancing concerns become, especially if interest rates rise—as they are likely to do—and rental income is uncertain. Thompson said that roughly half of the CMBS deals so far this quarter have IO components, and about 20% are fully IO.

“Fortunately, many of the full-term IO loans aren’t levered above the weighted average of the transaction pool’s LTV,” Thompson said.