CMBS Outlook - 2016

March, 2016

When it comes to the Commercial Mortgage-Backed Securities (CMBS) market, expect the unexpected in 2016. Since its inception, CMBS has certainly seen its share of volatility given its reliance upon the capital markets, which are increasingly tied to global risk. Macro-economic market conditions including prolonged declines in oil prices, concerns over short-term liquidity, election year uncertainty in the US and linkages to previously fast growing economies, are causing CMBS investors to de-risk overall. This has caused CMBS bond prices to continue widening, which directly impacts CMBS mortgage spreads. As a result, in the short term, borrowers may find bank and insurance products more compelling as this execution does not rely on the capital markets. However, in the long run, as these institutions fill up on their annual allocations and evaluate the market, they will likely widen spreads as well.

CMBS may be dislocated, but it serves a niche and currently represents nearly 20% of all outstanding commercial mortgage loans, per the MBA Quarterly Data Book. Volatility is nothing new for CMBS, which hit peak issuance levels approaching $225 Billion globally in 2007, before the onset of the financial crisis and ensuing lender bailouts set the table for a dismal stretch that effectively shut the CMBS market down from 2008-2010. Ultimately the market recovered and the sector regained significance thereafter, including a near tripling in issuance from 2011-2014.

2015 CMBS issuance surpassed $100 billion for the first time since 2007, but exuberance was short-lived as global and domestic economic uncertainty dampened late-year issuance. This trend extended into 2016, and according to Commercial Mortgage Alert, through Feb. 26 (roughly the time of writing), issuers floated only $11.4 billion of CMBS, roughly one-third less than the $16.9 billion issued through the same period in 2015.

Although most lenders and borrowers have continued to successfully wade the choppy seas, some were stalled by volatility and widening pricing in H2 of 2015. CMBS is experiencing elevated volatility and will likely continue to do so throughout 2016; even if the capital markets begin to stabilize, CMBS will still implement new risk retention rules towards year-end resulting in upward pricing adjustments. Borrowers should expect increasing costs of capital across the board and should factor this into refinancing needs.

CMBS Basics

Simply put, CMBS are bonds backed by the cash flow stream of commercial mortgages. A CMBS transaction begins when lenders originate commercial loans with the express intent of contributing them into a structure which allows cash flows from the mortgage payments to be rated and sold to investors as bonds, a process commonly referred to as securitization. Once the bonds are securitized, capital is returned to the lenders, who are then able to redeploy that capital for the purpose of making more loans. The CMBS securitization structure enables capital to flow efficiently between borrowers, lenders and investors, hence the name "conduit" given to lenders using this approach.

Conduit lenders have historically provided a significant source of volume and liquidity to the commercial real estate market. According to the Mortgage Bankers Association's Q3 2015 Quarterly Data Book, CMBS and other securitized products comprise almost 20% of roughly $2.76 trillion in outstanding commercial property debt. Balance sheet lenders simply do not have capacity for all that debt; the liquidity created by CMBS is extremely important to the health of commercial lending.

Choppy Seas in the Interest Rate Forecast

The interest rate a borrower will be charged on a CMBS loan is calculated by adding the risk-pricing premium, or "spread", to a benchmark index, which is typically tied to Treasury Bills or Swaps. Specifically, the benchmark used in CMBS is typically the higher of the: (1) like term Treasury bond, or (2) like term Swap Side offering. These instruments trade daily in the markets so their current price is always readily available.

The second component of rate- the lender's spread premium- is fuzzier. Spread generally accounts for perceived risks in the macro markets, as well as micro factors related to the loan at hand. These micro considerations include property type, market location, and borrower strength, as well as the economic factors of the loan such as underwritten leverage, DSCR, and debt yield, among others.

Borrowers must understand that both components of CMBS pricing are market driven and therefore, dynamic. Furthermore, CMBS lenders typically won't rate lock until 24 hours before closing. Therefore, in times of heightened volatility it is difficult to predict how market conditions will change during the 45-60 day processing period. This unpredictability will impact the final rate on the loan because of underlying movement to the index and or the spread.

Storm Watch Posted - CMBS Pricing Headwinds

Recent fixed-income market volatility has caused CMBS securitization programs to widen loan spreads. At the apex of the immediate problem is broader bond-market volatility owing to a number of factors, namely uncertainty in foreign economies (China), plummeting energy prices, and concern about short-term liquidity. This has raised concerns about the prospects of CMBS; buyers of fixed income investments are being very selective about their investments and yield targets, causing CMBS spreads to widen sharply, which creates headwinds for CMBS lenders when pricing and executing loans.

Additionally, with nearly 40 actively originating CMBS lenders, there is no dearth of competition for new loans which are met with dampened demand for CMBS bonds. Ultimately, this function of supply and demand will lead to a survival of the fittest; CMBS lenders with lower costs of funds and diverse lending products will be able to weather the volatility. Some CMBS lenders have already exited the business as a result, and more may surface who cannot afford to keep the lights on.

Successful CMBS lenders will counteract the perceived risk and relative value of their bonds by increasing the yield to investors, effectively making the bonds more attractive on a risk adjusted basis. This can be accomplished by increasing the risk spread premium on the loans to make the yield more attractive to bond buyers, and also theoretically protect the profitability of the issuer. Unfortunately, however, widening loan spreads typically translate to increased borrower costs by means of higher interest rates.

Changing Tides in a Regulatory Sea of Change

Passed in response to the Great Recession, The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") was signed into federal law by President Obama on July 21, 2010. This legislation brought the most significant changes to financial regulation in the United States since the regulatory reform following the Great Depression, and brought changes in the American financial regulatory environment that affect almost every part of the nation's financial services industry.

Although this sweeping legislation was passed back in 2010, many of the regulations resulting from Dodd Frank are being slowly implemented over the next few years. For CMBS, new regulations center on two hot button issues, liability and risk retention. There is little doubt that along with new regulation for lenders, particularly of these types, comes additional perceived risk, as well as inefficiency and nuisance, which will invariably result in cost increases for CMBS lenders. It seems only logical that these increased costs will be partially, if not fully passed along to consumers in the form of increased credit spreads and consequently higher borrowing rates.

Charting a Path for Safe Voyage

Currently, there exists a large pipeline of CMBS loans that will mature in 2016-2017, given nearly $600B of loan issuance that occurred during 2005-2007, most of which included 10-year balloons. Balance sheet lenders simply do not have the willingness or capacity to refinance all of this debt. Thus, much of this loan volume is expected to refinance back into CMBS.

Despite current market volatility, CMBS lenders remain among the most aggressive and ingenious on Wall Street, which affords certain benefits to borrowers that are difficult to duplicate elsewhere. First, the majority of CMBS loans offer 10-year fixed rate terms, which allows borrows who are weary of rising rates the ability to lock in their rate longer when compared to 5-year terms commonly associated with bank debt. Another unique benefit is the nonrecourse, higher-leverage nature of the debt; this is markedly different from the personal liability associated with typical higher-leverage bank debt.

From an underwriting perspective, borrowers can routinely achieve up to 75% of value (75% LTV), on a 30-year amortization, often with an interest-only period. These metrics compare favorably to the 20-25 year amortization that most balance sheet lenders prefer. It is not uncommon to observe debt yield minimums of 8.0% and Debt Service Coverage Ratios (DSCR) of 1.25x as issuers fight for deals. Indeed, borrowers who are sensitive to proceeds will find CMBS lenders to be quite aggressive.

CMBS lenders also differentiate themselves in their willingness to provide "cash out" to borrowers. Owing to the strong industry and market fundaments in self-storage, much value has been created for owners in the past five years. Investors wanting to access and recycle equity in their properties might find that balance sheets lenders are tentative to lever up these assets, however CMBS lenders that are comfortable with the cash flow history will routinely lever these assets to current market and underwriting constraints and allow the investor to access the capital on a tax free basis.

Finally, CMBS lenders are more willing to understand "hairy" deals, like those burdened with a "storied" history related to the property, borrower, or market. CMBS lenders excel at understanding opportunities in secondary and tertiary markets, and less mainstream property types. In fact, in 2015, CMBS constituted 16% of all commercial mortgages originated, 28% of which were funded in tertiary markets, including 32% of hotel loans and 28% of retail loans, according to Real Capital Analytics. Therefore, while they certainly prefer larger loan sizes and core primary-market deals, many CMBS lenders are comfortable competing for loans as low as $1.0 million in secondary and even tertiary markets.

The Silver Lining

Although there exist navigational challenges on the horizon, CMBS remains a viable and important source of capital for self-storage borrowers. While it is difficult to predict what is in store going forward, borrowers equipped with the proper knowledge and navigational guidance will undoubtedly be better positioned to traverse the choppy waters. Expect that volatility will be passed through higher borrowing costs that are likely to bounce around throughout the loan origination process. Working with lenders and brokers that are familiar with these concepts and who can provide transparency and explanation for the market movements will help craft a positive experience.

Articles: March 2016

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