By Brian Holstein
The commercial real estate lending markets started 2016 slow and choppy and spent the rest of the year making up lost ground. Volume was down, but available for good deals; rates and spreads were accommodative, even with the year-end Treasury rate spike; defaults rose slightly, but not alarmingly and banks and life insurance companies picked up market share at the expense of CMBS lenders. This year, the debt markets will face their own set of unique and unprecedented challenges, but the picture remains rosy.
Wall of Maturities
Much has been made about the so-called “Wall of Maturities” in 2017, which is largely the result of the $230 billion of CMBS loans originated in 2007, most of which were 10 year loans. There are approximately $208 billion of “Non-Bank” commercial real estate loans set to mature in 2017; approximately half of it is CMBS. The “Wall” would be even larger if not for the fact that 55% of CMBS loans that were paid off between the start of 1Q15 and 3Q16 were actually prepaid prior to their scheduled maturities. Even with 2016 CMBS volumes coming in far below expectations ($68.3 billion actual issuance vs. initial expectations of $100-125 billion), a significant dent in 2017 maturities was made. The average debt yield on the remaining pool of 2017 conduit CMBS maturities in total and for hotels is very manageable at approximately 12% and just below 15%, respectively.
PREDICTION: THERE WILL BE A HIGHER THAN NORMAL OCCURANCE OF MATURITY DEFAULTS, BUT THEY WILL NOT BE MEANINGFUL ENOUGH TO DAMAGE THE LIQUIDITY REQUIRED TO REFINANCE THE REMAINING PERFORMING LOANS. MOST EXPERTS ARE CALLING FOR $65 TO $75 BILLION OF 2017 CMBS ISSUANCE. LOWER LEVERAGE LOANS WILL BE SNAPPED UP BY FRESH LIFE COMPANY ALLOCATIONS AND BANKS STILL EAGER TO EARN MORE THAN THE FED FUNDS RATE. HIGHER LEVERAGE LOANS WILL BE REFINANCED WITH THE AID OF MEZZANINE FINANCING OR FLOATING RATE BRIDGE LOANS FROM REITS AND DEBT FUNDS. REAL ESTATE ENCUMBERED BY LOANS THAT CANNOT BE REFINANCED AT PAR, BUT ARE NOT UNDER WATER, WILL RECEIVE EQUITY INFUSIONS OR BE SOLD.
Interest Rates
Rates are officially on the rise after the Fed announced its latest rate increase on December 14th to a range of 0.50% – 0.75%. Forward guidance from the Fed shows median expectations of three rate increases in 2017 and a stabilized Fed Funds rate of 3.00%. The Wall Street Journal Economic Forecast Survey on interest rates predicts the 10-year Treasury rate will be 2.79% by the end of 2017.
At this point in the cycle, long-term rates not rising are the bigger concern. If 10-year Treasury rate does not follow the Fed Funds Rate on its upward trajectory, it will lead to a flatter and potentially negative yield curve, the most fool-proof, forward-looking recession predictor of them all. In fact, there have been nine recessions since 1953, and other than a slightly early signal in the late 60’s, each time the yield curve inverted, there was a recession an average of 13 months after such inversion.
PREDICTION: THEY 10-YEAR TREASURY RATE WILL FINISH 2017 HIGHER THAN CURRENT LEVELS BUT BELOW THE WALL STREET JOURNAL ECONOMIC SURVEY RATE OF 2.79%.
Risk Retention Implications
The long-awaited (and dreaded) CMBS Risk-Retention rules kicked in on Christmas Eve. The rules require CMBS issuers to retain 5% of the credit risk of any deal it issues. Issuers can accomplish this by retaining a 5% vertical strip (equivalent to owning a 5% participation in a pool of whole loans), a 5% strip of junior bonds which can be passed on to a qualified B-piece buyer, or a combination of the two. Most of the chatter surrounding risk retention has been negative with experts predicting CMBS spreads will rise by 20-50 basis points and that lenders will eventually run out of capacity or be forced to slow down due to balance sheet constraints.
Most “experts” are not giving enough credit for the higher loan quality and lower risk profile that is the result of issuers now having “skin in the game” and the disappearance of the bottom tier lenders that could not cope with the new rules. While the yield required to sell or retain the B-piece (5% of the capital stack) will go up, this will be offset by lower spreads on AAA bonds (70% of the capital stack). Most banks will choose to retain a vertical strip as opposed to a horizontal “B-piece” strip, but the positive effect on AAA bond pricing is conceptually the same.
As for capacity issues, it should be a zero-sum game. To gain a competitive advantage and control their own destiny, many lenders have begun purchasing/retaining their own B-pieces. To do so, lenders, both bank and non-bank specialty finance companies, have either raised additional outside capital or received increased internal capital allocations to expand their balance sheet lending capabilities. In other words, lenders that now have capacity to buy or retain their own B-pieces, but did not before, are competing for capital with legacy funds that traditionally purchased B-pieces. Capital is capital and it chases returns.
PREDICTION: NOT ONLY WILL SPREADS NOT WIDEN IN 2017, BUT THEY WILL TIGHTEN. CAPACITY WILL BE A NON-ISSUE AND THE ADDITIONAL BALANCE SHEET CAPACITY INDIRECTLY CREATED BY THE ONSET OF RISK RETENTION RULES WILL HAVE POSITIVE EFFECTS ELSEWHERE, AS DISCUSSED BELOW.
Winners and Losers
Beginning with “RegAB” (executives personally liable for CMBS disclosure errors) and ending with Risk Retention, approximately 20-25% of the securitized lenders that began 2016 open for business have now shut their doors. Most that remain in earnest have done so by expanding their balance sheet capabilities to invest in B-pieces and/or filed for their own lending shelves (ability to issue bonds directly instead of having to go through outside broker dealers). Lenders that were traditionally only in the securitization business, aka, the “moving business,” have entered the balance sheet lending business, aka, the “storage business.” These same lenders that focused mostly on fixed-rate loans in the past are now closing floating rate loans with regularity.
Additionally, the early 2016 pullback in the CMBS market gave a market share boost to banks and life insurance companies which are less susceptible to capital market swings. The ground that they gained is unlikely to be given back, especially if the Trump administration is successful at repealing Dodd-Frank which will make banks more profitable in the short term.
PREDICTION: THE BIG WINNER IN 2017 WILL BE BORROWERS. WHETHER OR NOT DODD-FRANK IS REPEALED, BALANCE SHEET EXPANSION UNDERTAKEN BY FORMER “SECURITIZATION-ONLY” LENDERS WILL LIVE ON AND BE A HUGE POSITIVE FOR BORROWERS. IT WILL RESULT IN LESS RE-TRADING ON FIXED-RATE LOANS (IT’S HARD TO BLAME THE B-PIECE BUYER IF YOU ARE THE B-PIECE BUYER!) AND MORE BRIDGE LOAN AVAILABILITY, ESPECIALLY OF THE BRIDGE-TO-PERM VARIETY.
