Heartland Real Estate Business

FEB 2018

Heartland Real Estate Business magazine covers the multifamily, retail, office, healthcare, industrial and hospitality sectors in the Midwest.

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www.REBusinessOnline.com Heartland Real Estate Business • February 2018 • 23 2018: YEAR OF TRANSITION FOR CMBS INDUSTRY A rising interest rate environment, plus an expected slowdown in refinancing will likely put a crimp in annual volume after $90.5B of private-label issuance in 2017. By Catherine Liu and Karina Estrella A s a result of new Dodd- Frank risk re- tention regulations that went into effect in December 2016, last year was widely considered to be a pivotal period for the CMBS industry. Formulated to hold banks more account- able for their own investment decisions and place a greater emphasis on col- lateral quality, the regulatory provi- sion imposed higher capital charges on sponsors by requiring them to retain a 5 percent interest in an asset-backed securitization. The mandate fueled concerns that CMBS would become less competi- tive compared with other commercial real estate lending sources, leading to speculation of a potential slowdown in interest among investors, a reduc- tion in market liquidity and higher borrowing costs. In short, the rules require issuers to retain a portion of the credit risk in their own transactions. This is accom- plished by setting aside additional capital that amounts to 5 percent of the value of newly issued bonds on their balance sheets. There are three different methods of fulfilling the retained risk require- ment, which take shape in the form of one of three structural options: a hori- zontal slice equal to 5 percent of the lowest bonds in the deal waterfall, a vertical slice that amounts to 5 percent of each tranche in the deal, or an L- shaped (also called hybrid) structure that combines the other two holding strategies. Although sponsors can sell the hori- zontal slice to a B-piece investor, they are not allowed to hedge or transfer the retained risk throughout the term of the transaction's life. Surpassing expectations Despite the new regulation, private- label CMBS issuance for 2017 ultimate- ly soared well above initial projections and exceeded the prior year's volume. New issuance was buoyed by an influx of single-borrower deal activity and capped off at roughly $90.5 billion. Various factors contributed to a more energized CMBS market in 2017, such as interest rates remaining at his- toric lows, tighter bond spreads, and issuers' growing comfort with risk re- tention rules. CMBS deals with the horizontal risk retention structure made up 44 per- cent of the year's securitizations as the dominant structural type, with $40 bil- lion across 60 deals. Vertically structured deals followed close- ly behind with $37.6 billion across 61 deals, or 42 percent of the year's balance. Deals under the L-shaped risk reten- tion category com- prised the remain- ing 14 percent. Driven mostly by heavy deal flow on trophy skyscrapers in major metro- politan areas, office loans made up the largest portion of total issuance with $26.5 billion, or 29 percent of volume. New hotel/lodging issues amount- ed to $25 billion, or 28 percent of the total volume, bolstered by the rising trend of consolidation and expansion strategies in the hospitality segment. Unsurprisingly, the retail sector took a significantly smaller share than in previous years with just 13 percent of 2017's issuance balance. Investor sentiment toward retail was particu- larly tepid after a turbulent year high- lighted by a slew of big-box bankrupt- cies, struggling Class B and C malls, and shifting consumer fundamentals. Rounding out the major property types, mixed-use loan issuance grew to $11.4 billion (13 percent of the 2017 total) while multifamily and indus- trial accounted for roughly 6 percent and 3 percent of the new issue pipe- line, respectively. Overall, total issuance in 2017 in- creased 28.1 percent over the prior year's tally of $70.6 billion. Despite this significant growth, many believe that issuance is still running below the expected pace, considering that some $110 billion in CMBS loans was slated to mature in 2017. Last year also marked the end of the "wall of maturities" period as the large wave of more than $300 billion in CMBS loans issued between 2005 and 2007 was scheduled to come due as part of the 10-year term structure. Drop in issuance projected As the amount of loans that will be up for refinancing winds down, 2018 will act as a major turning point for the sector since the maturing balance drops off to a total of $30.3 billion this year. Consequently, private-label CMBS issuance is expected to decline to an approximate range of $60 billion to $65 billion in 2018. In 2017, roughly $86.6 million in CMBS loans were resolved or paid off in any manner, bringing the dis- position total for the wall of maturi- ties period to $294.3 million. A little more than 12.7 percent of the retired balance from loans liquidated in 2017 incurred a loss, translating to an aver- age loss severity of 42.4 percent across all property segments. With just $18.5 billion in 2017 loan maturities still outstanding based on underwritten maturity dates, the sec- tor has made much progress in paying off or refinancing the large volume of maturing debt thus far and will con- tinue to fulfill the capital needs of its participants. When it became clear that risk reten- tion was not going to serve as a major hindrance to CMBS activity, as many of the initial concerns surrounding it did not materialize, the regulatory require- ment did introduce several profound changes to the securitization landscape following its implementation. For starters, risk retention caused a number of smaller players that could not afford to hold large balance sheets or the costs of regulatory compliance to exit, which has reduced the size of the CMBS investor base. As a result of the consolidation of CMBS market participants, lenders have also been increasing their use of single-borrower transactions and split loans to minimize leverage and their overall pool exposure to weaker per- forming assets. This has led to greater dispersion of credit quality and pricing within a transaction, otherwise known in the industry as credit barbelling and price tiering. The risk retention requirement did positively contribute to strong inves- tor appetite and considerably tighter spread pricing on new issues. This has resulted in sizable yield rates for issuers, aided by a reduction in over- all supply, minimal volatility, and the market perception that credit quality has increased with additional sponsor and third-party involvement. Challenges, opportunities Looking ahead, the CMBS indus- try faces several headwinds in 2018. Many of the concerns stem from ris- ing interest rates and the Federal Re- serve's self-imposed downsizing of its balance sheet, which could further reduce liquidity. Other hurdles include a lower vol- ume of maturities in need of refinanc- ing, signs of overbuilding in certain commercial real estate property sec- tors, slowing rent growth and prop- erty value fundamentals, along with the sustained pushback in reform ef- forts to curtail the regulatory burden of current Dodd-Frank rules. On the other hand, borrowers seek- ing to lock in low rates should help boost the volume of CMBS issuance. Meanwhile, a growing number of yield-hungry investors tied to large projects too capital intensive to fi- nance via other lending vehicles will likely turn to CMBS. The lower tax rate stemming from the recently passed GOP tax legisla- tion will provide additional incentives to partake in acquisition and develop- ment activity, while spreads are expect- ed to hold steady. Meanwhile, CMBS will continue to distinguish itself as an increasingly attractive source of com- mercial real estate financing. Catherine Liu and Karina Estrella are research analysts with Trepp LLC based in New York City. Founded in 1979, Trepp provides data, analytics and technology solutions to the global securities and investment management industries. Private-Label CMBS Issuance by Year The volume of private-label CMBS issuance rebounded in 2017, reaching nearly $90.5 billion, up 28.1 percent over the previous year's total of $70.6 billion. Source: Trepp LLC 100 90 80 70 60 50 40 30 20 10 0 2012 2013 2014 2015 2016 2017 $Billions Catherine Liu Trepp Karina Estrella Trepp

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