July 1, 2013
The commercial mortgage-backed securities market is back, with investment levels not seen since the last market peak. Current yields are strong compared to many investment types, and loans originated in the past three years are showing no signs of delinquency.
Yet, analysts are already expressing concern that underwriting standards are starting to ease, and may continue to slip as more and more originators enter the fray. As underwriting standards bend to the more aggressive side, b-piece investors will want to kick out loans that they view as too risky, and banks have been resistant to any kick-outs in recent years. It is a balancing act for originators, underwriters and investors to compete aggressively in a rising market without crossing the invisible line into territory where returns don’t match the risk profile.
CMBS Issuance by Year
Source: CREFC Compendium of Statistics
Can institutional investors make the most of the current favorable conditions without losing sleep over the potential downside of an overheated market? The answer is yes—if they put the right practices in place to minimize exposure to risk.
CMBS investment is hotter today than it has been for years. Issuance in the first half of 2013 is expected to top $39 billion, compared to about $15 billion during the same period last year. Analysts in January predicted this year’s volume to far outpace the $48 billion issued in 2012.
Delinquencies on CMBS 2.0 (post-2009) loans have held at a low 0.03 percent overall, according to Fitch Ratings Index Report. However, investors don’t need a good memory to know that loans can go south; Fitch reports that there are $9.3 billion in delinquent loans that have already matured, and another $20.9 billion in current delinquencies on loans maturing after 2013, most of them originated during the last market upsweep.
It may be wishful thinking to assume that investors have learned the lesson of due diligence. Market analysts observe that loans originated in the second quarter of 2013 allowed higher levels of leverage than the market has seen since 2008 and more borrowers are opting for riskier interest-only loans. Some loans on properties in primary markets are engaging in pro forma underwriting, where future increases in property revenue are assumed in the underwriting.
According to Standard & Poor’s, more than half of second-quarter volume came in the form of conduit/fusion transactions that carry greater levels of risk than CMBS product originated in the past three years—and are measurably riskier than conduit/fusion deals originated as recently as the first quarter.
“The risks associated with continued deterioration in loan standards this year, especially in recent deals, could eventually lead to higher loss rates,” S&P stated in a recent report. “Too many investors are unfazed by the credit drift, largely content that anchoring to existing cash flow obviates risk along other dimensions.”
Investors need to remember that the success of any CMBS investment is based on both the buy and the sell. Investment would be simple if the market could be counted on to remain the same in the future as in the recent past; however since market dynamics are always changing, the smart money has an exit strategy in mind when making an investment.
Here’s a basic five-point plan for developing an investment strategy that allows you to ride the wave of good yields today while minimizing downside risk at the back end:
The best way to combat this “risk creep” is to set your own standards and draw your own line in the sand from the outset. Later, in the heat of battle, it may be difficult to back out of a seemingly rising market. But developing a solid strategy and a backup plan—and summoning the discipline to follow that plan when it becomes necessary—will help ensure that you’re not caught in a sudden market contraction down the road.
About Jack Mullen of Summer Street Advisors:
As Founder & Managing Director of Summer Street Advisors, Jack Mullen leverages decades of experience in valuation, underwriting, and risk management to lead multi-million and multi-billion dollar CRE transactions.
Previously with GE Capital and large institutional banks, he has shaped investment strategies for some of the industry’s largest deals. A recognized leader, his insights are featured in GlobeSt.com and CREFC Finance World, and he is a sought-after speaker at industry conferences and top universities.
For strategic advice on your portfolio or transaction, contact:
jack.mullen@summerstreetre.com
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