Risk Retention Clarity is Key to CMBS Future
The volume of commercial mortgage-backed securities (CMBS) issuance this year is running at about half of 2015’s level, for reasons that go beyond the disruption in global capital markets. CMBS sponsors are struggling to contend with new risk retention rules that go into effect in December. But as of now, it’s still not clear exactly how lenders can comply with the new rules. That lack of clarity is doing more to slow CMBS volume than the rule itself.
Let’s be clear: Risk retention is not a bad idea for the CMBS market, if it’s done right. In any debt arrangement, the entity that assesses and prices the risk should be on the hook if things go wrong. When CMBS loan originators knew they could flip loans for a quick profit with no residual risk, it was inevitable that the underwriting process would get sloppy and default rates would rise. The new law is designed to motivate lenders to underwrite conduit loans as if they were portfolio loans; because, in a way, they are.
Risk retention is mandated by Dodd-Frank, the set of financial reforms passed by Congress in the wake of the Great Recession. Starting in December 2016, CMBS sponsors must retain a 5% stake for at least five years without selling or leveraging the assets, or find one or two third-party entities to take their place. The retained portion is called the B-piece because it’s below institutional grade. B-piece investors lose all of their investment before the holders of high-grade securities lose anything.
In the past, B-piece buyers were hedge funds and other opportunistic capital sources who made money by quickly reselling their investments at a profit. These funds are set up to net high yields in a short period of time, so a five-year hold requirement generally doesn’t work for their investment model. Some private equity funds are being formed to acquire B-piece investments, but their investors will expect higher yields to offset not only the longer risk period but the additional cost of performing due diligence on loans.
If hedge funds are out of the B-piece investment game, who will take their place? Life insurance companies usually stick to permanent loans with low loan-to-value and high debt service coverage ratios; their most severe real estate losses in the past 10 years have come from higher-risk investments like CMBS B-pieces, so they’re unlikely to dive into the market. The most likely players going forward are banks, many of which are already originating CMBS loans. Syndicates comprised of multiple banks are being formed to spread out the risk of any one bad CMBS deal.
Whatever the source of B-piece financing, buyers will perform more intense due diligence than in the past, and will kick out loans that fail to meet their stringent risk criteria. As a result, CMBS won’t be the best execution for borrowers as often as it has been in the past. More deals will be done directly with banks, life insurance companies and, in the multifamily sector, Fannie Mae and Freddie Mac.
Whatever solution the market arrives at, it must come sooner than later. CMBS should be a significant—but not dominant—player in the commercial real estate debt market, accounting for about $100 billion in average volume. But if the risk retention issue can’t be resolved, annual volume could be closer to $50 billion going forward. If that happens, a lot of borrowers will find it difficult to finance or refinance their properties.