By Shawn Hill
When it comes to the commercial mortgage-backed securities (CMBS) market, self-storage investors should expect the unexpected in 2016. Since its inception, CMBS has seen its share of volatility given its reliance on capital markets, which are inherently tied to global risk. Current macro-economic market conditions, including declines in oil prices, concerns over short-term liquidity, U.S. election-year uncertainty 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 mortgage spreads.
In the short term, borrowers may find bank and insurance products more compelling, given these executions don't rely on the capital markets. In the long run, however, as these institutions approach their annual allocations and evaluate the market, their spreads will likely widen as well.
Although dislocated, CMBS serves a niche and currently represents nearly 20 percent of all outstanding commercial mortgage loans, according to the Mortgage Bankers Association’s (MBA) Commercial/Multifamily Quarterly DataBook. Volatility is nothing new for CMBS. After hitting peak issuance levels approaching $225 billion globally in 2007, the financial crisis and ensuing lender bailouts set the table for a dismal stretch that effectively shut the market down from 2008 to 2010. Ultimately, the market recovered and CMBS regained significance thereafter, including a near tripling in issuance from 2011 to 2014.
CMBS issuance in 2015 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. According to the “Commercial Mortgage Alert” newsletter, through Feb. 26 of this year, 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 CMBS players have continued to wade the choppy seas, some were stalled by volatility and widening pricing in the second half of 2015. Even if the capital markets stabilize, CMBS lenders face regulatory challenges with new risk-retention rules that will be implemented toward the year’s end, which are likely to result in upward pricing adjustments. Borrowers should expect increasing costs of capital across the board. For those with near-term debt maturities, now’s the time to consider your options. Simply put: The cost of debt is rising.
CMBS are bonds backed by the cash-flow stream from commercial mortgages. The transaction begins when lenders originate loans with the express intent of contributing them into a structure that allows the cash flows from mortgage payments to be rated and sold to investors as bonds. This process is referred to as securitization. Once the bonds are securitized, capital is returned to the lenders, who can then redeploy it to make more loans. The CMBS structure enables capital to flow efficiently between borrowers, lenders and investors, hence the name "conduit" given to these lenders.
Conduit lenders have historically provided significant sources of volume and liquidity to the commercial real estate market. Per the third-quarter 2015 MBA DataBook, CMBS and other securitized products comprise approximately 20 percent of the $2.76 trillion in outstanding commercial-property debt. Balance-sheet lenders simply don’t have capacity for all that debt; CMBS-generated liquidity is extremely important to the health of commercial lending.
Choppy Seas in the Interest-Rate Forecast
The interest rate a borrower is 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 in CMBS is typically the higher of the like-term Treasury bond or like-term swap-side offering. These instruments trade daily and can be found easily online.
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 specific to the loan in question. These micro considerations include property type, location and borrower strength in addition to economic factors such as underwritten leverage, debt-service coverage ratio (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. In times of heightened volatility, it’s difficult to predict market movement during the 45- to 60-day processing period. This unpredictability will impact the final rate on the loan because of underlying movement to the index or 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 factors such as uncertainty in foreign economies (China), plummeting energy prices and concerns about short-term liquidity. This has heightened scrutiny toward CMBS. Fixed-income investors are currently selective about their investments and yield targets, causing CMBS spreads to widen sharply. This creates headwinds for CMBS lenders when pricing and executing loans.
Additionally, with nearly 40 actively originating CMBS lenders, there’s no dearth of competition for new loans, which are met with dampened demand for CMBS bonds. This function of supply and demand will ultimately lead to a survival of the fittest. CMBS lenders with lower costs of funds and diverse lending products are better suited to survive. Some have already made an exit, and more may surface who can’t stay afloat.
Successful CMBS lenders will counteract the perceived risk and relative value of their bonds by increasing the yield to investors, effectively making them more attractive on a risk-adjusted basis. This is accomplished by increasing the risk-spread premium on loans to make the yield more attractive to bond buyers. Unfortunately, however, widening loan spreads typically mean increased borrower costs by means of higher interest rates.
Changing Tides in a Regulatory Sea of Change
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) was signed into federal law by President Obama on July 21, 2010, in response to the Great Recession. This legislation brought the most significant changes to financial regulation in the United States since the regulatory reform following the Great Depression. The resulting changes in America’s financial-regulatory environment affect almost every constituent of its financial-services industry. Although this sweeping legislation was passed in 2010, many of the regulations resulting from Dodd-Frank are being slowly implemented in the coming years.
For CMBS, regulations center on two hot-button issues: liability and risk-retention. With new regulation for lenders—particularly CMBS—comes additional perceived risk, inefficiency and nuisance, which will invariably cause cost increases for CMBS lenders. It seems only logical that these increases will be partially, if not fully, passed along to consumers through increased credit spreads and consequently higher borrowing rates.
Charting a Path for Safe Voyage
There exists a large pipeline of CMBS loans that will mature in 2016 and 2017, given nearly $600 billion of issuance that occurred during 2005 to 2007, most of which included 10-year balloons. Balance-sheet lenders simply don’t have the capacity to refinance all that debt. Thus, much of this loan volume will likely 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 and are difficult to duplicate. The following outlines CMBS deal points that borrowers typically find attractive:
- The debt is nonrecourse.
- There are 10-year, fixed-rate terms. Borrowers who are weary of rising rates can lock in their rate longer than the five-year terms typical of bank debt.
- There are 30-year amortization schedules. This compares favorably to the 20- to 25-year amortization common in balance-sheet deals.
- There’s higher leverage. Borrowers can routinely achieve up to 75 percent loan-to-value.
- There’s aggressive cash-flow underwriting. Debt-yield minimums of 8 percent and DSCR of 1.25x are common.
- CMBS lenders often allow a “cashout.”
Finally, these lenders are more willing to understand “hairy” deals or those with a “storied” history related to the borrower, market or property. This includes opportunities in secondary markets and less mainstream property types. According to data and analytics firm Real Capital Analytics, CMBS constituted 16 percent of all commercial mortgages originated in 2015. Of that sample, 28 percent funded in tertiary markets, 32 percent were secured by hotels and 28 percent were obtained by retail. In summary, while they prefer larger loans in core markets, many CMBS lenders are comfortable thinking and lending outside the box.
Finding the Silver Lining
Despite navigational challenges on the horizon, CMBS remains a viable and important source of capital for self-storage borrowers. While it’s difficult to predict what’s in store going forward, borrowers equipped with the proper knowledge and navigational guidance will be better positioned to traverse the choppy waters. Volatility will be passed through higher borrowing costs that are likely to bounce around throughout the origination process. Working with lenders and brokers who are familiar with these concepts and can provide transparency and explanation for the market movements will help craft a positive experience.
Based in Chicago, Shawn Hill is a principal at The BSC Group, where he advises clients on debt and equity financing and loan-workout services for all commercial property types nationwide, with an emphasis on the self-storage asset class. For a succinct summary of terms available by loan program, Shawn can be reached at 312.207.8237 or email@example.com. For more information, visit www.thebscgroup.com/loan-programs.php.