The Repricing of Risk in Commercial Mortgages

By Cynthia A. Hammond, President, Churchill Commercial Capital, Inc.

Tumultuous – this is the best word to describe the credit markets over the past weeks and months. Easy money for commercial properties is gone. Lenders are re-evaluating risk, and tightening their underwriting of loans. This credit tightening means lower loan dollars, higher interest rate spreads, and a flight to the higher quality properties and borrowers. What is happening, to whom, and why?

The commercial mortgage market is comprised of over $3 trillion loans originated by commercial banks (43% of the total), securitized loans (includes Wall Street conduits) at 22%, life insurance companies (9%) and agencies (Fannie Mae, Freddie Mac, Ginnie Mae) at 7%. Securitized conduit loans are made up of individual commercial mortgage loans that are aggregated into a pool, divided up into sections given a certain risk rating, called “tranches”. These tranches are rated like a bond, from the least risky AAA rated piece to the most risky unrated, or “B” piece. The bond is then sold in the commercial mortgage backed security (“CMBS”) market (called securitizing the loans). The buyers of the highly rated, least risky bonds include the life insurance companies, and the buyers of the unrated B pieces have historically included many hedge funds.

Over the last few weeks CMBS trading has experienced rapidly widening spreads, fewer buyers, and in some cases, no buyers for the riskiest piece of a CMBS transaction. Widening spreads are causing CMBS lenders’ breakeven interest rate spread (the lowest interest rate spread at which they can write a loan and make a profit when they securitize it) to rise daily. The spread on the least risky AAA rated CMBS bonds have risen by 35-41 basis points (.35% - .41%) in three securitizations that were priced the week of August 6th. Beginning in late July, and continuing on into August, markets were so tumultuous that many lenders ceased quoting interest rates or circling (“fixing”) a rate on certain days – and many are still on the sidelines, not yet quoting
loans. This turmoil is reported to have caused four major conduit lenders to delay scheduled securitizations until the CMBS market regains some stability and liquidity.

What are the causes? The much publicized subprime mortgage fallout caused investors to scrutinize the credit analysis behind the loans that are the collateral for commercial mortgage backed securities. Investors thought that maybe the excesses of the residential subprime market may have seeped into the commercial arena. Buyers of the AAA CMBS bonds criticized the rating agencies (Standard & Poor’s, Moody’s and Fitch), who assign risk ratings to a CMBS bond, for being too lax in their analysis. Rating agencies listened to this criticism. In February, Fitch issued a statement criticizing lenders for underwriting future property cash flow prematurely. In April, Moody’s announced that they would be increasing subordination levels on future CMBS transactions. This means that a greater portion of a particular CMBS deal will have a lower credit rating than before: lower rated credit trades at a lower price and at a higher interest rate. If the conduit lender made loans assuming a greater portion of their securitization would have higher credit ratings (and sell for higher prices), then this change means they may lose money on the securitization. Buyers of CMBS bonds immediately started requiring higher yields on their investments as a result of the rating agency pronouncements. In the last month, certain CMBS securitizations found lenders unable to sell large chunks (“tranches”) of the portfolio of loans that comprise a securitization. The buyers of the “B” or unrated tranches of the securitization have been “kicking out” loans that they deem to be too risky, and essentially telling the seller of the securitized transaction that they won’t buy any of the unrated tranche of the bonds unless those loans are removed. This action removes all of the present profit from that group of “kicked out” loans for the CMBS lender who originated the loans, and potentially results in losses from those loans.

What does this mean for the commercial real estate mortgage broker?

Loan underwriting is now more conservative. Ten year full term interest only loans are not in the cards, unless you have a low leverage (under 50% loan to value) loan. Underwriting rent increases several years into the future to calculate today’s net operating income is no longer acceptable. Interest rate spreads are rising among both CMBS lenders and life insurance companies – life insurance companies have to look at alternative investments, which include corporate bonds and CMBS bonds, whose rates have risen. The loan that priced at a 125 spread six weeks ago is today being priced at a 200 spread.

Choosing your lender is key. Portfolio lenders, like life insurance companies and banks, are able to keep their loans on their books; they don’t need to sell it. So once they fix an interest rate, generally the borrower is likely to be able to close that loan without it being subject to repricing due to volatility in the capital markets. Conduit lenders all have clauses in their applications that give them the ability to re-price or pull a loan due to a material adverse change in the capital markets. We are experiencing now this “material adverse change”, and a securitized lender cannot confidently fix a rate until the market volatility is reduced. Some conduit loans are being re-priced, or turned down.

This turmoil will subside and the markets will settle. The million dollar question is “when?” Vacations are underway in the offices of many CMBS market participants. September should see desks re-staffed, which should help increase liquidity in the credit markets. In the long run, this turmoil and a move toward more prudent loan underwriting will help prevent overbuilding and loan delinquencies in the commercial property markets, which will help all of us in the industry.

Sources:
Mortgage Bankers Association – Press Release –Debt Outstanding.
Source information from one of our lenders, their source was Trepp.