Simple RE

CMBS and Credit Spreads

According to several lenders I've been in contact with spreads on CMBS or conduit loans are now in the 250 basis point range.  This is up from a low of around 100 basis points earlier this year.  Although I've talked about swap spreads here before, the most recent action has been with the movement in credit spreads.  What I'm asking and everyone else is asking is, "Where are spreads (and rates) going and how fast are they going to get there?"

Here's my thinking: 

1. There was an unusually high number of b-piece buyers in the market in Februrary and March of this year and spreads were getting unreasonably low at the same time that lenders were getting more aggressive with their terms and looser with their underwriting standards.  As an example we closed an 80% LTV loan with 10 years interest-only at around 120 over the 10 year treasury in February of 2007.  As long as the b-piece buyers were in the market buying the bonds the lenders were happy to push the risk envelope on their loans.
2. The sub-prime meltdown starts in May 2007 and many b-piece buyers get hurt.  Many of these buyers were banks from around the globe who were trying to boost their yields and get outsized profits by purchasing the lower-rated CMBS.  This is important to note because these buyers are not typically market participants.  However, their added participation and aggressive buying caused credit spreads to sink to unreasonably low levels.
3. Once the bond buyers started getting hurt they pulled out and spreads widened. Conduit lenders are still taking losses because they can't profitably sell the b-pieces of their loans or they can't sell them at any price and are carrying the first-loss pieces on their books.
4. Many conduits stop originating, which means less competition for loans.
5. Underwriting standards tighten: less IO, higher debt coverage requirements, fewer earn-outs, lower LTV.
6. B-piece buyers are coming back into the market, but in smaller numbers. 

The combination of the more conservative underwriting and the improved liquidity afforded by b-piece buyers indicates to me that spreads are going to come back down. I'm targeting credit spreads under 200 bps by the second quarter of 2008.  Eventually I think we'll be down around 160, but I'm very uncertain about the timing.

Brad Anderson, a CMBS originator at Wells Fargo and all around good guy, pointed me to the recent purchase of AAA rated bonds by Wells Fargo. This is another indicator that tells me that spreads are going to come down.  It seems that Wells thinks the yields are high and the bonds are cheap.  They are betting that the bond prices will go up on tighter spreads in the future.

So, what is a property buyer to do?  IMHO, I believe that one should look at the many portfolio products that lenders are coming out with before jumping into a CMBS deal.  This means more work on the part of the borrower because your favorite CMBS loan correspondent may not quote you anything but the on-balance-sheet program that his/her home institution is offering.  Also, as many have commented, life insurance companies may be a good alternative for fixed rate, non-recourse financing.

Quick CMBS Update

This was sent to me today from Brad Anderson of Wells Fargo:

"The market saw significant tightening in CMBS AAA’s.  The tightening was all due to secondary market trading, not new CMBS issuance.  The tightening related to a positive September jobs report coupled with a major revision of the August report which also drove the 10-year U.S. Treasury up seven basis points.  Some feel that the credit spread rally was exaggerated, since spreads have tightened considerably over the last few weeks.  However, we should have price guidance on a TOP pool this week to get a better sense of pricing for new issuance.  While good economic news has had a positive impact on CMBS credit spreads, it has had a negative effect on bond yields.  It seems like all-in interest rates have maintained equilibrium over the past couple months due to what has become an inverse relationship between CMBS spreads and the U.S. Treasury index."

The bad news is that the all-in rate hasn't improved.  The good news is that as more CMBS pools are priced, lenders have a better sense of breakeven and spreads will stabilize.  With stable spreads borrowers have a sense of what their financing cost is likely to be over a 3 - 6 month period and the real estate markets will be better able to factor in the cost of capital when valuing deals.

Swaps - How They Affect Conduit Loan Pricing

If you've financed property with a conduit loan, you have heard the people at your originator of choice talk about swaps, swap spreads, and that they can impact the interest rate you will pay on your loan.  I wanted to know more about swaps and now that I have some answers, I thought I'd share with you.  The information here is pulled from two sources: an email interview I had yesterday with Damon Reed of Capmark Finance (Capmark bought GMAC Commercial Mortgage over a year ago), and from the Bridger Funding website.

Damon Reed explains the pricing process: "In the past, lenders would determine what breakeven pricing was and then add on [their] profitability to the spread along with any other add on’s (I/O, forward rate lock, etc.)  “break-even” would move as deals sold in the market and as swap rates moved up or down.  Generally, as swaps increase, your spread increases on a one for one basis.  Today, some lenders are quoting deals over swaps [rather than over treasuries] due to the volatile market."

Background on Swaps From the Bridger Funding Website: (See the source here)
Swaps -- also known as interest rate swaps -- are an important determinant in the pricing of most fixed-income instruments, including Commercial Mortgage Backed Securities (CMBS). Swaps are a security that most financial institutions utilize to manage interest rate risk. Interest rate risk reflects the potential impact that movements in general interest rates (e.g., U.S. Government Treasury Securities) will have on the value of fixed-income securities. For instance, as interest rates increase, the price (value) of fixed-rate bonds tends to decrease (at higher amounts for longer term bonds).

Swaps are agreements that reflect the notional exchange of fixed-rate interest payments for floating-rate interest payments. This allows an institution to hold a floating rate security, for instance, but effectively receive a fixed-rate of interest for the like term. Although there may be a cost to hold the hedge in place, the "insurance" premium is worth it to most institutions. While the physical exchange of interest payments doesn't necessarily take place, the market price of a swap contract fluctuates in such a manner as to emulate the exchange of payments. The market for swaps is very deep and liquid, and exists because different investors have different views of the direction of interest rates -- not to mention different exposures to rising or falling rates.

The swap yield, or rate, is the fixed-rate of interest paid (or received) in an interest rate swap contract. This yield is equal to the like-term U.S. Treasury Security yield plus a "risk premium", which is referred to as the "swap spread". Think of the swap spread as a generic risk premium that the market prices in to fixed-income securities to compensate for general interest rate risk. CMBS bonds, like most asset-backed bonds, are priced not just over like-term Treasury Securities, but swap spreads as well (in addition to asset-specific credit spreads to account for perceived risk of the subject asset class).

If swaps are an important determinant of CMBS value, why aren't they used more often as a benchmark in quoting CMBS conduit loans?
While larger CMBS conduit loans are often priced over swaps, the traditional practice of the industry has been to index their loan spreads only over the like-term U.S. Treasury Yield (with an increasing caveat explained in the loan application that allows for adjustments to the interest rate based upon swap spreads). The Treasury yield remains the most popular loan pricing index because it is a very relevant determinant of CMBS bond yields, and tend to be more volatile than swap spreads or CMBS-specific credit spreads. In addition, Treasury yields are better understood by many property investors, who find that it’s easier to locate the current Treasury yield in newspapers and web sites (although a few sites, like BridgerFunding.com, also display swap spreads.)  Find swap spreads here.

How can swap spreads affect your mortgage interest rate?
Sustained increases in swap spreads usually result in lenders’ raising their loan spreads (and/or inserting language in the loan application that adjusts the interest rate for future changes in swap spreads). In addition, if your loan’s interest rate has not been locked, an increase in swap spreads could have a material impact on the value of your loan. Accordingly, in rare circumstances the lender may work with you to adjust the interest rate when it is locked to offset some of the decline in value. The impact of changing swap spreads affects all mortgage players equally.

What factors tend to cause swap spreads to increase?
Typically, interest rate swap spreads will rise with Treasury yields. This is especially the case when the market starts to perceive that higher Treasury yields may last for a while. As interest rates start to rise, the value of fixed-rate bonds decreases, which tends to increase interest rate swap spreads. In other words, the generic risk premium expands in the face of expectations for rising rates. In addition, swap spread movements can be exacerbated by the aggregate impact of asset-backed security hedging, which often becomes acute with quick jumps in interest rates.

As Mr. Reed said when he referred me to the Bridger information, "This will give you some color on swaps, but again it doesn’t help you in today’s market because we are just guessing where break-even is today.  Until all the stacks of a CMBS sells in the market, spreads will continue to be a guessing game.  I expect this to flush out next month as most of the supply will be gone."

In the interest of full disclosure - I've done many deals with Damon, and a few with other originators. I have a sense of what kind of service is standard in the market.  Damon and his team go well beyond "standard"; they have executed far better than any lender I've worked with.  That's why I went to him to help me with this post. That's why I'm plugging him and his team. And that's why we keep doing deals with him even though we are in California and he is in Birmingham, Alabama. If you are looking to do a CMBS/Conduit loan I suggest you give them a shot at your business.

Assumption Update

Let me first say that the head of the Transactions Group at Key Bank, Peggy S., is a gem.  Since getting involved with our file she has been extremely responsive and is a very reasonable person.  I sincerely enjoy working with her. 

She clarified with me today that they don't have an issue with our Buyer assuming the loan. They are happy to recommend him.  They only have an issue with him self-managing the property. 

So, here's the learning point.  When dealing with a Conduit Loan/CMBS loan, the Special Servicer is looking for an experienced third party management company or a self-managing buyer who has experience operating the same type of property, preferably in the same market area. It doesn't really matter if they have other relevant experience if it doesn't fit into their narrowly defined box.

They are willing to reconsider their position in 18-24 months after the buyer has some experience with the property.  She commented that if the DSCR stays strong and the property continues to perform well, a request to self-manage at that time would likely be approved.

As you can tell, my tone is a lot less frustrated today. I have renewed hope that we will get this deal done.

Conduit Loan Assumption - The Ongoing Saga With Key Bank

In a previous post I talked about the challenges I was having with Key Bank in getting an assumption approved so we could sell a portfolio property.  My dealings with Key improved briefly, and then they got much worse. 

Let me explain.

My original frustration was that they were moving so slowly.  On 8/15/07, the day after my last post about this matter, I started calling around to see if I could get an ally within Key Bank to exert some pressure.  To my pleasant surprise that same day I received a call from the head of the Transactions Group in Dallas before any of my acquaintances within Key had a chance to call or email them.  It turns out that the management is competent and had, on their own, realized that my file was languishing and reached out to me to assure me that they were prioritizing it.  They told me that it would soon be passed from their hands into the hands of the Special Servicer.  In fact, they said it should all be written up and passed along by Monday, August 20th.

So far so good.  I had a smile on my face.  I couldn't believe my good fortune. 

But then things took a turn for the worse.  On Monday the 20th both the Buyer and I get a last minute request for some additional information.  I was perturbed because it was information that they could have requested weeks ago if only they had reviewed the file more carefully at some point in the first 14, 21, or even 30 days. 

Now today, a week later, our underwriter calls the Buyer to tell him she is not inclined to approve the assumption.  I'm blown away.  Her reason is that the Buyer doesn't have the experience needed to make her comfortable with him doing his own property management. 

Did I mention that they have had the Buyer's resume and a description of his professional experience for about two months now?  How is it that they are just now concluding that the Buyer is not sufficiently qualified to operate a small commercial property? 

What does an unqualified buyer look like you might ask.  In this case our unqualified buyer is in his late fifties or early sixties.  He has been a real estate investor most of his career.  He has made most of his money in single family homes, and although not commercial property, he has had the organizational ability and professional savvy to buy and sell hundreds of homes and most recently maintained a portfolio of 42 homes in two states, CA and TX.  He mastered the landlord/tenant laws in two states sufficiently to stay out of trouble with his tenants and keep his properties rented.   He has fee managed other peoples SFR investment properties. He has amassed enough personal wealth that he would qualify as an accredited investor.  He is also a real estate broker in California and Texas.  He manages a staff of several employees while running his own brokerage and investment business. 

Not only that, but should the deal close, he will have nearly five times the cash equity in the deal than our current partnership. 

If I were the lender I would be rejoicing.  Key Bank has a performing loan on a property that has gone up in value improving their LTV position.  Rents have been substantially increased so the property's DSCR is much higher now than when they underwrote it.  And they have a person of substantial means and good credit who wants to step in and replace our paper gains with his own real cash equity in the deal. 

I just don't get it. I pray that reason will prevail.

If you're reading this and think I'm missing something, please email me or comment and let me know. I'll take all the help I can get.

Conduit Loan Assumption Nightmares

Like I mentioned in a previous post, when dealing with a conduit loan assumption you should expect it to be more hassle and take longer than you think it should.  I felt prepared for that.  However, dealing with Key Bank on our current deal is maddening.  We originated the loan with Column Financial, and Key Bank is the Master Servicer. The deal calls for our buyer to assume our existing financing.

When we first submitted the application for the assumption we planned on closing the deal by the end of August.  Thankfully our buyer (the assumptor) is very motivated to close the deal and has been very prompt in providing all of the requested documentation about himself and his entity. 

After several phone calls and emails looking for confirmation that we were on track for an end-of-August close, I finally received an email saying that closing in August will be impossible.  I called again this morning to find out what the new timing would be (of course Key Bank didn't include that vital bit of information in the original email response).  I looks like we are more likely close around the end of September.  The explanation for the delay... there are other borrowers with looming exchange deadlines.  Pam, the rep I've been working with hasn't been able to get our package together to submit to the Special Servicer who is the second step in the assumption process.  AAAARRrrrrggggg! 

OK, so lets assume you are in my shoes someday.  What should you do?  Here's some suggestions.  I'll let you know how they work.

1. Create urgency.  Since I don't have a looming exchange deadline, I'm going to tell them that my buyer's resolve is wavering and they better not make me lose the deal.   
2. I'm going to contact our rep at Key Bank who works in origination (not servicing) and see if he can exert some pressure. 
3. I'm going to contact the head of Key's Conduit Lending group here in the West, Louis Weisman, and see if he can help me.  Key originated a $5M loan on a self storage property we acquired in 2005 and Louis wants to put the permanent financing in place now that the property is leased up. Hopefully he'll see helping me as getting a leg up on the competition. 
4. I'm going to talk to the correspondent lenders who originated the loan and see if they can exert any influence even though they are not with Key Bank.

I wondered out loud in a previous post if there is room in the market for "premium servicing".  I'm not sure I would pay for it up front when it was so uncertain whether I was going to need the "premium" part.  However, in the present circumstances I would gladly pay an addition $1-5K to get some speedier service and a guarantee that we would close by a reasonable date. 

I also wonder if a lot more assumptions are in the pipeline because the spread on conduit loans have increased to around 200+ bps over the treasury with lower LTV and higher DSCR thresholds.  The current conditions in the lending market  certainly make assuming a loan a lot more attractive these days. 

Market Swings Vs. Fundamentals

In my last post I talked about the volatility in the debt markets. 

The thing that really strikes me is that all of the increases in spreads are coming after the problems with the sub-prime loans and after lenders have tightened the underwriting criteria for conduit loans.  It seems like the time for the bigger spreads was before the underwriting got more conservative, not after. 

The spreads widening after is a function of the fear in the market.  It has nothing to do with the underlying fundamentals of the loans or the assets behind them.  Because of the changes in underwriting, the loans have become less risky, not more.

I bet the guys who are moving into the corporate bond and CMBS markets now are going to do great because they are taking advantage of a market swing caused by market forces that are not tied at all to the fundamentals of the investment.

I believe Splash & Dash Carwash is going to benefit from the same thing.  Car washes are the redheaded stepchildren of commercial real estate.  Retail developers are reticent to include them in their developments, and many lenders are reticent to loan on them.  However, in my opinion, that's just the current market perception.  If you look at the fundamentals, these are great deals. 

Because Splash n' Dash and their investors are ignoring the market for the time being and focusing their attention on the fundamentals, I think they are poised to win big in the medium to long term.

You can make money on momentum and arbitrage, but most investors will make money by taking risks based on the fundamentals.

Key Financing Indicators

Today's Wall Street Journal Reported today in an article by Sudeep Reddy, Mark Whitehouse, and Kelly Evans:

• "Futures markets, in a reversal, now bet that the Federal Reserve is almost certain to cut its key interest rate, now at 5.25%, by a quarter-point before the end of the year."
• "Mark Kiesel, a corporate-bond portfolio manager at Pacific Investment Management Co. in Newport Beach, Calif., estimates that the backlog of unsold bonds and bank loans exceeds $300 billion -- a situation he sees as similar to that in the housing market, where the backlog of unsold homes has also reached new highs. At June's rate of existing home sales, it would take 8.8 months to unload all the houses on the market -- a 15-year high."

Brad Anderson, of Wells Fargo Commercial Mortgage, sent me some interesting info on the CMBS market and the impact it is having on Conduit Lenders and borrowers.

• Because  of the heavy supply and the  weak demand for  CMBS by  hedge funds and other institutional investors  the  spreads  charged by the conduits to borrowers have soared in the last week.  A typical conduit loan on a Self Storage deal is likely to be priced at 180 basis points over the treasury yield.  This represents a 50 basis point or one-half percent increase in interest rates to the borrower over the last week. According to Brad there is  $58,658.60 MM in CMBS supply  hitting the market in the  third quarter.   
  
  It looks like higher spreads are hear to stay for a while.

Click Image to see it bigger.

A silver-lining and possible white knight

• Treasury yields have dropped over the last week to somewhat offset the increase in spreads. Treasuries yields dropped 17 basis points over the last week to close at 4.79%.  This is down 41 basis points from the July high of 5.20% on July 6th.
   
• The WSJ reported today that some hedge funds that have not been hurt by the sub-prime mortgage fiasco and the volatility in the bond market are stepping in to buy bonds because of the more generous yields.
  
  
• These new entrants, although acting opportunistically, are bringing an additional level of liquidity to the debt markets at a time when liquidity is sorely needed.  If this trend continues, it may help stabilize the CMBS market as well.

Conduit and CMBS Loan Assumptions: Prepare for More Work Than You Thought

Most conduit loans are structured to allow one or more assumptions.  If the ability to have the loan assumed isn't disclosed in your original term sheet, you should ask for it.  I have never had a lender increase the interest rate because I asked for this flexibility.

It seems like the assumption process should be relatively simple, especially if the property has gone up in value during the time it was held by the original borrower, and especially if the NOI of the property has increased since the loans inception, allowing for greater debt service coverage. Unfortunately its not.

I'm currently working on selling one of our portfolio properties, and the buyer is trying to assume our loan.  The process is fairly simple, but the time line is much longer than I would have imagined.  The lender requires 45-60 days from the time they receive your non-refundable deposit, and your application, including the requested information about the proposed borrower. So in reality, your time to close is more likely to be  75-95 days because the buyer will need some time to put together the information the lender will require, and the buyer will likely want to do some due diligence before paying the non-refundable deposit to the lender.  I know I would.

The process is drawn out and complicated for two reasons. 

1. There are three layers of approval that slow everything down.
   
   Master Servicer: The first person you deal with is the Master Servicer.  This is usually the same place you send you loan payments and the same people you work with if you are trying to get a refund from your impound account.  They review the assumption package and write a case to be reviewed by the Special Servicer.
   
   Special Servicer: The special servicer reviews the case presented by the Master Servicer.  The special servicer has a higher level of authority and handles the more complicated matters like assumptions and prepayments (through defeasance or yield maintenance). After approval, they pass the case on to the Directing Certificate Holder.
   
   Directing Certificate Holder: The directing certificate holder is the investor who purchased the riskiest or "first loss" piece of the securitized loan.  They review the case and comments of the Master and Special Servicers and make the final determination regarding the approval of the assumption.
    
2. Because the loan is securitized,  the lender's underwriting of the assumption is much more in depth.  You can see a detailed description of how the assumption of a Conduit or CMBS loan is underwritten here: Download CMBS World Article: Assumptions of Securitized Loans.pdf .  You can also find this article and several other articles written for borrowers of CMBS loans at the Commercial Mortgage Securities Association website.
   

The quick take-away is that Conduit or CMBS loans offer great rates and terms, but everything else about them from their initial underwriting, to assumptions, to pre-payments (through defeasance or yield maintenance) takes more time and effort than you think it will.

Conduit Lending: How the sub-prime meltdown affects commercial mortgage interest rate spreads and other thoughts

I attended a well-executed conference organized by the California Self Storage Association, lead by Erin King, and a host of generous sponsors.  I'll post more later about the conference and the interesting attendees.  For now I'm limiting my comments to the things I learned from the remarks made by Dan Smith's with RBC Capital Markets.

Here are a few takeaways for those of you who didn't attend.

1. Dan Smith, Managing Director of RBC Capital Markets - Real Estate Mortgage Capital Division did a great job explaining why the sub-prime mortgage meltdown is affecting the terms and spreads in CMBS loans for self storage and other commercial properties. You can contact Dan here.

Here's the brief version...

The conduit lenders pool a diversified group of loans together into a portfolio and sell interests in the pool as bonds or as they are better known, Commercial Mortgage Backed Securities (CMBS). The conduits make money when the average interest rate spread the investor pays for the pool is lower than the average spread they charged to the borrowers in the commercial mortgage transactions. 

Except its not quite so simple.  The cash flows from the loan portfolio are segmented into different "pieces" depending on the amount of risk, and investors earn different yields depending on the riskiness of the piece they are buying.  The least risky portion of the cash flows are sold as AAA rated bonds.  Other bonds based on the cash flow from the portfolio are also issued with ratings from AA to BBB to below investment grade or "junk bonds".   

So here is where the connection between sub-prime residential and the commercial loans lies; the investors who bought (and are being hurt) by the sub-prime residential mortgages are the same investors who are buying the highest risk pieces of the commercial pools. When the sub-prime market took such a large hit, the investors buying the riskiest pieces of the commercial mortgage pools walked away from the table.  The conduits were left holding on to the riskiest loans. 

While this was all happening, Moody's downgraded some of the bonds in the portfolios, i.e. from AAA rated to AA etc.  This meant that the conduits had to pay a higher average spread to investors causing them to make less, or possibly lose money when they securitized the portfolio of loans.

What this all means is that lenders have increased their spreads to attract the highest risk investors back to the table and to compensate for the changes in the way the ratings agencies (Fitch, Standard and Poors, and Moody's) have rated the loans in their portfolio. 

2. The reason you get such crappy service from the servicer on your conduit/CMBS loan is because servicing is so aggressively bid. The servicers have a very limited ability to increase there revenue per loan, so they focus on cutting costs.  The lowest paid and least experienced people end up in the servicing group.  (I don't want to get too far off topic, but I wonder if there is room in the market for "premium servicing".  Pay an extra basis point or two for a real improvement in the customer service.)
   
   
3. The top CMBS lenders over the last 5 years have consistently been GE, Wells Fargo, Wachovia, and RBC.  Countrywide, which financed one our acquisitions earlier this year, came out of nowhere to be the top CMBS lender in 2006.  I wonder how committed they are to being among the leaders for the long-term.
      
   
4. The correction in the interest rate spreads and underwriting standards among conduit lenders is a good thing.  It is hard to stomach in the short term, but it assures that the CMBS financing will be available  for the long term.