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.
- 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.
- 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.)
- 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.
- 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.
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.