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CRE Finance World, Autumn 2013

U.S. Conduit CMBS Update: Credit Metrics Were Stable in Third-Quarter 2013, but Transactions Remain Riskier Year-Over-Year A publication of Autumn issue 2013 sponsored by CRE Finance World Autumn 2013 53 retail locations. The traditional mall model appears to be changing in favor of a more all-encompassing shopping and entertainment experience that includes more sit-down dining options as well as traditional grocery stores and even fitness clubs. Some older malls have seen vacated anchor spaces filled by Targets, Wal-Marts, and Costcos. Industrial demand has been buoyed by e-commerce E-Commerce has been a boon to industrial space demand, as retailers require fulfillment centers in key locations to ensure speedy delivery to their customers. Prologis, the world’s largest industrial property landlord, recently reported via the Financial Times that average warehouse rents climbed 4% year-over-year in second-quarter 2013, marking the second consecutive quarter of growth. One potential risk though is speculative development in certain locations. According to a recent analysis by Cushman & Wakefield, 70% of warehouses currently under construction in Southern California’s Inland Empire do not yet have tenants. B-piece buyers went up to 11 The total estimated par size of 2013 B-pieces is now about $2.4 billion, compared with $2.2 billion last year and $6 billion in 2007, according to Commercial Mortgage Alert data aggregated by Standard & Poor’s. Cerberus Capital Management recently became the 11th B-piece buyer this year, nearly matching the dozen buyers during the peak years and surpassing last year’s eight. Eightfold Real Estate Capital, Rialto Capital Management, and LNR Partners remain the most active buyers, accounting for about 65% of purchases by deal count, although their combined share has fallen from earlier in the year, reflecting a more diverse buyer base (see chart 1). Chart 1 Top Three B-Piece Buyers’ Market Share* Sources: Commercial Mortgage Alert, S&P. Data points are based on month-end figures. Market participants generally associate a higher number of Bpiece buyers with higher credit risk, as more competition lowers buyers’ ability to kick-out potentially weaker assets from a pool. In addition, all else being equal, the more B-piece buyers in the sector, the higher the total issuance capacity, and we’ve found that higher annual issuance is positively correlated to a higher vintage loss rate. That said, annual issuance is still just a fraction of 2007’s $230 billion, and the marginal credit impact from each additional new B-piece buyer is likely small at the current levels. Another important aspect of today’s B-piece market is that participants appear genuinely focused on the potential credit risks they are exposed to for the entire life of the bonds they hold. This contrasts to the last credit cycle when B-piece buyers were offloading much of that risk by bundling securities and selling them in collateralized debt obligations. Lack of investor appetite, scrutiny from credit rating agencies, and new risk-retention rules are likely to limit a repeat of this strategy. Other Trends We’re Watching Lease rollover assumptions and partial IOs highlight limited pro forma underwriting The practice of including upside potential in property-level cash flows and values remains limited, but does still occur, albeit mostly in single borrower deals. In some recent examples, tenants who currently pay below market rents are assumed to re-sign at market levels (or give way to a tenant who will pay market levels) at future lease rollover dates, leading to a higher cash flow assumption. We believe in-place cash flows and sustainable vacancy assumptions are more appropriate for commercial real estate analysis, especially for debt investors, who typically don’t participate directly in property-level upside. Pro forma analysis leaves CMBS investors more vulnerable to adverse performance. Another loan structuring practice associated with pro forma analysis also appears to be making a comeback: the partial IO term. Anticipating rent growth, borrowers and lenders are agreeing to IO periods lasting up to half the loan term. The initial DSC might be moderate, but by the time amortization kicks in, the idea is that the property’s net cash flow will increase to support the higher debt service burden. However, there are many cases of loans with partial IO periods securitized between 2005 and 2007 where the upside rent assumptions didn’t occur (rents and occupancy dropped), leading to defaults.


CRE Finance World, Autumn 2013
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