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CRE Finance World, Summer 2014

A publication of Summer issue 2014 sponsored by CRE Finance World Summer 2014 51 • Beware Servicer Fees and Non-Recoverable Advances. Just because an asset may be worth its appraised value, does not mean that the CMBS trust will recover that value. Servicing fees and the repayment of servicer advances can result in losses of greater than 100% and have unintended consequences for more senior trust classes. • Say “No” to Desktop Underwriting. While desktop underwriting may work for senior AAAs with a loan pool of over $1 billion in collateral, when your trust has been reduced to a handful of loans, each loan can have a meaningful impact on your returns. Can you really afford to say, “that retail property can’t be worth less than $50 per square foot” without looking under the hood? • Duration and Extension Risk. The returns of discounted CMBS purchases are highly sensitive to the timing of repayment. By way of example, a loan purchased at 85% of face that repays in one year yields a 15%+ IRR before interest; however, extend that loan to three years and you earn roughly a 5% return. CMBS investors need to carefully analyze not only how long underlying loans can be extended within the CMBS trust but also how much longer a loan may be “trapped” in a CMBS trust due to lengthy resolution procedures such as foreclosure and bankruptcy. • The Bottom Ten Loans. Understandably, when Wall Street is selling a new conduit CMBS transaction, the buyer’s attention is focused on the “top 10 loans” that can represent as much as half (or more) of the trust’s initial collateral. While this may be fine, particularly for buyers at the top of the capital structure, the bottom 10 loans are likely to have a greater impact on making or breaking your returns, especially as one migrates down the stack in search of greater yields. Here, information is typically more scarce but essential to understanding what can happen to your investment. • Interest Rates. Since Ben Bernanke’s tapering began in May 2013, interest rates have been on the rise (see below) but remain at historically low levels. If you are a total return oriented investor, don’t let rising interest rates overwhelm your credit decisions. Hedge your rate risk by purchasing floating rate assets or by purchasing interest rate protection. Chart 7 10-Year U.S. Treasury Bond Yields (1974–Present) Source: Bloomberg • Exit Strategies for Underlying Loans. Investors need to carefully underwrite the exit strategies (recovery and timing) for the remaining CMBS loans that secure their credit tranches. How will these assets be impacted by higher interest rates; given outstanding debt levels and coupons, is the borrower motivated to accelerate repayment through a sale or refinancing; who is the special servicer and how long do their loans typically stay in special servicing, etc.? While one can always trade out of a CMBS investment opportunistically or defensively, depending upon the individual circumstances, ultimate repayment needs to come from the underlying assets. Conclusions Until the $360 billion of maturing CMBS debt is resolved with some clarity and/or the CMBS market can grow to closer to $1 trillion in size (thereby affording broader research and trading support), we see CMBS as a compelling field of investment able to provide a wide array of investors access to returns that range from core to opportunistic, from AAA to CCC, and from six months to 30 years. What we find particularly compelling about CMBS is the ability for investors to customize investments to fulfill very specific risk/ reward parameters for a particular asset. By way of example, through credit tranching, investors with a view on an asset resolution can participate in the recovery via the more senior bonds or The Case for Commercial Real Estate Debt Now “The two-thirds of the CMBS market that matures over the next four years creates the opportunity and the governor on recovery.”


CRE Finance World, Summer 2014
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