CMBS- Party Like it's 2007

CRE Finance World, Winter 2013

CMBS — Party Like its 2007 How Deteriorating Credit Standards are Bringing Us Back to 2007 Edward L. Shugrue III Chief Executive Officer Talmage, LLC I —Prince, 1999 underlying collateral.Furthermore, in addition to the CMBS trust debt levels, subordinatedebt in the form of B-notes and mezzanine loans is becomingmore frequent and increasing the true debt burden of thewas dreaming when I wrote this; forgive me if it goes astray.But when I woke up this morning, could have sworn it wasjudgment day.” The Reintroduction of Mezzanine Debt With insatiable demand from investors for yield, CMBS issuers are Since the financial crisis, which was substantially driven by high loosening underwriting standards to win loans in an increasingly leverage, CMBS 2.0 has sought to address investor concerns with competitive origination environment. While the CMBS market is better CMBS structure and less leverage. To bridge the gap and still recovering from the aftereffects of the financial crisis — with to get transactions closed in an environment with less CMBS debt, delinquency rates hovering around 10% and more than $76 billion mezzanine debt re-emerged in 2012 in a meaningful way. In 4Q12, of loans in special servicing — underwriting standards for new three mega-transactions were announced with debt structures issue CMBS transactions are sliding into 2007 levels. Granted, totaling nearly $7 billion, of which one-third (or $2-plus billion) is the excesses of the top of the market have yet to be met, but the comprised of multi-tiered mezzanine debt. While mezzanine debt trends are alarming. is held outside of the CMBS trust and is not secured by the real property (but rather by a pledge of the sponsor’s equity in the Loan-to-Value Creep property) and can provide CMBS investors with an extra layer of Both issuer underwritten loan-to-value ratios (LTVs) and stressed cushion from a potentially experienced operator, it also poses the LTV data by Moody’s demonstrate that in CMBS 2.0 LTV ratios following risks: for conduit transactions have been steadily increasing. While underwritten LTVs appear to have topped at 65%, these self- •Default Risk. Additional leverage places greater default risk reported issuer levels have been trending upward, with levels as on the assets and decreases free cash flow. The above noted high as 67%. Perhaps more alarming is that 3Q12 saw the first transactions increased the cumulative underwritten LTV from CMBS 2.0 transaction since the crisis that exceeded 100% of 50% (CMBS trust) to 73% (CMBS + mezzanine); Moody’s stressed LTV levels. To be sure, LTVs are still below levels at the market peak, when 16% of deals topped 100% of Moody’s •Tranche Warfare. The above transactions had multiple layers stressed LTVs and 9% of issuer underwritten LTVs, but the of credit-tranched mezzanine debt. In the event of a default, rate of change is steep as the pressure to originate competitive this tranching can lead to numerous delays and unintended loans increases. consequences for the CMBS trust as the mezzanine holders skirmish among themselves; and Exhibit 1 Q3 Conduit Leverage Tops 100% MLTV •Intra-Tranche Warfare. In a broadly syndicated mezzanine tranche (the above transactions had individual mezzanine tranches as large as $500 million), consent to resolve a defaulted transaction may be impossible to obtain due to the diverging interests of the various holders, thereby unnecessarily delaying or hindering a resolution from the CMBS trust’s perspective. Mezzanine debt, in-and-of-itself, is not necessarily a problem and must be considered on a transaction-by-transaction basis. There are many pre-crisis CMBS transactions that in hindsight were over-leveraged with mezzanine debt and were successfully restructured without cash flow interruption to the CMBS trust — even though in some cases the original borrower was replaced by Source: Moody’s Investors Service Pre-sale Reports a mezzanine debt holder. Examples of such transactions include: COMM 2006-CNL2 (CNL Hotels), CSMC-2006-TFL2 (Kerzner), CRE Finance World Winter 2013 20


CRE Finance World, Winter 2013
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