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CRE Finance World, Winter 2014

A publication of Winter issue 2014 sponsored by CRE Finance World Winter 2014 79 are becoming more prevalent. Additionally, loan-to-values are increasing alongside decreasing debt service coverage ratios that are often based on pro forma underwriting. The trend of more relaxed credit and underwriting standards is coming in the face of $1 trillion in commercial real estate loans maturing over the next four years, including $400 billion in CMBS originations, and almost $270 billion in 2006-2007 CMBS originations. Couple these circumstances with an anticipated increase of both interest rates and cap rates and the industry may be headed back into another over-leveraged crisis, in many ways similar to the recent down cycle. With ramped up production volumes, CMBS producers’ seasoned, full-time underwriting teams risk being stretched beyond capacity. Yet best practices in underwriting may be achieved only through strict quality-control measures including multi-sector and local real estate market knowledge. These skills and measures alone ensure consistency in the quality of the CMBS end product. In fact, today’s lenders, bond buyers, and rating agencies all share in the responsibility for keeping the industry disciplined and ensuring quality underwriting. Best practices are of paramount importance for both loan originators and investors. For lenders the highest underwriting standards are of utmost importance in order to continue along the path of recovery in the CMBS market. Investing in proper due diligence and consistent, high-quality underwriting benefits lenders from a reputational and profit perspective as investors and rating agencies strive to avoid a return to the past. For investors, quality due diligence is key. In today’s market, timing between loan origination and closing of the CMBS trust is greatly compressed. Often, more than half of the loans in a pool have not closed at the time the B-piece buyer is selected. This new paradigm demands and allows B-piece buyers to provide feedback to loan contributors regarding loan structures and sizing in real time. While the timing compression in some ways adds complexity to the process, the added input from the B-piece buyers is generally regarded as a positive enhancement to credit quality. Risk Retention — What Effects Will it Have? Though implementation is at least two years out, the effect of risk retention on CMBS new issuance is on everyone’s mind. The proposed general guidelines require that issuers retain 5% of the fair value of the bonds. Conservative loans with a 1.5–1.75 debt service coverage ratio (depending on property type) and less than 65 percent loan-to-value are expected to be exempt from the five percent calculation. These guidelines continue to be redefined and are expected to be implemented in 2016. Though two years out, this is creating buzz in the marketplace now. Lenders are uneasy with the uncertainty of the final regulations. Adding to this, the high volume of loan maturities in 2016 and 2017, occurring just as the regulations are to be implemented, will likely result in higher borrowing costs and a higher level of scrutiny toward lenders regarding underwriting and quality standards as the competition for exempt loans (i.e. high-quality loans) inevitably heats up. Looking Ahead While the lack of definitive risk retention guidelines and underwriting standards are two core concerns putting weight on the burgeoning CMBS marketplace, the industry recovery forges onward. There is no arguing that participants on all sides continue to jump back into the game. Volumes are expected to increase annually but will they meet the needs of legacy debt as it matures over the next four years? Proper due diligence will remain at the crux of the industry’s future, and a legitimate determinant of whether the industry will face the pains of another industry bust. Risk retention, when fully defined, may also change the playing field, helping to maintain the underwriting standards necessary to keeping the industry healthy. About Midge Brogan and Ned Smith Midge Brogan is Managing Director for Sabal Financial Group’s New York office and Ned Smith is Relationship Manager for Sabal Commercial Advisors. Brogan and Smith both oversee business development for this Sabal commercial real estate loan transaction services business. A Look Ahead at the Recovering CMBS Marketplace


CRE Finance World, Winter 2014
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