Eric Tupler
Senior managing director, HFF, Debt & Equity Team, Denver
Commercial mortgage-backed securities have long been a source for high-leverage financing of real estate assets that did not qualify for more friendly balance sheet financing executions. In the latest real estate cycle, CMBS has become a black sheep lending source. According to Commercial Mortgage Alert, the first half of 2016 saw $30.7 billion of total transaction volume. This represents an approximate 43 percent decline in transaction volume from the first half of 2015. As borrowers continue to see CMBS as a last-ditch effort for financing, it is expected that transaction volumes will continue to decline.
Tyler Dumon
Real estate analyst, HFF, Debt & Equity Team, Denver
Further complicating this process is the implementation of risk retention, which is the final act of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The new rule will go into effect Dec. 24 of this year, and was designed to discourage reckless mortgage-backed security lending that was a large contributor to the financial catastrophe seen in 2008. All conduit transactions sold after Dec. 24, 2016, must comply with risk retention regulations. Major CMBS issuers have scrambled to determine how to implement risk retention into their programs and how it will affect the pricing of conduit deals going forward.
Risk retention requires the issuer, or major affiliate of the issuer (B-piece buyer), of CMBS bonds to hold a 5 percent piece of the securitization on its balance sheet for the initial five years of the bond’s life. There are two main methods to structure this risk retention, an “eligible vertical risk piece” and an “eligible horizontal risk piece.”
Vertical risk piece. The sponsor or issuer of the CMBS transaction is required to retain 5 percent of the face value of each class of securities issued in the CMBS transaction.
Horizontal risk piece. The sponsor is required to retain the most subordinate class or classes of securities issued in the CMBS transaction in an amount equal to 5 percent of all the “fair value” of all the CMBS transactions issued. This form of risk retention is more commonly known as the B-piece buyer retention option.
Hybrid risk piece. A final hybrid structure permits the sponsor to satisfy the risk retention requirement by a combination of horizontal and vertical retention, known more commonly as the “L” slice. This provision would allow CMBS sponsors to supplement the horizontal piece by retaining themselves, or through a B-piece buyer affiliate, an additional vertical interest to “top off” the amount by which the securities retained in the horizontal risk piece falls short of the required fair market value. Similar to the vertical risk piece method, the sponsor would be required to retain a portion of the CMBS bond that represents an interest in each class of the CMBS, including an interest in the class or classes retained by the B-piece buyer.
The legislation further states that a sponsor cannot retain more than its pro rata share (based on collateral contributed) of the risk retention obligation, nor may any originator retain less than 20 percent of the sponsor’s risk retention obligation. Therefore, sponsors who contribute less than 20 percent of the collateral for a CMBS transaction are not permitted to retain any of the required risk piece. What this means in the market is that smaller CMBS originators who contribute to larger CMBS pools will not be able to retain any portion of the required risk piece and will likely see more expensive pricing from the main book runners in order to cover the cost of risk retention. This cost will then be passed on to the borrower in the form of wider interest rate spreads.
In early August, the first conduit transaction to comply with the risk retention regulations was priced in the market. The $870.6 million transaction was led by Wells Fargo, Bank of America and Morgan Stanley. The three book runners chose to retain a vertical risk retention piece totaling approximately $43.5 million. The 10-year AAA tranche priced at SWAPs+94 basis points, with the BBB- tranche pricing at SWAPs+425 basis points. This pricing presented the tightest spreads seen in a conduit transaction in 2016. Though some of this favorable pricing was driven by larger market factors, including a lack of recent CMBS supply, this pricing also proves investors’ confidence in the ability of major national banks to navigate risk retention and support the retention piece with ample balance sheets. However, many CMBS analysts consider this conduit deal an anomaly compared to future deals that will comply with risk retention since it was solely pooled by major national conduit lenders.
There are very few CMBS originators who have the ability to afford to hold the risk retention piece on their balance sheet for five years. As the year continues, it will be quite interesting to see how these regulations affect future conduit transactions. Many of the smaller CMBS shops that do not have their own shelf will see significant increases in pricing that will then be passed on to borrowers. HFF has been in constant communication with CMBS lenders, and many have procrastinated implementing the necessary steps needed to fully comply with risk retention, choosing to take a “wait-and-see” approach. No lender wants to be punished for being the guinea pig.
According to Trepp, it is estimated there will be $95 billion in CMBS maturities in 2017. As risk retention looms, coupled with a pending glut of refinance demand, the greater CMBS market will be in for a tumultuous ride in the fourth quarter of 2016 and first quarter of 2017. Borrowers, mortgage bankers and other capital markets participants anxiously wait to see if risk retention will drastically change the conduit process or if it will simply continue with business as usual.
Sources:
http://www.crenews.com/2016-cmbs-deals-initial-pricings.html
