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2011 Brings a Resurgent CMBS Market, More CRE Liquidity

But Specter of Cheap Money Backing Questionable Deals Still Haunts Industry Shaken by Recession
February 23, 2011
The Christiana Mall in Newark, DE, backs the largest loan in Morgan Stanley's latest CMBS deal.
The Christiana Mall in Newark, DE, backs the largest loan in Morgan Stanley's latest CMBS deal.
CMBS activity has flourished in the past few weeks with more than $6.5 billion in new securitization coming to market. In addition, Freddie Mac brought two multifamily-backed offerings totaling $1.86 billion to market.

The activity in February alone is almost two-thirds of all CMBS deals offered last year - and for some is reminiscent of 2007 when commercial mortgage-backed securities offerings were at their peak, which has the commercial real estate market bullish and fretful at the same time.

On the one hand, the volume in CMBS loan origination is another welcome sign that liquidity has returned to the markets. However, relatively large amount in a short period of time is also raising apprehensions that the still frail health of general commercial real estate is being unduly sustained by perhaps overly eager lenders.

"I think it is clear that CMBS is coming back -- something that is probably positive in the short-term as far as jump-starting the investment marketplace and helping to establish a new baseline for pricing while, hopefully, alleviating some of the distress issues out there. But is it a good thing in the long run?" Garrick Brown, Northern California research director of Cassidy Turley BT Commercial asked.

"I have serious concerns as to whether we have learned the lessons of the past," Brown answered. "The fact is that too much capital chasing too few assets is one of the factors that helped to create a commercial real estate investment bubble in the first place. I suppose I may be old school, but the problem I see is that the stock market was always about higher levels of risk and reward, but commercial real estate was the safe and stable alternative. Yet, as we saw during the last cycle, injecting Wall Street via CMBS offerings into the commercial real estate market didn't do much to improve CRE returns but certainly sent the risk through the roof."

Robb Barnum, CFA, vice president structured and quantitative research at Conning & Co., an asset management firm in Hartford, CT, added that, "Contrary to the thinking a year ago or so that [the CMBS deals] would be much better this time around, I don't think the new deals are tremendous. Just look at the new [J.P. Morgan Chase Commercial Mortgage Securities Trust 2011-C3] deal. Though underwritten with lower LTV [loan-to-value] and higher DSCR [debt service coverage ratios], it doesn't mean it's a good conduit deal. Over half the properties are in secondary or tertiary markets. Almost two-thirds is retail. 15% is a Class B mall in a secondary market. Given how much CMBS spreads in general have marched in, the market seems over bought to me."

Rush To Fill the Void

While there is no real count of the number of financial institutions jumping in to CMBS loan origination, Marcus J. Mollmann, president of Reliquid, a Greenwood Village, CO-based online network that connects CRE capital seekers with CRE capital providers, said he is seeing fresh interest from originators this year.

"CMBS originators are broadening their lending criteria as the market stabilizes, capturing quality loans just outside the comfort zone of the larger insurance companies," Mollmann said. "This has filled an attractive void in the CRE capital market, with CMBS originators picking up quality loans with strong risk adjusted yields and owners again finding a non-recourse option at higher loan-to-value ratios."

And as the number of originators increases, so too is it likely that the number of CMBS issuances is likely to grow. That also means the competition to loan will grow, which could be a double-edged sword.

"As the number of participants in CMBS lending continues to increase, the competition to originate loans eligible for new CMBS deals will be fierce," said John O'Callahan, capital markets strategist for CoStar Group. "Insurance companies, GSEs [government sponsored enterprises], and even the healthier large banks will lend on the best properties in desirable markets, while CMBS originators will compete among themselves for the leftovers. They will have to cast a wider net across all markets to garner the volumes anticipated in 2011."

In fact, O'Callahan said CMBS origination statistics reveal that approximately 85% of origination volume in the second half of 2010 was outside of the most popular markets. And most CMBS volume financed retail properties (55% by volume), with office a distant second (27%).

"CMBS originators are clearly unable to compete effectively with the GSEs, insurance companies, or banks for apartment loans, and the supply of eligible hotel and warehouse loans remains muted," O'Callahan said. "In 2011, CMBS originators will likely face even stiffer competition for high-quality loans, which will force issuers to push the quality envelope until investors or ratings agencies push back."

A slight decrease in quality is already visible in pool average underwriting parameters in one of the first deals to market in 2011, O'Callahan noted. In 2010, pool weighted-average LTV and DSCR were better than 60% and 1.65, respectively, and relatively few loans had debt yields lower than 10%. But an initial 2011 deal has a 62% LTV, a 1.49 DSCR, and includes a larger number of loans with single-digit debt yields. The number of interest-only loans is also creeping up, from approximately 12% of the total in 2010 to 20% in 2011.

Outlook for 2011

CoStar's prediction for CMBS volume this year of around $25 billion on a conservative basis is at the low end of the estimates thrown around by others on Wall Street. CoStar also noted that there could be another $5 billion or so of new issuance coming from "unanticipated" sources.

Not everyone is enamored with CMBS loans either, which could hold back CMBS activity.

"There is debt available from private lenders and it's not garden variety financing," said Chris Germain, president of Piping Rock Partners, an investment firm in San Francisco. "We just financed the purchase of a 120-unit Class B-, value-add apartment property (1993 construction) at 90% loan to cost with a first and second mortgage from the same lender--the first was 10 years fixed under 5% and the second was 3-year I/O under 4%, both are fully pre-payable."

"It was a bit of an unusual situation, but on top of being optimized/customized for our needs, (the loan) was much easier to close than a CMBS deal, which can be checklist-driven nightmares for a borrower," Germain said. "This deal was also done in a small, tertiary market in the Midwest, where there is still limited capital available."

"Perhaps my anecdotal experience is an indication that more small and regional banks are returning to the market, which could then mean that CMBS volumes will take a very long time to recover," Germain said. "On top of the regulatory issues, CMBS deals are a pain in the neck to close, and if you can get a cheaper/better deal from a local bank that's easier to close, why not do it?"

Jones Lang LaSalle is one of those among the more optimistic with regard to CMBS prospects. In its 2011 Commercial Real Estate Financing Outlook, the firm said total issuance in 2011 is expected to top $40 billion, providing added liquidity to owners with maturing loans to refinance.

"We're far closer to that fully functioning debt market than we've seen since the recession," said Tom Fish, co-head and executive managing director of Jones Lang LaSalle's Real Estate Investment Banking practice. "Given the financing spigot temporarily turned off, a natural evolution occurred last year in which lenders returned to safe lending-targeting only low-leveraged, trophy assets. Now, demand has begun to exceed supply, and lenders are moving more aggressively to place capital. In the following months, we expect to see lenders move increasingly up the risk continuum as we're still in a low overall yield environment, and there's a high demand for yield generation."

Jeffrey Berenbaum, Citigroup's head of CMBS research, told CoStar Group that his outlook falls in between.

"We are expecting new issuance to be in the $30 billion to $40 billion range. While this is a huge improvement from the $9.8 billion issued in 2010, it is likely not enough to jump-start the investment market by itself," Berenbaum said. "However, there are many other sources of real estate debt capital, such as life insurance companies, banks, REITS, and hedge funds. Thus, debt capital is far more abundant now than it was just a year ago and is available at a relatively low cost due to increased competition among lenders."

"Additionally," Berenbaum said, "borrowers are able to obtain much higher leverage (up to 90% in some cases) as mezzanine/subordinate debt has returned to the market. So we think the revival of the CMBS market will certainly contribute to an investment market revival, but that the other factors mentioned above will also play an important role in the revival of investment market."

Berenbaum said he does not think the market is "over-exuberant" yet.

"With over a trillion dollars of commercial real estate loans maturing over the next few years, there is still far more demand for debt capital than is currently available. And so long as this exists, lenders will be able to selectively fund the better assets," he said. "However, a concern is that fierce competition to lend on the best assets could lead to erosion in underwriting standards."

"It's also important to keep in mind that a $30 billion to $40 billion market is very small when compared to the mid 2000s," Berenbaum said. "Overall, the credit quality of the new issue collateral remains very strong compared to the 2005-2007 peak of market originations. While this creates some bifurcation between new issue and legacy classes lower in the capital stack, there is minimal difference in credit quality at the super-senior level."

The Stage is Set

While investors have returned to market and are beginning to look outside of a handful of major markets and the best trophy properties, lenders have been able to come back in slowly with more confidence in the quality of projects.

"This is very healthy and when you think of it," said Michael Federle, senior vice president of NorthMarq Capital Inc. in San Francisco. "We needed to retract to a slower and more discerning level because the abuses were rampant and it shook up the whole world. The flow of capital is supporting an enormous industry and everyone needs real estate in one fashion or another. Bringing the industry to its knees wasn't planned and let's face it, over aggression criminality was wide spread."

But Federle added, "now that we have better understood the ways that the system got gamed, we can rein it in and have a higher quality of reliable capital flows. It needs to grow slowly at first but with huge stacks of money needing to be redeployed and to provide higher returns to investors and the resultant distribution into the pension world, orderly growth will occur bringing confidence and predictability back into our world."

Joe Strain, President, ISHC Hotel Realty Advisors Inc. in Dallas, pointed out that just because lending is moving beyond trophy properties, doesn't mean it is moving into junk properties.

"When you consider less than the best but still very good sponsors with great properties in strong locations, albeit perhaps with some weakness in income history or low temporary occupancy but high potential, demand across all CRE types for these highest two tiers could easily exceed the suggested issuance ranges," Strain said. "The stage is set and momentum rising for lending standards to open to a wider range of property types and quality tiers-just as buyers will begin to search for next-to-best deals when the best are priced too high for them."

"None of this would matter if it weren't for the core compelling advantages of a CMBS loan: off-put risk to the primary lender, lower interest rates and non-recourse liability (if that feature remains) for the borrower," Strain said. "Now we just have to figure out how not to let lender competition create crazy money CMBS loans written on future incomes or it will be, as has been so very well put, déjà vu all over again."

The Latest CMBS Deals To Come to Market

DBUBS 2011-LC1 Commercial Mortgage Pass-Through Certificates

$2.18 billion
47 loans; 83 properties: retail (43.7%), office (39.5%), lodging (6.8 %), mixed-use (5.9%).
The loans were originated by German American Capital Corp., UBS Real Estate Securities and Ladder Capital.
Largest loan: $234.5 million; Kenwood Towne Centre is a 1.16 million-square-foot regional mall in Cincinnati, OH. The property is anchored by Dillard’s, Macy’s and Nordstrom and features more than 140 in-line tenants and kiosks. The total collateral size is 756,412 square feet as Macy’s and Nordstrom own both the store and land underneath the improvements. The loan is sponsored by General Growth Properties Inc. and The Teachers’ Retirement System of the State of Illinois.

J.P. Morgan Chase Commercial Mortgage Securities Trust 2011-C3

$1.49 billion
45 loans; 109 properties: retail (62.8%), office (24.8%), lodging (6%).
The loans were originated by JPMorgan Chase Bank.
Largest loan: $215 million; Holyoke Mall is a 1.56 million-square-foot regional mall in Holyoke, MA. The property was constructed in 1979 and expanded and renovated in 1995. The mall is anchored by a Macy’s, Sears, Target, and J.C. Penney and features three additional tenants occupying more than 50,000 square feet that include Burlington Coat Factory, Forever 21, and Best Buy. The total collateral size is 1.36 million square feet, as Macy’s owns both the store and land. The loan is sponsored by The Pyramid Cos.

Morgan Stanley Capital I Trust 2011-C1

$1.55 billion
37 loans; 79 properties: retail (43.6%), office (28.1%), lodging (9.8%), industrial (7.7%), self storage (5.9%), mixed use (4.9%).
The loans were originated by Morgan Stanley Mortgage Capital Holdings and Banc of America Mortgage Capital Corp.
Largest loan: $235 million; Christiana Mall is a 1.1 million-square-foot enclosed super-regional shopping mall in Newark, DE. The property was originally constructed in 1978, expanded in 1990, and is currently in the final stages of a $187.5 million renovation and expansion. The expansion included the construction of a wing that features a new food court, restaurant space, a Target, and a Nordstrom. Nordstrom is expected to open in April 2011. The mall has four anchor tenants, Macy's, JCPenney, Target, and Nordstrom, and one major tenant, Barnes & Noble. The mall has 129 retail tenants. The loan is sponsored by Prime Property Fund and General Growth Properties.

WF-RBS Commercial Mortgage Trust 2011-C2

$1.3 billion
50 loans; 96 properties: retail (52.1%), office (15.7%), mixed use (11.8%), industrial (6.1%), land (5.5%), self storage (4.5%).
The loans were originated by Wells Fargo Bank, Royal Bank of Scotland, Natixis and Basis.
Largest loan: $168.1 million; Hollywood and Highland is a 458,686-square-foot retail/entertainment center at the corner of Hollywood Boulevard and Highland Avenue in Los Angeles, CA. Built in 1999-2001, the center includes 161,058 square feet of retail shops, 25 restaurants/eateries, two nightclubs, one multi-screen cinema, a large event theater (the Kodak Theatre), a grand ballroom, billboards, and a bowling alley. The property is considered to be an area landmark and tourist attraction due to its 696 feet of frontage along the Walk of Fame. The loan is sponsored by CIM Group.

Freddie Mac Structured Pass-Through Certificates, Series K-010

$1 billion
76 loans; 81 multifamily properties
The loans were originated by: Beech Street Capital, Bellwether Real Estate Capital, Berkadia Commercial Mortgage, CBRE Capital Markets, Centerline Mortgage Partners, CWCapital, Deutsche Bank Berkshire Mortgage, Financial Federal Savings Bank, Grandbridge Real Estate Capital, HFF LP, KeyCorp Real Estate Capital Markets, M&I Marshall & Ilsley Bank, NorthMarq Capital, Primary Capital Advisors, The Community Preservation Corp., Walker & Dunlop and Wells Fargo Bank
Largest loan: $133.36 million; East Coast 6 is a 499-unit apartment complex in Long Island City, NY, built in 2006. The loan is sponsored by Queens West Development Corp. and Rockrose Development.

Freddie Mac Structured Pass-Through Certificates, Series K-701

$861.3 million
44 loans; 44 multifamily properties
The loans were originated by: Berkadia Commercial Mortgage, CBRE Capital Markets, CWCapital, Deutsche Bank Berkshire Mortgage, Grandbridge Real Estate Capital, HFF LP, KeyCorp Real Estate Capital Markets, NorthMarq Capital, PNC Bank, Primary Capital Advisors, Walker & Dunlop and Wells Fargo Bank
Largest loan: $241.5 million; Franklin Park At Greenbelt Station is a 2,877-unit complex in Greenbelt, MD, built in 1963 and renovated in 2009. The loan is sponsored by Fieldstone Properties.

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