Commercial Mortgage Backed Securities Market – Yesterday and Today

Editor’s Note: The following article was written by David Nass ’91, managing director and co-head of real estate finance at UBS.

David Nass
David Nass

After the credit crisis, I questioned if the commercial mortgage backed securities (CMBS) market would revive. There were many questions that needed to be answered. For example, would financial institutions commit capital for commercial real estate lending platforms again? And, if these institutions determined that lending could be a possibility, would they restart the aggregation for CMBS issuance? I questioned whether investors would trust the underlying collateral, and if investors would trust rating agencies and capital stacks again. There were many unknowns. What I was hoping for was the reemergence of a fully functioning, efficient, liquid and competitive CMBS market. What I learned was – be careful what you wish for, you might just get it.

Unquestionably, it is a good thing to have an efficient and liquid market with a plethora of capital committed to commercial real estate lending – but is too much of a good thing actually bad? The CMBS market is experiencing tremendous growth, liquidity and investor demand. Rates remain at historical lows and borrowers are capitalizing on the low rate environment to help refinancing existing debt and to fund acquisitions opportunities. Banks, insurance companies, mortgage REITS and specialty finance companies are actively lending and creating a vibrant new issue CMBS market. But, does excessive competition create an environment that ultimately causes an increase in leverage, deterioration in loan structure and the potential to misprice risk?

CMBS volume has increased from $25 billion in 2011, $45 billion in 2012, $86 billion in 2013, to $93 billion in 2014. Volume projections for 2015 range from $100 to $125 billion. And, with growth and competition, the market has experienced deterioration in credit quality. One of the more universal underwriting measures, loan-to-value (LTV), has modestly increased over the past several years. For example, the weighted average LTV has widened from approximately 58.7% LTV in 2010 to roughly 64.5% LTV in 2014. Another key underwriting measure, debt yield, measures the amount of debt that is supported by the net operating income (NOI) of the property. In a consistent trend, debt yield has decreased from about 12.7% in 2010 to approximately 10.3% in 2014.

Although this development of credit deterioration may be concerning to investors as issuers continue to produce loans with more aggressive credit metrics, it is important to employ perspective. For example, pre-crisis LTV and debt yield metrics in 2007 were 69.6% (about 8% higher than the 2014 average) and 8.9% (about 16% lower than the 2014 average), respectively. And, more importantly, the underlying values and NOI’s exclude certain assumptions that were commonly acceptable pre-crisis. For example, frequently, pre-crisis appraised values assumed a future stabilized value rather than the then a current value. And, issuers frequently included pro forma rent assumptions in the NOI rather than the current rent in place. Today’s CMBS market, almost exclusively, includes today’s values and today’s cash flows. Therefore, in addition to today’s more conservative credit metrics (vs pre-crisis), the definition of the credit metrics is considerably more conservative.

Another important distinction between today’s CMBS market versus the pre-crisis CMBS market is the rating agency credit enhancement levels. Rating agencies have materially increased subordination levels over the past few years as LTV’s have increased and debt yields have decreased. Pre-crisis, rating agency subordination levels appeared to remain constant even as the credit metrics of the loans continued to deteriorate. Today, there is considerable differentiation regarding the treatment of transactions based on the credit metrics of the underlying loans. For example, as leverage has increased over the past several years, Moody’s Baa3 subordination has increased from an average of 5.7% in 2010 to an average of 10.2% in 2014. Investors have regained confidence that the rating agencies are rating deals based on the credit and fundamentals of the transaction and have eliminated many of the inherent conflicts of interests that existed pre-crisis. Therefore, based on the credit metrics, the definitions of how the metrics are calculated and the rating agency standards, the underlying risk associated with new issue CMBS continues to be measured and reasonable.

Less competition and less efficient markets can be very attractive. Lenders have an opportunity to charge more and to earn more. However, efficient markets clearly provide more certainty of execution and provide more transparency of how to price risk. As the post-credit crisis CMBS market continues to evolve, I will look for a balance of healthy competition to underwrite sound collateral for new issue CMBS. However, it is often said that the commercial real estate industry operates based on 10 cycles with only eight-year memories. I am hoping that, post-crisis, the industry changes the mantra from, “if it is worth doing, it is worth overdoing” to “everything in moderation.”

David Nass ’91 is a managing director and co-head of real estate finance at UBS. In this role, he oversees the Real Estate Finance group’s securitized and balance sheet lending platforms including loan origination, pricing, hedging, structuring, distribution and trading. Prior to this, Nass was head of capital markets – real estate finance for UBS, where he was responsible for principal and agent CMBS new issue partnerships and the execution of new issue CMBS transactions and commercial real estate debt advisory assignments. Nass holds a B.S. in marketing/management from the Whitman School of Management at Syracuse University and an MBA from the John M. Olin School of Business at Washington University in St. Louis.