The commercial mortgage-backed securities market in 2013 recorded its most active year since the financial crisis, packaging $80 billion in commercial real estate loans and selling them as bonds. Real estate finance experts predicted 2014 would be even better, with $100 billion in new CMBS bonds issued.
But CMBS activity so far is well short of meeting expectations. Issuances totaled $40 billion through the first half, a year-over-year drop of about $2 billion, according to the Commercial Real Estate Finance Council, a trade group representing lenders, bond investors and other CMBS industry participants. The dip came even as underwriting standards relaxed, partly due to competition from other lenders.
The disappointing performance is raising questions as to whether the market will be prepared to help refinance $350 billion in 10-year CMBS loans maturing through 2017. That's about 14% of the roughly $2.5 trillion in outstanding commercial real estate debt in the U.S.
"We've been slower than expected," said Joe McBride, a research analyst for Trepp, a provider of analytics to the CMBS, commercial real estate and banking industries. "One of the big themes going on right now is uncertainty.
CMBS loans often are not fully amortized, so borrowers have to come up with a balloon payment or refinance at the end of the loan term. Without a healthy CMBS market, some property owners would have trouble finding replacement debt, risking a maturity default. Lenders that keep their commercial property loans on the books don't have the capacity to handle all the demand.
A Crucial Role
The commercial mortgage-backed securities industry is made up of several dozen lenders — including affiliates of Goldman Sachs Group (GS), Cantor Fitzgerald and Starwood Capital Group — that make loans, bundle them with other commercial property mortgages and then sell them as bonds.
"CMBS has to be a viable sector in the commercial real estate finance industry to refinance what is coming down the pike in CMBS and allow banks and other lenders to handle other non-CMBS maturities and loans that need to be done," said Stephen Renna, CEO of the Commercial Real Estate Finance Council.
Some of the uncertainty in the market surrounds the end of the Federal Reserve's quantitative easing stimulus set for October. If interest rates start to climb, it could hinder borrowers' ability to refinance, according to recent research by Trepp and Standard & Poor's.
CMBS issuers also are unsure how Dodd-Frank risk retention rules will affect the market. The regulations, which are still being written, would require issuers to retain 5% of the value of mortgage bonds sold to investors.
But this year's restrained CMBS volume also reflects competition from other banks and life insurers, say McBride and Renna.
Banks and thrifts saw their commercial real estate debt holdings reach $914 billion in the first quarter, a rise of $16.5 billion from the last quarter of 2013, according to the Mortgage Bankers Association.
"In an environment of low interest rates and low volatility, banks and life insurance companies can compete aggressively on price," Renna said.
CMBS activity could pick up in the second half of 2014, particularly in the fourth quarter, as borrowers with loans maturing in 2015 begin to refinance their mortgages, Renna suggests. At the same time, life insurers and non-CMBS banks may slow their lending as they reach their loan targets, he adds.
Like home lenders that sold risky residential mortgages to Fannie Mae and Freddie Mac before the financial crisis, many CMBS lenders watered down underwriting standards in 2005-07 and lent money based on inflated property income and value forecasts.
Later, borrowers with risky loan terms and properties couldn't make their payments. CMBS investor losses on loans made in 2004-08 totaled about $28 billion as of late 2013, according to CoStar Group, a commercial real estate analytics company and online marketplace. CoStar projects that total losses from those years could reach roughly $61 billion by 2020.
In some cases, the properties underlying maturing CMBS loans may have fallen so much in value in the last 10 years that they'll need additional equity or mezzanine debt — a pricey subordinated loan — to make them eligible for refinancing.
"A lot of the really bad deals with silly underwriting have already failed and been dealt with," said David Hendrickson, managing director for real estate investment banking with Jones Lang LaSalle. "Maybe some of the borderline deals will need an equity or mezzanine injection, but there are sources to fill those gaps.
What's more, to compete with other banks and life insurance companies, mortgage bankers and analysts say that CMBS lenders are getting more aggressive in their underwriting. They are making loans with higher loan-to-value ratios and allowing interest-only payments for a few years of a loan's term, or even the entire term.
In a May report, Standard & Poor's said 55% of CMBS loans included an interest-only component in the first quarter, up from 50% in 2013 and 34% in 2012.
By comparison, interest-only payments were allowed in 90% of CMBS loans made in 2007.
Los Angeles-based real estate investment manager CIM Group recently secured an $85 million CMBS loan from Citigroup Global Markets Realty Corp., part of Citigroup (C) . It used the funds to acquire EpiCentre, a 305,000-square-foot retail, entertainment and office project in Charlotte, N.C. The mortgage features interest-only payments for the entire seven-year term, according to a prospectus filed with the Securities and Exchange Commission.
Renna recognizes that an overly competitive lending environment could lead to looser underwriting and ill-advised loans. But he says CMBS participants are still mindful of the big CMBS defaults and losses during the financial crisis and recession.
"Competition makes you more aggressive and borrowers benefit from the fact that they get better pricing and structure," he said. "But having lived through the last few years, I think people have their guards up and are more vigilant."