CMBS: The Facts

Today, we take a few moments to chat with Erik Johnson, noted commercial real estate mortgage banker in the Twin Cities and Vice President at Venture Mortgage of Edina, MN. Erik has 15 years of experience in commercial real estate banking, and he has generously agreed to shed some light on the segment of commercial lending known as Commercial Mortgage Backed Securities, commonly known as CMBS. First, let’s look at a description of how CMBS loans are originated, taken from the VentureMortgage.com website:

                “Commercial Mortgage Backed Securities (CMBS) loans are underwritten and funded by a qualified conduit lender, then sold to a trust. Those trusts pool many single loans of varying size, property type, and location, then issues bonds that vary in yield, duration, and payment priority.”

With this basic understanding in mind, let’s get started.

Q: Erik, thank you so much for taking the time. I’ll get right to the heart of the matter: in light of recent market volatility, many commercial real estate investors are looking to explore stabilized financing options beyond the bank, including CMBS loans. What property types are eligible for CMBS financing?

Erik: CMBS loans have historically been a great source of financing for investors who own non-investment grade assets, or who own assets that are investment grade but are highly leveraged, and this applies across all commercial real estate asset classes. CMBS properties can be in major metropolitan areas and secondary markets; in some cases, properties in tertiary markets may also qualify.

Q: Who would benefit from CMBS as an option? Are there situations where CMBS would not be a good choice?

Erik: CMBS is a great option for investors seeking a long-term fixed rate, higher leverage, long amortizations, and/or non-recourse financing. Both sophisticated investors with large portfolios and “one-off” borrowers can utilize these loans. Generally speaking, loan amounts are $3 million at a minimum, so relatively small projects do not qualify, and there is no specified maximum, which allow for financing of very large projects (to the hundreds of millions of dollars) that likely would not be possible from alternative capital sources.
The use of CMBS is not advised in cases where the investor is considering selling the subject property in the near future, where the asset is not stabilized, or where there is significant near-term lease roll.

Q: That provided a lot of clarity as to what property types and borrowers are a good fit for CMBS. I’m curious about something you mentioned earlier: oftentimes, borrowers in secondary and/or tertiary markets have difficulty securing financing from certain sources, but you stated that CMBS is an option in these cases. How are these lenders able to finance in these markets, when other lenders are not?

Erik: It’s mostly a matter of dispersing the risk that comes with these smaller markets. These loans are placed into pools and sold, and the lenders will usually price some premium into such deals to compensate for some of the perceived risk involved. The investors, or “B-piece buyers”, that buy these loan pools are aware and generally comfortable with some level of heterogeneity in the asset types and their respective geographic locations. Also, these CMBS lenders and investors acknowledge that there is a lot of competition for loans in those core primary markets (from banks, life insurance companies, and agencies) and, therefore, know that they need to expand their radius to source deals.

Q: It seems that CMBS has been a good option for many commercial real estate investors, and I am wondering if that will continue to be the case in the future. As I understand it, there are some developments in the financial world that may have direct implications for CMBS borrowers: are changes coming that borrowers need to be aware of?

Erik: Good question. A couple of CMBS shops have actually closed in the last few weeks, and there is some speculation that others will follow. CMBS shops closed primarily because they mis-priced a large number of deals and, thereby, incurred substantial losses from which they could not recover. The mis-pricing was due to overly aggressive quotes designed to win business in a highly unstable bond market. These events have shaken borrower confidence in CMBS execution. 
Another major disruption coming later this year is the implementation of the Dodd-Frank credit risk retention rules: basically, these rules state that CMBS issuers will be required to retain 5% of the deal and hold some additional reserves. I recently returned from the 2016 MBA CREF conference, and most CMBS lenders represented there indicated that these new regulations will add anywhere from 25-50 bps to spreads sometime in 2016. This increase in spreads will, in turn, decrease loan proceeds due to underwriters’ minimum debt service coverage ratios. It seems that, going forward, CMBS will be a less viable option, and the primary beneficiaries will be life insurance company lenders and banks. I would add that, given this changing landscape, it is more important than ever that borrowers work with a skilled, experienced mortgage banker who can bring clarity and real-time market knowledge to a given borrowing situation.
The general message going forward should be that which CMBS lender you work with matters: do they have a warehouse line? Do they have other business lines? Are they stable and trustworthy, with sufficient financial backing, or are they a recent fly-by-night operation?

Q: Thanks, Erik. It sounds like you’re advising borrowers to carefully weigh options, and I think we can all agree that comparing offers from varying lending sources before obtaining commercial mortgage debt is always prudent. If CMBS isn’t a compelling option, will borrowers need to return to life company lenders and banks to finance commercial real estate? In short, what are the options here?

Erik: I guess that the simple answer is that there will likely remain a place for CMBS lending for the foreseeable future.  For those seeking non-recourse, there are deals that simply will not fit the life insurance company profile, whether because of the sponsor, the property, or the loan structure. CMBS will remain a good option for those deals.  However, for those borrowers willing to trade recourse for a better rate or more flexibility, banks and life companies will be more attractive options.

Q: Can you go into more detail regarding what factors a borrower needs to carefully weigh when choosing a capital source?

Erik: As far as factors that borrowers should consider, I always stress flexibility and options.  Borrowers typically don’t give enough thought to the future, whether that means selling, making needed capital improvements, or succession planning.  There is often a misalignment of their investing objectives and their lender type and/or loan terms. 
The top items that I feel are too frequently overlooked or not addressed by borrowers are 1) prohibition on secondary financing, 2) assumability, and 3) prepayment penalty (particularly in the event of a sale).  These things should absolutely factor into the type of lender that borrowers choose. 
For example, if a borrower is certain that this is a “hold” asset, they should probably be looking at life company and/or CMBS.  But within each type of loan, there are options beyond the “rack” structure that the lenders offer that the borrower may not know exists.  In the case of CMBS, I would highly advise borrowers to pay the extra couple of basis points in rate to get yield maintenance instead of the standard defeasance.  And with life companies, I would certainly investigate whether the lender can offer an alternative to yield maintenance; many of them do.  This increases options and greatly lessens the financial pain in the case of an unforeseen future event.  I’ll say it again: flexibility and options.

Q: Thank you very much, Erik. We investors really appreciate this in-depth insight on CMBS and commercial real estate mortgage debt.

Do you have further questions about capital sources that we didn’t address here? Feel free to email Erik Johnson directly at ejohnson@venturemortgage.com, or call his cell at 612.385.4147.