By Todd McNeill, Senior Director at Metropolitan Capital Advisors
Recent events have made the CMBS market unpredictable as a tool for commercial real estate financing, especially when the equity needed for a property acquisition is coming from a passive third-party investor. Why? Because commercial real estate is a leverage game where the debt is used to torque the equity returns on the investment. If you cannot forecast the exact cost of debt, then it is almost impossible to accurately project the investment return on equity. As difficult as “locking in” the interest rate has become in the tumultuous CMBS market, it is almost impossible to get the equity side of the transaction to “commit” without the element of certainty.
What has caused this commotion? Macro-economic issues such as the European debt crisis, downgrade of U.S. credit rating, market sentiment, double dip recession fears all the way down to the simple fact that investment banks are not prepared to take risk on commercial real estate loan inventory. S&P’s recent gaffe on the rating of the Goldman / Citigroup securitization, which resulted in the offering getting pulled from the market in late July, has caused the rest of the CMBS Lenders to hit the pause button.
The culmination of all these events caused “spreads” to widen to a point that there was limited profitability in a CMBS trade. Interest rate spreads widen in an uncertain market so that CMBS lenders can easily offload the loan in the securitized market and still, hopefully, make a profit. The CMBS lender is essentially “hedging their risk” by widening their spread, which ultimately correlates to an increased cost of capital for the borrower. This is the CMBS’ way of staying in the game while ensuring that no losses will be made on the sale of the securities. Some will say that the CMBS lenders are pricing themselves out of the market so that borrowers will go elsewhere (or nowhere), for the time being. This practice ensures that the CMBS lender never has to tell a borrower the dreaded words, “we are out of the market” or, “your deal is dead.”
Why should we expect this commotion to settle down? At a recent finance conference in Dallas, the CEO of Archon/Goldman, S&P indicated that S&P admitted that there really was no error in the rating and that their rescinding of the rating was a mistake. Essentially, S&P will probably be out of the rating business as it relates to CMBS pools for the foreseeable future according to some traders. Expect Moody’s and Fitch to become bigger players going forward. This will certainly help if the rating agencies can continue to gain trust from the bond buyers.
Goldman and Citi, along with several others, will soon be bringing their securitizations to the market. The market will be watching closely to how those bonds price and will (hopefully) give a benchmark to the CMBS lenders on where spreads need to be to profit from the sale of the loans. Once the market absorbs the recent securitizations, there should be better clarity on CMBS pricing.
After the latest rounds of securitizations are finalized, Markit, a predominant CMBS analytics firm, will be using the approximately $3.2 billion in securitizations to create “TRX2”, a second generation “total return swap index” that will provide a uniform flow of daily price data to the 12 major Wall Street dealers. This will track price movements from the most recent 18 major securitizations. In turn, this will enable the CMBS lenders to more accurately “hedge” their positions while accumulating loan inventory between securitizations. Since the CMBS market revived in 2009, CMBS lenders have lacked a reliable way to hedge their positions. The most popular option has been to take the short side of derivatives based on the oldest series of the CMBX index of credit default swaps, from 2005-2006 vintage securitizations. As you can imagine, this is like hedging apples and oranges. This is surely going to tighten pricing and remove spread volatility from the process.
With this tool, along with approximately $3.2 billion of securitizations occurring in the next 30 days, the market will have a clear picture of current pricing, along with a much improved hedging product for the CMBS lenders. This will trickle down to the borrowers and CMBS will again be a loan product that can be counted on to deliver what is applied for. The next item to conquer will be a true rate lock for the CMBS product. We should all hope that, after CMBS pricing settles down and hedging products become reliable, a good old fashioned rate lock will not be too far behind…Cross your fingers!!!
Do you want to learn more about the CMBS market? Contact Todd McNeill, Senior Director, of Metropolitan Capital Advisors.