By Scott Lynn
Basel III, HVCRE…all these new lending regulations that mean lenders are loaning me less and charging me more. Good grief!!! And now, Risk Retention Rules, well, what the heck is that? Another new term you should be familiar with if you’re borrowing commercial real estate capital? Indeed, the so-called “Risk Retention Rules” were adopted in late 2014, which will come into effect for CMBS and other asset-backed securities on December 24th, 2016. That is right around the corner, and the capital markets have been reacting.
What is Risk Retention? Simply put, they are rules that require the issuer of CMBS securities to “retain risk in a bond offering significant enough to function as an incentive for the originator to monitor the quality of the loans being made”. The thesis is pretty simple; you’ll be darn careful about what you put into the sausage if you’re going to be required to buy and keep five slices of salami for every one hundred you sell.
Like all Rules, an EXEMPTION allows CMBS to pass off the risk retention piece (that is 5% of the salami) to an eligible third party, commonly known as the B Piece Buyer, who, by the way, must adhere to the risk retention rules, which means keeping the asset on their books and may even require the holder to post or pledge additional capital or reserves.
So, for now, Risk Retention has created two to CMBS players; Loan originators who intend to hold risk retention pieces and alternatively, those loan originators who plan to take advantage of the exemption and sell their risk retention pieces.
Adherence to and acceptance of the Risk Retention Rules has been the primary factor behind the recent CMBS market turbulence and pull back. CMBS origination volumes are down. Players are pricing the risk of keeping inventory on their books. The evolving pricing theme seems to be those that are keeping the risk are lending more conservatively, albeit at lower spreads. On the contrary, those selling off the risk might “stretch” for slightly more loan proceeds but will charge a spread that compensates for the extra risk on proceeds, as well as the risk associated with holding the investment on the books of the ultimate bond holder. No surprise; we’ve seen many of our friends on Wall Street and the CMBS world in motion lately as they are jumping ship to a platform that can buy their own B Pieces or they are out raising new FUNDS to buy the B Pieces or they have folded their tent altogether and exited the CMBS market because of the increasing regulation and low margins.
As the world turns, count on the CMBS world to do the same for the time being. Notwithstanding, CMBS remains a viable option for favorably priced, long-term, fixed rate debt, even with the market turbulence and changing regulatory environment.
Risky Business? Not so much, but risk retention is here to stay.
The Author, Scott Lynn, is the Founding Principal of Metropolitan Capital Advisors. Scott can be reached at firstname.lastname@example.org