Mixed Trends in CMBS Underwriting
Nearly a year ago, the commercial mortgage-backed securities (CMBS) market officially adopted risk retention rules as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. The rules were designed to align the interests of sponsors and investors. Risk retention requires lenders originating loans to retain a 5% slice of each CMBS deal for five years, thereby forcing issuers to have “skin in the game.”
Risk retention had been the biggest regulatory challenge the CMBS industry faced since the financial crisis. This commercial real estate cycle has been characterized by greater restraint on the part of creditors and regulators. As a result, banks are reporting tighter lending standards. Since the financial crisis, we are seeing an improvement in some underwriting metrics, as seen in this week’s chart. The average issuer loan-to-value (LTV) ratio of pooled conduit deals so far in 2017 is 57%, compared to 60% in 2016, 64% in 2015 and 66% in 2014. A similar improvement has been observed in debt-service coverage ratios (DSCR) with an average of 2.15x in 2017, up from 2.01x in 2016, 1.8x in 2015 and 1.73x in 2014. While risk retention has influenced loan underwriting trends, investor sentiment has also played a role. AAA-rated CMBS market spreads have seen a corresponding downward trend as investors are more willing to pay up for lower leverage.
However, CMBS conduit transactions are also signaling some credit concerns which should be carefully monitored. The increasing presence of full-term interest-only loans could signal greater maturity default risk as these loans lack amortization. In addition, the increased use of subordinate debt can underestimate true leverage risk. Subordinate debt can also increase default risk and complicate the loan resolution process.
While trends in metrics such as DSCR and LTV have notably improved in recent years, it is important to be aware of all potential risks within CMBS conduit transactions. Headline credit metrics should be deconstructed to paint a more accurate picture of true credit risk. The inclusion of large, low leverage, high quality loans can mask tail risk within the pool. We have had an up in quality bias as we move into the later stages of the current real estate cycle and remain cautious going down in credit given the current risk reward opportunity.
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