As economic conditions improve, a recent article explains how the booming Commercial Mortgage Backed Securities market collapsed with such stunning speed and severity. About $32.5 billion of the loans made in 2007 are maturing in 2012; and, according to CoStar Group, 50 to 60 percent of those maturing this year will fail to refinance or pay off in full.
Only an estimated 28 percent of all CMBS loans maturing in 2012 will be paid off or refinanced. The same problem is expected to occur in 2014 and 2017 as loans with seven- and 10-year terms are set to mature.
The article, published in New York Times , describes a $204 million loan made to Pinnacle Group that was secured by a mortgage on 36 apartment projects in New York. The loan was made despite the fact that Pinnacle’s actual cash flow was grossly insufficient to support the required annual interest payments. Pinnacle was forced to drastically raise rents to meet the annual interest payments, but the loan still went into default in 2009. It was later sold for approximately $117 million — a 49 percent net loss to the investors.
The Pinnacle loan illustrates two of the most fundamental causes for the crash cited by industry professionals: First, a significant deterioration in underwriting standards for loans put into CMBS pools. Second, bankers’ incentive to earn profits for packaging and selling loan pools outweighed their concern over declining credit quality.
These two factors fed on each other along with the false perception that real estate values could only increase to create an extremely inflated market and the resulting violent crash.
The Pinnacle loan defaulted relatively early but many other CMBS loans are still performing, although the value of the underlying property securing many of the loans is less than the loan amount. These so-called “zombie loans” appear to be performing but are actually likely to be in default and will be almost impossible to refinance upon maturity. The question becomes what to do with them.
Foreclosure is a costly and lengthy process that often ends with the lender recovering less principal. Modifications and extensions can also be complicated because of the limits on what powers loan servicers have to modify terms of the loans. Some lenders have simply chosen to wait and hope the market recovers enough to resolve any issues.
Ironically, the worst category of CMBS loans in default is apartment and condominium loans due to overly optimistic projected rents and values. But the condo market is currently one of the bright spots in commercial real estate, particularly in Florida. It remains to be seen whether the recent recovery in this sector, and the resulting increase in rents and values, will be enough to help resuscitate the zombie loans secured by apartment projects.
And despite all the grim market data, not all investors in CMBS securities faced losses. CMBS issuances are typically split into different tranches with different priorities and payment characteristics. Some tranches are exposed to first losses — generally, in return for a higher expected return — while others are secure until the first loss tranches are wiped out. Consequently, some holders of CMBS securities are doing fine and would resist any proposed amendment or restructuring of the CMBS issuance. This partly explains why addressing the problems in the CMBS markets is complex.
In Florida, there have been encouraging signs that the CMBS markets are improving. Recently, the owner of the Somerset Shoppes, a shopping center in Boca Raton, successfully refinanced a $30 million CMBS that was set to mature in September 2012. In April 2012, the $412 million mortgage on the Fontainebleau Hotel in Miami Beach was sold to CMBS investors and the loan was divided into five tranches.
The future of the CMBS market will certainly be heavily influenced by the Dodd-Frank Act signed into law nearly two years ago. The law is still being debated and many of the provisions that affect CMBS markets have not been finalized.
One of the act’s key provisions, however, was designed to curb the excesses of 2007 and is already causing concern among bankers and real estate professionals. The proposed provision would require mortgage originators to retain 5 percent of any loans they repackage and sell in order to have skin in the game.
This could cause investment banks to exit the market since the retention provision would likely cause CMBS issuances to be less profitable. Many industry experts think this could cause more pain for the real estate markets and inhibit real estate lending. The retention requirement will likely be finalized this year.
Looking forward, there’s little doubt that CMBS issuances will once again become an important part of the commercial real estate finance market as markets continue to stabilize and general economic conditions improve in the U.S. and around the world.
The liquidity provided by CMBS issuances is critical to restore healthy real estate markets. But underwriting guidelines will become stricter and the types and sizes of the real estate projects securing CMBS loans will become more selective. And the finalization of Dodd-Frank Act provisions regulating the CMBS markets is likely to have a significant effect on future issuances.
For now, many servicers are likely to continue to extend and pretend.
WSH Partner Joseph Hernandez routinely represents banks and other lending institutions in secured corporate loan transactions. A former real estate and corporate banker, Joe has over twenty five years of experience working in transactional real estate. He is a member of the Firm’s Real Estate Group and Business Organizations and Transactions Group.
Author(s): Joseph Hernandez
