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COMMERCIAL REAL ESTATE

JULY 27, 2011

Funds Could Fizzle

Key CMBS Investors See Troublesome Trend in the Market
By AL YOON

A key funding source that has made the commercial mortgage-backed securities revival possible may back further away from the market in coming months, leaving lenders to scramble for other buyers or watch their volume fizzle. Some participants in the small but powerful group of investors that support the riskiest parts of CMBS bonds backed by office, retail and apartment buildings are finding a troublesome trend in the loans that they are offered. These investors, known as "B-piece" buyers, are paid higher interest rates but suffer the first losses if loans go bad. With CMBS sales this month hitting a post-financial crisis high, the buyers say recent deals have had weaker underwriting standards. Among their concerns: a higher percentage of interest-only loans and structures that strip some control from investors. The trend has accelerated as more lenders re-entered the market in 2011, boosting competition to make loans in a market still challenged by the fragile economic recovery. There are fewer than six active B-piece buyers, about half of the number that existed during the heady days of 2007, according to Standard & Poor's. CMBS issuance is a fraction of its $234 billion 2007 peak, but B-piece buyers today must support more of each deal and will likely have to bear risks longer under new financial regulations. The average subinvestment-grade portion of a CMBS issue that B-piece buyers must pick up has nearly doubled since 2007 to about 5.8%, S&P said. For now, underwriters have found sufficient B-piece buyers for their deals, and some analysts say the concern being expressed by some investors is overblown. "The potential for excess does exist at some future date. That day is not today," says Harris Trifon, a CMBS strategist at Deutsche Bank. But some investors warn that borrowers and underwriters may have trouble selling CMBS deals in the future. That would mean certain deals couldn't be done or underwriters would have to reject the weakest loans from CMBS issues to get them sold. "Eight weeks ago, there were four deals out for the bid ... that's a lot in a market with only three or four active, experienced B-piece buyers," says Steven Schwartz, managing director at Torchlight Investors, a B-piece buyer. "If you can't find one of those guys, you're going to have to find someone new, and that's potentially a problem," says Mr. Schwartz, who spent 19 years in commercial-property lending and CMBS at J.P. Morgan Chase & Co.

"That's going to be a limitation for the CMBS market." B-piece buyers also include BlackRock Inc., the world's largest money manager, and real-estate firm Rialto Capital Management. Hedge funds H/2 Capital Partners and Elliott Management also buy subordinated CMBS. BlackRock was a major buyer early on, but lately the firm has "backed off," says Daniel Sefcik, a managing director. "People ask if we are out of the market," he says. "We have been bidding, we just haven't been winning." CMBS volume topped $20 billion last week, on pace to meet industry estimates for a $35 billion to $40 billion market, up from $15.3 billion in 2010 and $3 billion in 2009. The outlook could be too optimistic, however, with weaker collateral and market volatility resulting in higher costs for issuers, Lisa Pendergast, co-head of CMBS risk and strategy at Jefferies & Co., said in a research note on Friday. The growing resistance by B-piece buyers isn't the only concern facing the CMBS market. Last week, Goldman Sachs Group Inc. and Citigroup Inc. had to sweeten a $1.48 billion CMBS issue for senior investors unhappy with low yields and credit support. This response will help check any drop in loan quality, says Deutsche Bank's Mr. Trifon. Investors globally are also reassessing risk appetites amid concern over the possibility of European and U.S. sovereign-debt defaults. Head winds for CMBS lending come when the U.S. property market is still struggling in many regions outside large cities, where there is little or no economic growth. Many owners who bought near the height of the realestate bubble using high leverage have defaulted on their mortgages. The renewal of the CMBS market has helped some borrowers, enabling them to refinance. But that option will be less available if a dearth of B-piece buyers causes volume to fall. "It's going to be felt by the commercial real-estate industry as a whole because a very important source of capital is going to become much more costly and much less available, and that's going to have a ripple effect," warns Ethan Penner, president of CBRE Capital Partners who pioneered CMBS in the 1990s. B-piece buyers compare the current market to the heyday of 2007, when they were asked to take more risk for the same return, according to three B-piece investors. For example, they are concerned that CMBS issues are being structured so that they will have less power in a default situation. One B-piece buyer, who asked to remain anonymous, said he might give up B-piece investing for other highrisk, high-return commercial real-estate assets. He noted, for example, that Anglo Irish Bank Corp.'s $9.5 billion U.S. real-estate portfolio is currently out for bid. Write to Albert Yoon at albert.yoon@dowjones.com

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