Five Steps to a Safe CMBS Exit Strategy
The commercial mortgage-backed securities market is back, with investment levels not seen since the last market peak. Current yields are strong compared to many investment types, and loans originated in the past three years are showing no signs of delinquency.
Yet, analysts are already expressing concern that underwriting standards are starting to ease, and may continue to slip as more and more originators enter the fray. As underwriting standards bend to the more aggressive side, b-piece investors will want to kick out loans that they view as too risky, and banks have been resistant to any kick-outs in recent years. It is a balancing act for originators, underwriters and investors to compete aggressively in a rising market without crossing the invisible line into territory where returns don’t match the risk profile.
CMBS Issuance by Year
Source: CREFC Compendium of Statistics
Can institutional investors make the most of the current favorable conditions without losing sleep over the potential downside of an overheated market? The answer is yes—if they put the right practices in place to minimize exposure to risk.
CMBS investment is hotter today than it has been for years. Issuance in the first half of 2013 is expected to top $39 billion, compared to about $15 billion during the same period last year. Analysts in January predicted this year’s volume to far outpace the $48 billion issued in 2012.
Delinquencies on CMBS 2.0 (post-2009) loans have held at a low 0.03 percent overall, according to Fitch Ratings Index Report. However, investors don’t need a good memory to know that loans can go south; Fitch reports that there are $9.3 billion in delinquent loans that have already matured, and another $20.9 billion in current delinquencies on loans maturing after 2013, most of them originated during the last market upsweep.
It may be wishful thinking to assume that investors have learned the lesson of due diligence. Market analysts observe that loans originated in the second quarter of 2013 allowed higher levels of leverage than the market has seen since 2008 and more borrowers are opting for riskier interest-only loans. Some loans on properties in primary markets are engaging in pro forma underwriting, where future increases in property revenue are assumed in the underwriting.
According to Standard & Poor’s, more than half of second-quarter volume came in the form of conduit/fusion transactions that carry greater levels of risk than CMBS product originated in the past three years—and are measurably riskier than conduit/fusion deals originated as recently as the first quarter.
"The risks associated with continued deterioration in loan standards this year, especially in recent deals, could eventually lead to higher loss rates," S&P stated in a recent report. “Too many investors are unfazed by the credit drift, largely content that anchoring to existing cash flow obviates risk along other dimensions.”
Investors need to remember that the success of any CMBS investment is based on both the buy and the sell. Investment would be simple if the market could be counted on to remain the same in the future as in the recent past; however since market dynamics are always changing, the smart money has an exit strategy in mind when making an investment.
Here’s a basic five-point plan for developing an investment strategy that allows you to ride the wave of good yields today while minimizing downside risk at the back end:
- Understand the assets. Relying solely on rating agency perspective can not only be risky, but confusing as well, since different analysts use different assumptions. A property’s future occupancy challenges may be considered insignificant by one analyst and problematic by another. An investor making a big play in a CMBS pool can conduct a separate analysis and arrive at an informed decision.
It may not be feasible for an investor to thoroughly scrutinize every asset in a CMBS pool before making an investment decision; however, by digging below the surface of the asset’s cash flows, a smart investor can quickly hone in on issues that could raise a red flag, from large looming capital expenditures to an anchor tenant that is reducing its workforce.
- Know the market. As with direct lending and equity investing, some CMBS investors favor pools with concentrations in institutional-grade markets like New York and Washington, D.C., while others want to see greater geographic diversity, with growth markets like Austin and Portland in the mix.
For investors, one question is whether the potential ups and downs of a given market align with risk-adjusted return targets. For example, cap rates on Austin loans carry a premium of roughly 100 basis point over similar assets in New York—in part because more investors are focused on New York, but also because it has been shown to be resilient. New York’s office occupancy rates rose swiftly during the recession when banks and law firms were reducing their space needs, but fell just as swiftly after just a couple of years and are now among the lowest. A smaller city—even one with strong current absorption like Austin—might not be as resilient when faced with a setback.
- Understand the deal and pool structures—In terms of deal structures, it’s important to understand borrowers’ options for liquidation, collateral requirements, and opportunities for loan modifications, among other details that can affect yields in a variety of ways. Moreover, investors should not forget to look at the structure of the overall trust. Has the capital stack been arranged effectively to provide the right risk-adjusted returns to investors up and down the line? How does the level of reserves strengthen or weaken your confidence in the trust’s ability to cover loan losses? These are just a few of the many factors investors need to scrutinize to get an accurate picture of risk-adjusted returns.
- Know your risk tolerance—Perhaps that should read, “Adhere to your risk parameters,” because investors always know their risk tolerance—they just don’t always stick to it, as intensifying competition and the pressure to capture higher returns leads some investors to expose themselves to greater risk levels.
An opposing argument says that investors with agility can balance good returns and minimal risk. But not all investors can claim a high level of agility, and it’s easy to get caught in the trap of gradually accepting looser and looser standards.
- Have a Plan B—Having an exit strategy in mind when you invest in CMBS is important, but that strategy may need to be changed if assets and markets don’t perform as expected. For example, a pool with a heavy concentration of loans to one retail chain will be under a lot of stress if that retailer goes into bankruptcy.
This is where the importance of deal monitoring comes in. By tracking performance of the pool overall and of the loans with the biggest potential risks--or by retaining a third-party surveillance company to do so--investors may be able to see downside risks developing before the market as a whole does, and take action to protect their investment.
Planning for these contingencies makes it easier to maneuver if and when they occur. This may be a matter of selling off when delinquencies appear likely, or considering hedge strategies when market vacancies reach a certain level. In addition to enabling you to act quickly when necessary, formulating a Plan B at the outset provides a psychological advantage. People can be slow to acknowledge their strategy isn’t working, but if an early exit or other contingent adjustment is part of the initial plan, then the psychological barrier to act to protect the investment is removed.
Invest with Confidence Underwriting standards today are still strong enough to provide investors with a high degree of confidence that risk-adjusted return targets will be met. But who knows how long current standards will hold? The typical cycle of any investment type is that, as more and more capital chases fewer and fewer quality deals, yields get squeezed and underwriting standards get loosened. It doesn’t happen all at once, so it can be difficult to pinpoint the moment when risk outweighs return.
The best way to combat this “risk creep” is to set your own standards and draw your own line in the sand from the outset. Later, in the heat of battle, it may be difficult to back out of a seemingly rising market. But developing a solid strategy and a backup plan—and summoning the discipline to follow that plan when it becomes necessary—will help ensure that you’re not caught in a sudden market contraction down the road.