Will CMBS Uncertainty Impact Valuations?

By Robert Brunswick, CEO of Buchanan Street Partners

NEWPORT BEACH, CA—As the CMBS market continues to slow, how will the capital markets sector be affected? Buchanan Street Partners’ Robert Brunswick weighs in on the subject EXCLUSIVELY with GlobeSt.com.

Much has been reported about the CMBS market continuing to slow, plateau, freeze—fill in your own verb. GlobeSt.com spoke exclusively with Robert Brunswick, CEO of Buchanan Street Partners, to get his take on how this trend is affecting the capital-markets sector now and in the future.

GlobeSt.com: As wider spreads translate into higher costs for borrowers on CMBS loans, what alternative financing solutions are coming available?

Brunswick: When we talk about CMBS, we first need to frame what it has brought to the real estate markets and where it might be lacking. The advent of CMBS brought much-needed liquidity and additional participants to the debt markets­—both improving liquidity to the market and further validating real estate as an asset class in terms of investor fluency and their ability to assess risk and return. In turn, real estate debt through CMBS now competes with capital flows to other asset classes and the greater volatility of the liquid markets. Geopolitical issues, market cycles, rating agency moods, increased regulatory requirements and past CMBS performance all affect the day-to-day pricing of new origination and resale and purchase of existing bonds. Therefore, we need to be careful to not overreact when CMBS goes down or up since it is not an indicator of the demise of CMBS but instead recognition of the variables that impact its daily pricing.

In the past few years, we have seen a reduced volume of new issuance of CMBS, due in part to what happened with prior performance of CMBS and in large part due to real estate’s devaluation in the last cycle. Rating agencies were questioned as to their objectivity and the bond’s ultimate performance. Where are we today? CMBS bonds now have to compete with all other asset classes and types of bonds, and with that there is a more disciplined assessment of its associated collateral and cash-flow predictability. It’s currently difficult to provide borrowers with a predictable rate within the CMBS market until the loan is ready to close, thus limiting current origination volume. Further, banks and life insurance companies are much more active in their availability today, offering borrowers more predictability of outcome. Additionally, there is a trend for many buyers of real estate to de-lever (or bring in more equity to) their acquisitions and real estate, which plays more into the hands of the life- insurance companies and banks.

A majority of CMBS originations have catered to those borrowers seeking higher leverage to satisfy a refinance, a secondary or tertiary market consideration, or reduced equity position on assets that might not fall into a bank or insurance company’s lending parameters. CMBS has historically financed riskier assets, and with rating agencies starting to now see slippage in underwriting quality, and with the pending new risk‑retention rules for CMBS taking effect in December under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the bond-buyer market has become skittish, limiting originator capabilities.

With this uncertainty, many private lenders (shadow banks) are being formed and/or becoming more active to provide capital for the potential shortfall. We ourselves have set up a private-lending vehicle to provide a predictable capital source for those transactions that have good sponsorship, are properly sized, might require some structure but couldn’t go through a conventional CMBS underwriting or do not have the necessary time to wait. The private-lending market can be an interim source of capitalization for many borrowers, but it’s not a long‑term solution. As people fix their assets’ problems or buy assets and stabilize them, interim financing can be a short-term solution, but not a long-term one because the property cannot withstand the higher yield associated with these types of loans. This ultimately creates a lower-priced source of capital available to those buyers. To fuel this type of lending, many investors are eyeing the debt space since it affords a more predictable yield with tangible subordinate equity.

There are roughly $250 billion of CMBS loans maturing between 2016 and 2018. If the property is not sold, the refinance lender is either the new CMBS market or a private lender who might accommodate the transitioning nature of the asset. Interestingly, though, a lot of prior CMBS borrowers have defeased their loans early given the attractive refinance markets, brought in more equity and are now refinancing through banks and insurance companies. We have to recognize that CMBS, for most borrowers, has never been the first choice.

GlobeSt.com: What does the uncertainty in the CMBS market mean for buyers and sellers of commercial assets? What does it mean for asset values?

Brunswick: For every transaction, only 10% of the market uses CMBS. I would draw the conclusion that CMBS by itself is not going to drive down valuations or cause them to pause. There are other factors, such as the greater economy, the lack of significant growth in rent rolls, the over-exuberance of pricing as investors are wanting to put their money to work and get some yield. But this is a levered asset class, and as leverage is reduced, that will mean less yield on your equity. You’re either going to be willing to accept lower leverage with less yield on equity, or sellers will have to be more realistic on pricing their assets given the reduced leverage that is available to buyers. A slowdown in sales is not solely attributed to the debt markets; it’s a variable. You can put your money to work in other asset classes that might be better priced to get the yield you thought you were getting in real estate. Real estate appreciated too quickly.

GlobeSt.com: What does this turmoil mean for borrowers as originators stop making CMBS loans because it’s now dramatically more difficult to price loans due to the inability to predict the future cost involved?

Brunswick: Most borrowers who use CMBS either have a relationship with a particular lender or they have a higher-leverage requirement, and CMBS is their only option vs. going to a bridge lender who might charge more. Spreads have actually reduced recently as the bond buyers have come back into the market a little bit. They were in the 350 range, and are now 310 to 320, depending on the asset. It’s becoming a known reality that if you do a CMBS loan, you have to live with the volatility of not knowing what your rate is going to be until you close. That’s a tough presentation for borrowers as they want certainty of pricing. It’s creating volatility on the buy/refinance side, and it means that these borrowers will have to put more equity to work and accept some volatility.

GlobeSt.com: What else should our readers know about alternative financing solutions and CMBS?

Brunswick: A lot of folks are now saying they’d rather be in the debt seat than in the equity seat. They will put more in debt until they get comfortable with the valuations of CRE or debt yields are driven down on the private side. There will be varied debt players who will start to backfill the capital markets as their investor base reconciles this mispricing and opportunities present themselves, and investors recognize that the risk-adjusted yield is more attractive on the debt side than the equity side at the moment. CMBS is not going away. It will come and go as capital does and as the market adjusts. The market is pretty smart and will price and adjust accordingly.