Soaring CMBS spreads highlight new risks on both sides of the Atlantic

Widening CMBS spreads on both sides of the Atlantic reflect an uptick in supply but also highlight that investors are increasingly wary of the latest structures and collateral, and are demanding higher compensation as a result.

Data show US spreads have widened to their highest levels in almost two years, while the latest pricing from Europe - Deco-2015 Charlemagne, a multi-jurisdiction deal - illustrates that issuers need to pay hefty premiums to place non-Triple A bonds.

Market sources told IFR this reflected heightened investor awareness of the risks ratcheting up in CMBS deals. "Complexity is creeping back into the structure and the general quality of the collateral has been deteriorating," a European investor said.

After the financial crunch, European issuers soothed investors with straightforward structures, simple collateral such as German multi-family properties, and strong sponsors. But over time they slowly reinserted risk into the deals - with weaker sponsors and secondary/tertiary properties.

"The first post-crisis issues were really investor-friendly, but this is becoming less and less the case now, which is causing investors to take a step back," one investor said.

US conduit CMBS spreads on new-issue deals rated Single A- rose as high as 275bp in July from as low as 190bp in April, according to Morgan Stanley data. The last time spreads in the middle of the capital structure were this wide was the third quarter of 2013, according to JP Morgan data.

Another factor pushing pricing power back into the hands of investors is that issuers that exclude unfavourable ratings on lower-rung tranches end up paying for it. They are able to demand beefier margins for tranches that fail to get solid ratings from at least one major agency, according to Bank of America Merrill Lynch analyst Alan Todd.

Investors Less Naive

That trend, which Todd said had now more clearly crystallised since mid-May, might indicate that investors are less naive about the quality of the underlying collateral.

The fact that, contrary to other asset classes, the CMBS segment has not bounced back from heightened global economic uncertainties - specifically negative Greek and Chinese headlines in early summer - would appear to confirm this.

With Greek debt woes on the backburner, CMBS spreads have continued to languish at wider levels. Growing concerns over real estate loan underwriting standards could explain this, one investor at a New York-based asset manager said.

"I continue to be surprised by what I see getting underwritten."

The US investor said the continued onslaught of new deals had also kept pressure on spreads. CMBS issuance of US$71bn this year is running 26% higher than the same period of 2014, according to Bank of America Merrill Lynch data.

The European primary has also witnessed a surge in supply - with two deals pricing in the same week for the first time since the crisis. Deutsche Bank had to pay plus 525bp on BBB-/BB bonds and plus 425bp on BBB+/BBB notes at the end of July to place its Deco-2015 Charlemagne deal - 145bp more than initial talk.

Single As were also priced significantly wider to initial levels, at 290bp against 220bp.

While the two bankers blamed the painful results on general market weakness and mounting CMBS supply, the European investor was more suspicious, saying: "Investors may not want to spend their time taking a long hard look at CMBS structures and collateral that have wrinkles in them." 

Market Volatility Drives Down CMBS Prices

Volatility in the stock and Treasury-bond markets put downward pressure on commercial MBS prices this week.

The 10-year Treasury yield finished at 2.16% yesterday, after falling to as low as 1.86% on Wednesday, as a plunge in the stock market touched off a flight to safety. The yield was down by 12 bp from last Friday and 46 bp from the recent high in mid-September.

The decline caused CMBS spreads to widen this week, for two reasons. First, credit spreads in general rose on concerns about the U.S. economic outlook, the European debt markets and spread of the Ebola virus. Also, investors were insisting on a higher spread to compensate for the decline in the Treasury yield.

Many CMBS buyers require a minimum absolute yield to take down new issues. In the last two conduit deals, the benchmark bonds yielded 3.29%. The long-term super-senior class of a $1.3 billion offering led by J.P. Morgan and Barclays (JPMBB 2014-C24) carried a spread of 83 bp over swaps. The comparable tranche of an $842 million issue led by Citigroup and Goldman Sachs (CGCMT 2014-GC25) priced at 87 bp over swaps.

Because of the drop in Treasury yields, the next conduit offering — a $1.2 billion transaction by Deutsche Bank, UBS, Cantor Commercial Real Estate and Natixis (COMM 2014-CCRE20) — will have to carry a wider spread to match that 3.29% yield. With the 10-year swap yield down to 2.328% yesterday, the benchmark spread would have to be 96 bp to reach 3.29%.

"That says it all right there," one CMBS banker said. "The spread will have to be 10-15 bp wider to get it done."

A pullback by some bond buyers is also putting pressure on spreads, according to one CMBS trader. "It’s a tough ride right now," he said. "Any time you have that kind of Treasury volatility, people put their pencils down and say, ‘Let’s think about what we’re doing.’ "

Virtually no bonds from recent conduit issues changed hands in the secondary market this week. But dealers have widened their bid-ask spreads, indicating that they were willing to buy long-term super-seniors from those deals at spreads of 94-96 bp and sell them for 90-91 bp.

Elsewhere in the new-issue market this week, Colony Mortgage Capital continued to market a $320.8 million securitization of seasoned performing mortgages collateralized mostly by multi-family properties. Bookrunners Credit Suisse and J.P. Morgan circulated price talk of 100-bp area over swaps on the only offered class — $220.6 million of bonds with a weighted average life of three years and a triple-A rating from Moody’s.

Meanwhile, RAIT Financial started shopping a $219.4 million offering backed by 22 floating-rate mortgages on various types of commercial properties. The $126.4 million senior class of 2.4-year bonds is rated triple-A by Moody’s and DBRS. The subordinate classes are rated only by DBRS, including a 2.8-year tranche of junior triple-As. UBS structured the transaction and is running the books with Citi.

UBS and Citi were also pitching a $335 million offering backed by the senior portion of a fixed-rate debt package on the 506,000-square-foot office tower at 1500 Broadway in New York’s Times Square. They originated the 10-year package last Friday, including $170 million of mezzanine debt, on a 50-50 basis for Tamares Real Estate of London. The transaction is rated by Moody’s, DBRS and Morningstar.

Bullish CMBS Appraisal Sparks Questions

The appraisal of an extended-stay hotel portfolio collateralizing a $570 million mortgage that was securitized last week has raised the eyebrows of investors.

 

Blackstone acquired the portfolio from Clarion Partners for $800 million in August. But the Cushman & Wakefield appraisal cited by lenders J.P. Morgan and Deutsche Bank valued the properties at almost $100 million more.

 

The valuation gap is unusual. When real estate has just changed hands, the appraised value typically mirrors the purchase price. The issuers of securitizations, in turn, use that value to determine the leverage ratio of the mortgage on the properties. Because the high Cushman valuation increased the denominator, the stated loan-to-value ratio was lower than it would have been if the purchase price was used. Some investors view the higher valuation as an example of an ongoing slide in loan-underwriting standards.

 

The loan was the senior portion of a $675 million floating-rate debt package that J.P. Morgan and Deutsche originated on Aug. 12 in conjunction with Blackstone’s acquisition of the 47-hotel portfolio. The two banks securitized the senior loan last week via a stand-alone deal (BLCP 2014-CLRN), with the investment-grade classes pricing in line with the dealers’ asking prices.

 

In addition to its $800 million purchase, Blackstone incurred $35.1 million of closing costs and funded $10.1 million of upfront reserves, bringing its total outlay at the closing to $845.2 million. Blackstone has also indicated that it plans to spend $63 million on renovations over four years.

 

The securitization documents cite multiple appraised values that Cushman provided on July 1 at the behest of J.P. Morgan and Deutsche. The brokerage supplied valuations based on whether the hotels were appraised individually or were sold to a single buyer willing to pay a premium to buy in bulk. Cushman said the "as-is" value was $833.7 million on a one-by-one basis and $885.1 million on a portfolio basis.

 

The brokerage also supplied "hypothetical" appraised values that factored in "all planned capital dollars" that Blackstone will put in reserve to upgrade the properties. Using that hypothetical standard, Cushman valued the portfolio at $844.8 million on a one-by-one basis and $896.3 million on a portfolio basis.

 

Of the four potential valuations, J.P. Morgan and Deutsche chose the highest. As a result, the loan-to-value ratio highlighted in the deal documents was 63.6% — or $570 million divided by $896.3 million — on the senior debt and 75.3% on the overall debt package. By contrast, had Blackstone’s actual $800 million purchase price been used, the leverage ratios would have been 71.3% and 84.4%.

 

While it’s possible that Clarion left a lot of money on the table by selling the 5,908-room portfolio to Blackstone at a below-market price, real estate pros say that seems highly unlikely, given that both companies are sophisticated institutional investors and that Clarion conducted a broad-based auction via a major brokerage, JLL.

 

Instead, investors contend, the use of the most-optimistic appraisal is another sign that commercial MBS issuers are pushing the envelope on credit quality. They view the use of hypothetical valuations as akin to "pro forma" underwriting, under which lenders make credit decisions based on projected increases in property cashflows, rather than in-place income. The use of pro-forma accounting was widespread as the CMBS market was peaking in 2007 and contributed to the subsequent crash.

 

 "They call it a ‘hypothetical’ appraised value — that in itself should be a red flag," said one investor. "If you want to know what the true LTV is, you might want to use the actual purchase price."

  

J.P. Morgan, Deutsche and Cushman declined to comment on why the appraised value was so much higher than Blackstone’s purchase price. Blackstone and Clarion also had no comment. But the boilerplate fine print in the preliminary prospectus for the securitization effectively warns investors that the cited valuations may have little connection to reality. "Information regarding the appraised values of the Properties is presented in this offering circular for illustrative purposes only and is not intended to be a representation as to the past, present or future market values of any of the properties," the prospectus says.

 

Other recent stand-alone securitizations that financed the acquisitions of properties or portfolios cited appraised values that were equal or close to the purchase prices. Some examples: 

• A Related Cos. partnership bought two office condominiums at Time Warner Center in Manhattan from Time Warner for $1.3 billion (plus $35 million of closing costs). Lead manager Deutsche cited a Cushman appraisal of $1.3 billion (COMM 2014-TWC).

 

• A Mark Karasick partnership bought the leasehold interest in the Mobil Building in Manhattan from Hiro Real Estate of Japan for $900 million (plus $59.5 million of other costs). Lead manager Morgan Stanley cited a Cushman appraisal of $900 million (MSC 2014-150E).

 

• Blackstone acquired two hotel portfolios from separate sellers — an OTO Development partnership and special servicer CWCapital — for a total of $503.6 million, plus $14.7 million of other costs. Lead manager J.P. Morgan cited a combined appraised value of $513.6 million (JPMCC 2014-BXH).

Rialto, Eightfold Circle 3 B-Pieces

Rialto Capital has agreed to buy the junior portions of two upcoming conduit offerings, while Eightfold Real Estate Capital has circled the B-piece of a third deal.

Rialto’s purchases involve a $1.25 billion offering led by J.P. Morgan and Ladder Capital, and a similarly sized deal led by Wells Fargo and RBS.
Eightfold, meanwhile, has circled the bottom piece of a $1.25 billion offering by Goldman Sachs, Citigroup, MC-Five Mile, Starwood Mortgage Capital and RAIT.

Two of the three B-piece agreements — Eightfold’s purchase and Rialto’s contract with J.P. Morgan/Ladder — were awarded on a "negotiated" basis. That means the issuers didn’t hold multi-party auctions. Instead, they approached Eightfold and Rialto directly and came to terms.

Issuers often avoid auctions to simplify the sales process. The maneuver can also lead to a better execution, because the buyer might be tempted to pay a little more or accept questionable collateral loans if it means bypassing a bidding contest. On the other hand, the issuer also risks leaving money on the table if it fails to capture a sudden increase in B-piece valuations that an auction would have uncovered.

In any event, negotiated sales enable issuers to shore up their relationships with B-piece investors that may have been crowded out of the market in recent auctions.

Rialto has landed 10 B-pieces so far this year. Eightfold has circled three.

First Deal of Conduit Flurry Prices

The first of six scheduled CMBS conduit transactions priced late last week at levels that were substantially tighter than the last conduit, which priced three weeks earlier.

The benchmark AAA class of the latest deal, WFRBS Commercial Mortgage Trust, 2014-C22, priced at 84 basis points more than swaps, 6 bp tighter than the 90-bp spread for the last conduit, COMM, 2014-CCRE19, which priced on Aug. 13. And the BBB- class of the WFRBS 2014-C22 deal priced at 345 bp more than swaps, in 25 bp from the COMM deal.

What’s more, the latest conduit deal’s A-S class, which typically carries the highest ratings, was rated Aa1 by Moody’s Investors Service. That is the equivalent of a rating of AA+ from Fitch Ratings and Kroll Bond Ratings, the other two agencies that rated the WFRBS deal. It marks the first time that a conduit deal’s junior class has received split ratings. But the class still priced tighter than the previous conduit, at 115 bp more than swaps versus 118 bp. Said one investor: “There’s money out there that needs to be put to work.”

The A-S class of the WFRBS deal has 23 percent of credit support, meaning that 23 percent of the transaction would have to be wiped out before it would be impacted. For it to have won Moody’s Aaa rating, the thinking is that the bond class would need to have 25 percent of subordination.

WFRBS deal were somewhat of a surprise to some investors, given that five other conduit deals are in the wings and expected to price before the month is out. That volume ought to give investors the ability to be extremely selective, so they would demand greater yields from certain deals.

Indeed, the benchmark AAA class of COMM, 2014-UBS5, priced on Tuesday at a spread of 88 bp more than swaps. Its A-S class, which has a balance of $100.9 million and carries an Aa1 rating from Moody’s, but AAA ratings from Kroll and Morningstar, priced at 123 bp more than swaps and its BBBclass priced at 370 bp more than swaps.

The deal’s underwritten leverage level is 66.8 percent and it lacks the multifamily concentration of the WFRBS deal. Only 6.7 percent of its $1.4 billion collateral pool is backed by loans against apartment properties, which are considered less volatile than other property types. But the benchmark class of GS Mortgage Securities Trust, 2014-GC24, was being shopped at a level of roughly 87 bp more than swaps. The deal’s A-S class was being shopped in the area of 110 bp more than swaps.

Meanwhile, some investors still require a Moody’s rating, so the split rating could have excluded them, or forced them to price the class wide of where it printed.

The WFRBS deal benefited from its 16.8 percent concentration of loans against apartment properties, which included $65.5 million of residential cooperative properties, which have relatively low leverage. While the transaction’s underwritten loan-to-value ratio was 64.6 percent, Moody’s stressed LTV was 110.1 percent. That increases to 114.3 percent if the co-op loans are excluded.

Also helping was the fact that Moody’s rated bond classes down to the deal’s class C, which it rated A3. It hasn’t been asked to give its ratings for classes below the most senior in a number of previous deals. The rating agency often requires greater levels of credit support than other agencies for certain bond classes before it gives comparable ratings.

Meanwhile, the CMBS market was bound to see an improvement in spreads.Other fixed-income securities had tightened, so the expectation was that CMBS would as well. Spreads on the secondary market had tightened by a couple of basis points last week.

Investors expect at least two other conduits to price when all is said and done. Those would be led by Deutsche Bank and JPMorgan Securities, respectively.