CMBS delinquencies edge up in October

The delinquency rate on commercial-mortgage backed securities jumped slightly in October, but the story continues to be that bubble-era loans backing CMBS are being refinanced and paid off, Morningstar Credit Ratings reported.

The delinquency rate increased two basis points to 3.51 percent, but remains 64 basis points below the level of one year ago, Morningstar reported.

Analysts have been concerned about a wave of highly leveraged loans in CMBS that were originated during a period of looser standards between 2005 and 2007.

In its latest surveillance report, however, Morningstar said that the principal balance of CMBS declined by $9.97 billion in the month, an indicator that payoffs on 2005-to-2007 era loans are picking up.

The delinquent balance fell to $27.67 billion in October, down 13.6 percent in one year, Morningstar reported.

An S&P Ban Seen Having Big CMBS Impact

Word that the SEC may suspend S&P from rating commercial MBS transactions sent a shudder through the sector this week.

CMBS lenders said a ban would have a major negative impact on the single-borrower market, where S&P is the dominant rating agency. CMBS shops would likely have to turn to Moody’s or Fitch, which generally take a harder credit-quality stance on single-borrower deals. That would result in smaller loan sizes or higher interest rates, which could depress CMBS issuance by driving borrowers to other types of lenders or by rendering some acquisitions and refinancings uneconomical.

The secondary-market impact could also be significant if an SEC action voided S&P’s outstanding ratings during a suspension. That could force investors whose guidelines require a rating from a major agency to dump bonds, depressing prices.

Bloomberg reported on Monday that the SEC "is seeking to suspend" S&P from rating CMBS transactions. The news agency added that S&P was holding settlement talks in an effort to avoid the sanction.

Nomura researchers speculated that a ban could last one year. The SEC and S&P declined to comment.

The exact nature of the SEC’s investigation is unclear. In July, S&P disclosed that it was being investigated for possible violations of federal securities laws connected to its ratings and disclosures for six CMBS transactions in 2011. Bloomberg said the SEC was investigating whether S&P "bent rating criteria to win business."

Given the uncertainty about the likelihood, scope, timing and length of any SEC sanction, CMBS lenders said they were taking a wait-and-see attitude for now, continuing to quote loan terms on the expectation that S&P will rate transactions. But they acknowledged that they risk taking losses on loans being warehoused when an SEC action is announced.

Likewise, traders said the Bloomberg report had no immediate impact on prices in secondary-market trading.

S&P has almost disappeared from the conduit market because of a series of missteps since the crash and issuer complaints that its methodology doesn’t produce consistent rating patterns. But that same methodology produces relatively favorable credit-enhancement levels on single-borrower transactions, enabling lenders to write larger loans at lower rates. That has made S&P the dominant agency in that sector, with an 81% market share this year, versus 19% apiece for Moody’s and Fitch. Single-borrower transactions account for one-quarter of overall U.S. issuance.

But if S&P isn’t used, a lower percentage of a loan would qualify for an investment-grade rating. That would force a property owner to either borrow less or use mezzanine financing to make up the difference, increasing the blended coupon.

Lenders said the impact would vary widely from loan to loan, but as examples, they said that leverage ratios might decrease to 65% from 70%, and coupons might rise by 25-75 bp. Borrowers would then have to decide whether to pay the higher cost, borrow less, turn to another lender or not proceed at all.

Senior CMBS executives were glum about the prospect of a suspension. One said it would have "a major impact." Another said it would make "a material difference." A third said it would "cast a dark cloud over the CMBS market."

One veteran in the large-loan market said that profits have already been squeezed by increased lending competition this year. "We’ve been skating on thin ice as it is," he said. "If S&P goes away, it’s going to make this business extremely tough."

"Stand-alone deals will still get done," said another lender, "but it means the whole pipeline will have to get re-priced. If it

happens suddenly, there will be some people who’ll get stuck. They’ll have priced a deal a certain way, then find they have to change directions mid-stream. That’s where the pain will occur."

For the secondary market, the worst-case scenario is that S&P would be forced to withdraw its rating on outstanding bonds. Some buy-side shops have investment guidelines requiring that bonds carry a rating from S&P, Moody’s or Fitch. So if S&P’s ratings are dropped and neither of the other agencies rates the bonds, those investors could be forced to sell.

"If [S&P has] to take all their prior ratings off, that would be a problem," said one CMBS trader. But another trader noted that since the market crash, some institutional investors have dropped the requirement of having a rating from the traditional "big three." And the impact would largely be limited to post-crash single-borrower transactions.

So far, secondary-market prices haven’t been affected. This week, unrelated to the Bloomberg report, an unidentified holder sold about $55 million of single-borrower CMBS rated in most cases by S&P but not the two other major agencies. All of the bonds traded at levels that met or exceeded price talk circulated by dealers.

The SEC’s investigation is believed to stem at least partly from a controversial incident in July 2011, when S&P abruptly withdrew its ratings on a $1.5 billion CMBS transaction that had already priced and was about to settle. The unprecedented action derailed the multi-borrower transaction and caused issuers

Goldman Sachs and Citigroup to lose millions, touching off a firestorm of criticism in the industry and prompting angry issuers to boycott the agency on conduit transactions.

S&P attributed the unprecedented action to the discovery of a possible inconsistency in how its analysts had been calculating the debt-service-coverage ratios for new and legacy transactions.

Real-Estate Funds Needn't Be Riled by Rising Rates

Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

Investors have pulled money out of real-estate funds for two straight months, even though they remain among the year's best performers and pay bigger dividends than many stock funds. The worry is that rising rates will hurt growth for the owners of apartment buildings, offices and other commercial real estate, as well as limit demand for their stocks.

Before joining the crowd, bear in mind that rising rates don't always mean losses for real-estate funds. Many have delivered solid returns even during periods of rising interest rates. The key is how quickly and how high rates rise. Real-estate fund managers say they can still make money for investors, though they acknowledge that the performance won't be as good as this year and the recent past.

"One of the things you have to ask is why are rates rising," says John Wenker, co-portfolio manager of Nuveen's Real Estate Securities fund since 1999. "If rates are moving up moderately because the economy is starting to strengthen, that's fine for commercial real estate."

For real-estate funds, dividends are king. Most invest in real-estate investment trusts, which can avoid income taxes if they pass on 90 percent of their profit to shareholders as dividends. REITs can own shopping centers, self-storage units or senior housing communities.

Because they pay out so much of their income as dividends, REITs attracted income investors who grew tired of the low yields offered by bonds. That demand helped the average real-estate fund return an annualized 17.4 percent over the last five years, according to Morningstar. That beats the 15.6 percent annualized return for the Standard & Poor's 500 index over the same time.

One concern for REITs is that a rise in interest rates, which economists say is inevitable, will push investors to dump them and go back to bonds. Higher interest rates also make it more expensive for REITs to raise money to buy and develop real estate.

Those fears hurt REITs last year, when the Federal Reserve hinted that it may curtail its bond-buying stimulus program. The yield on the 10-year Treasury note quickly jumped from 1.63 percent in early May to nearly 3 percent by the end of the year. That drove the average real-estate fund into the red in the last three quarters of 2013. For the year, the average real-estate fund returned just 1.5 percent, versus 32.4 percent for the S&P 500.

REITs can deliver gains if the increase in rates is more moderate and the result of an improving economy. In such a scenario, fund managers say property owners should be able to charge higher rents and have fewer vacancies for their apartments and office buildings. That would lead to higher dividends.

The economy hasn't been as strong as many had hoped, but it is improving. Many economists believe growth next year will be the strongest since 2005. The unemployment rate is also at its lowest level since 2008, and the job market is strong enough that the Federal Reserve earlier this week announced the end to its bond-buying program. The central bank could begin raising its target for short-term interest rates next year, and many economists expect a measured rise.

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.