New CMBS risk retention rules set to go into effect December 24th have been stirring concerns across the capital markets for months. Some of that anxiety has been put to rest with a warm reception from investors on the first conduit CMBS risk retention transaction to test the waters.
The WFCM 2016-BNK1 deal hit the market in early August. Originated by Wells Fargo, Bank of America Merrill Lynch and Morgan Stanley, the conduit was intended to gauge the pulse of both investors and regulators. Although the jury is still out on how regulators view the structure in relation to the new risk retention rules, the deal proved to be a hit with investors.
The conduit drew the most favorable pricing in more than a year, notably on its AAA piece, which priced at swaps +94. That price is three points tighter than expected and 14 basis points lower than the last CMBS conduit to price, according to research firm Trepp. In addition, pricing on the bonds lower in the stack was also encouraging, including AA- at swaps +125; A- at swaps +170; and BBB- at swaps +425.
The conduit likely priced well for three key reasons, notes Joe Franzetti, executive vice president of capital markets at Berkadia, a real estate services firm that handles mortgage banking. One is that per the new risk retention rules, the sponsors have skin in the game and shared a 5 percent ownership stake in the deal, which has a collateral balance of $870.56 million.
“Sharing the risk on a shoulder-to-shoulder basis is not only in the spirit of Dodd-Frank, but unique for CMBS investors,” says Franzetti. So that gave investors more confidence in the deal.
Two, the transaction included high quality real estate collateral backing the loans.
Three, there is pent-up demand from investors because of lower CMBS issuance. New issuance is running about 43 percent behind the pace of last year, notes Orest Mandzy, managing editor at Commercial Real Estate Direct, a Trepp subsidiary.
There were a lot of tailwinds behind the pricing, adds Mandzy. The collateral loans were very conservatively underwritten as it relates to metrics such as loan-to-value (LTV) ratios, debt service coverage and debt yields. For example, the LTV ratio on the portfolio was 55.6 percent compared to the other conduit deals this year that averaged about 61.0 percent, he says.
Despite the success among CMBS bond buyers, the more critical test for CMBS lenders—and the broader commercial real estate industry—is whether regulators will view the structure as meeting risk retention guidelines, and ultimately, whether regulators will view that structure as a loan or securities. That will be a critical distinction for the entire CMBS market going forward.
The risk retention rules give originators three options. One option is to retain a vertical strip, basically carving out a 5 percent ownership across all of the bond classes. The second option is that a 5 percent horizontal strip could be retained by a third party B-piece investor. One distinction of the horizontal strip is that it is held based on market value and not face value. The third option would be some combination of the first two.
In the case of WFCM 2016-BNK1, originators will hold the 5 percent vertical strip—$43.53 million, which is designated as a separate RRI bond class. Each originator will hold their own pro rata share of that $43.53 million depending on the amount of loans that each submitted to the pool. Wells Fargo Bank will hold the biggest stake at 39.4 percent, followed by Bank of America at 35.5 percent and Morgan Stanley at 25.2 percent.
Going forward, one question for bank originators will be whether they have the balance sheet that allows them to hold the vertical strip. “I think each conduit sponsor is going to have to make that determination based on their own balance sheet and their own cost of capital,” says Franzetti.
Another question that is unrelated to risk retention is whether bank regulators will view that vertical strip as a security or a loan participation. That will be a critical decision with significant implications for the broader CMBS industry, because the capital treatment is very different. A bank will have to retain more capital on its balance sheet if it is a security as compared to a loan.
“If the regulators say this is a bond, and not a loan, then this becomes undoable in the CMBS market, because there won’t be enough capacity,” says Mandzy. “Folks like Wells Fargo and Morgan Stanley won’t want to set aside whatever the regulators will want them to set aside. It just won’t be economical for them to continue playing in that role,” he adds.
It is also important to note that the WFCM 2016-BNK1 conduit was structured so that the risk retention owners have consultation rights, which is what a bank would have on a loan participation. So originators did make an effort to structure it to look like a loan participation, says Mandzy.
The industry will have to wait and see how regulators react to the structure of this first risk retention deal. In addition, there likely will be one to two more conduit CMBS deals put together this fall to further test different risk retention structures. After years of talking about the potential impact of risk retention rules, it is positive step that sponsors are now getting out ahead of the deadline to find solutions, notes Franzetti.
“I think a lot of people were really tolling the death knell for CMBS,” he says. “You have to give credit to the creative minds that put this deal together, because it does show that there is a way for CMBS to continue.”