CMBS lenders now offer higher and higher levels of leverage to make deals—especially as prices for apartment properties rise compared to rents.
“Lenders are having to get more aggressive in their underwriting,” says Jimmy Board, senior vice president for the Capital Markets Group at Jones Lang LaSalle.
These high-leverage loans worry market watchers like the bond-rating agencies. These ratings agencies are raising their credit enhancement levels. Bond buyers are getting pickier what loans they will accept. If these guardians of credit quality can kept CMBS underwriting relatively strong, then CMBS lending will be able to continue to grow and provide liquidity, particularly for borrowers in secondary and tertiary property markets.
Moody’s warns for high leverage
As the competition heats up to make deals, CMBS lenders now offer larger loans that sometimes cover up to 80 percent of the appraised value of a multifamily property. Interest-only loans, in which borrowers make small payments for a time that only cover the loan interest and not the principal, are also becoming more common, with interest-only terms as long as five years for 10-year, full-leverage loans. Debt yields, which express the income from the property as a percentage of the loan size, are typically around 8 percent, though debt yields go as low as 7.75 percent for attractive apartment properties.
Lenders have avoided some of the worst transgressions of the last cycle—so far. “We don’t see them underwriting future rent growth,” says Mike Riccio, senior managing director at CBRE Capital Markets. “There is a pretty good, strong level of discipline.”
Leverage continues to grow compared to income, however. The experts at Moody’s Investors Service track the size of CMBS loans compared to the net operating income from apartment rents at the properties. The average CMBS loan was 113.6 percent of the value implied by that income in the third quarter, according to Moody’s. That’s up from 112.2 percent in the second quarter. Those percentages might sound awfully high, considering that the average CMBS loan still covers less than 70 percent of the appraised value of a property. However, multifamily property prices have gotten very high compared to the income produced by the property.
Moody’s is striking back against leverage by giving fewer CMBS bonds its highest AAA rating, forcing more CMBS to wear a lower rating designating them as riskier. In the fourth quarter, Moody’s average Baa3 credit enhancement level averaged 11.5 percent, nearly a full percentage point above 10.6 percent in the third quarter.
B-piece buyers get tough
The most meaningful guardians of the quality of CMBS have begun to set limits on what lenders can offer to borrowers—starting with the buyers of B-Piece CMBS. B-piece buyers invest in the CMBS bonds that will be the first to lose value if there is any trouble with the loans underlying the bonds. That gives them a tremendous amount of power, because if no one buys those lowest-rated CMBS, the bond issuance will fail. Because of that, B-piece buyers can ask the issuers to remove loans they don’t like from loan pools. It rarely happens, but B-piece buyers have recently begun to flex their muscle, according to Mitchell Kiffe, senior managing director at CBRE Capital Markets.
“There’s been a little bit of push-back from B-Piece buyers on the amount of interest-only,” says Kiffe. The wrath of one B-piece buyer recently put a stop to a commercial real estate financing. “Three days before the closing, the lender said they couldn’t do the loan—that their B-piece bond buyer doesn’t like it,” says Kiffe, who declined to name the borrower of the lender in the transaction, which failed to transact.
Filling a niche
CMBS lenders continue to offer financing to properties and buyers who may not find financing from other sources. Interest rates for CMBS loans continue to be roughly 15 basis points higher than the leading competition for comparable properties—usually provided by Fannie Mae or Freddie Mac lenders, experts say. As a result, most CMBS loans are being made in secondary or tertiary markets to Class-B or lower multifamily properties.
These properties are also showing more strength as the economic recovery is finally spreading towards the relatively low-income renter who rent these apartments, allowing rents to rise. “We have seen a lot of rent growth,” says JLL’s Board.
CMBS loans will be especially important as the commercial real estate market overall handles an estimated $1.5 billion in loans maturities over the next three years. “CMBS is going to help refinance our market,” says Mike.