Headwinds Intensify As Risky CMBS Buyers Bristle Over Loans

A key funding source that has made the commercial mortgage-backed securities revival possible may back further away from the market in coming months, leaving lenders to scramble for other buyers or watch their volume fizzle.

Some players in the small but powerful group of investors that support the riskiest parts of bonds backed by office, retail and apartment buildings are finding a troublesome trend in the loans that they are offered.

Weaker underwriting standards including a higher percentage of interest only loans and structures that strip some control from investors have been pitched to these investors more frequently in recent months, some of the so-called "B-piece" buyers said. The trend accelerated as more lenders re-entered the market in 2011, boosting competition to make loans in a market still challenged by the fragile economic recovery.

At fewer than six active firms, the field of B-piece buyers is half that of 2007, limiting growth, according to Standard & Poor's. CMBS issuance is a fraction of its $234 billion 2007 peak, but B-piece buyers today must support more of each deal and will likely have to bear risks longer under new financial regulation.

The average sub-investment grade portion of a CMBS issue that the buyers must pick up has nearly doubled since 2007 to about 5.8%, S&P said.

"Eight weeks ago there were four deals out for the bid ... that's a lot in a market with only three or four active, experienced B-piece buyers," said Steven Schwartz, managing director at Torchlight Investors.

"If you can't find one of those guys, you're going to have to find someone new and that's potentially a problem," said Schwartz, who spent 19 years in commercial property lending and CMBS at J.P. Morgan Chase & Co. (JPM). "That's going to be a limitation for the CMBS market."

B-piece buyers include BlackRock Inc., (BLK) the world's largest money manager, and real estate firms Rialto Capital Management and Torchlight. Hedge funds H/2 Capital Partners and Elliott Management also buy subordinated debt.

CMBS volume topped $20 billion last week, on pace to meet industry estimates for a $35 billion to $40 billion market, up from $15.3 billion in 2010 and $3 billion in 2009. The outlook could be too optimistic, however, with weaker collateral and market volatility resulting in higher costs for issuers, Lisa Pendergast, co-head of CMBS risk and strategy at Jefferies & Co., said in a research note on Friday.

Resistance isn't limited to B-piece buyers, with Goldman Sachs Group Inc. (GS) and Citigroup Inc. (C) last week sweetening a $1.48 billion CMBS for senior investors unhappy with low yields and credit support. Investors globally are also reassessing risk appetites amid concern over European and U.S. sovereign debt defaults.

Whether dislike of loans, lack of capacity or regulation, headwinds for lending comes at a time when the U.S. property market is still struggling in many regions outside large cities, where employment has stabilized. The availability of credit has smoothed the transition for many borrowers with loans made at the height of the real estate bubble and who now have to refinance, or lose their investment.

"It's going to be felt by the commercial real estate industry as a whole because a very important source of capital is going to become much more costly and much less available, and that's going to have a ripple effect," said Ethan Penner, president of CBRE Capital Partners who pioneered CMBS in the 1990s.

As in the heydey of 2007, B-piece buyers are being asked to take more risk for the same return, three of those investors said. That includes positions in mortgages on which they lack control of servicing, or accepting deals in which they could shoulder losses for a loan not included when calculating their risk, one industry source said.

With that in mind, investors may turn to distressed assets as they emerge, including Anglo Irish Bank Corp.'s $9.5 billion U.S. real estate portfolio currently out for bid, said a B-piece buyer who declined to be named.

The trend increases chances that loans won't get placed into a CMBS as anticipated, putting lenders in a bind. For now, lenders are finding outlets.

"I can say all I want that 'I don't like that,' and what happens is there are other non-traditional buyers that have raised money, and are looking for a home for it," said Daniel Sefcik, a managing director at BlackRock, which he said has been outbid on deals by more aggressive investors.

"We were a big buyer early on and then we kind of backed off, and had people ask if we are out of the market," he said. "We have been bidding, we just haven't been winning."

-By Al Yoon, Dow Jones Newswires; 212-416-3216; albert.yoon@dowjones.com

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