While underwriting rules for securitized commercial mortgages have relaxed from the clampdown that occurred during the Great Recession, the pace that standards have eased has been so slow that the market was in danger of not paying enough attention to it until 2014.
The issue started to gain traction last April when Moody's Investors Service warned the commercial mortgage-backed securities market was at risk of "boiling frog syndrome," referring to the metaphor that a frog put in boiling water will jump out, while one in cold water won't notice the danger if the temperature heats up slowly.
The problem, of course, is that overlooking changes in underwriting quality could expose investors to additional risks, particularly as demand for CMBS deals grows. Researchers generally expect lenders to continue to relax their standards at this same slow pace in 2015, making it all the more important for the market to understand how close to boiling the frog really is.
What the market needs to focus on now is "the temperature of the water," Howard Esaki, global head of structured finance research at Standard & Poor's, said at a year-end 2014 commercial real estate briefing.
S&P and Moody's separately agree that underwriting standards for commercial mortgage-backed securities loans aren't yet as loose as the 2005-2007 standards preceding the crash in CMBS issuance in 2009, but the gap between the standards seen today and those seen at that time isn't as wide as it once was.
An index developed by S&P
At a reading of 103, 2014's score was 14 notches away from 2005's score of 117 and 43 notches below 2007's top score of 146. The 2013 score was lower at 92. The least risky vintage, 2010, scored 67. (In 2009, CMBS issuance volume was so low that there was insufficient data for S&P to create an accurate score.)
Moody's director of CMBS research, Tad Philipp, suggests not drawing too many across-the-board conclusions about the CMBS quality because of differences in property types and regions, among other things.
One aspect of the market currently comparable to 2005-2007 is leverage, which in terms of loan proceeds per dollar of cash-flow is comparable to 2006-2007, according to Philipp. Other indicators are more in line with healthier markets currently.
However, pressure to dole out more loan proceeds to borrowers with increasingly favorable terms is likely to grow this year, a recent Commercial Real Estate Finance Council survey suggests.
"You have an increased number of loan maturities from the CMBS perspective coming due, also increased allocations by lenders and investors that are already in the space and then new entrants coming into the space," said the council's CEO and president Stephen Renna.
"You have a lot more capital to be invested and a lot more chasing of yield. You're also going to have the borrower saying, 'Hey this is a great time to be a borrower,'" he added. "So the borrower is going to be trying to push the envelope to get the best possible deal that they can, and there is competition for that borrower's business."
Forecasts call for an
Volume has been trending upward, but market participants responding to the CRE Finance Council's survey expect it to grow more significantly this year due to loan maturities coming due and economic optimism as well as increased capital allocations, Renna said.
"I think it's just going to be a much bigger year. From a CMBS perspective, they're estimating about a 25% increase in volume, which is pretty significant, and then life insurance companies and banks are likely to increase their allocations to commercial lending. Private equity firms, hedge funds, and specialty lendershave been very aggressively entering the marketplace so there's a lot of capital and I think it's going to be a year that really tests the market," he said.
More distressed product as well as new issuance will be entering the market as loans made between 2005 and 2007
"I think you're going to see a significant rebounding in the distressed loan space when these loans come due, but we're more practiced now in resolving them. We've gone through all the CMBS 1.0 distressed loans, the market knows how to handle them, they're staffed up to do it, and there seems to be a lot of capital in the marketplace to take advantage of the opportunities. So I think the loans will be worked through," Renna said.
"But that doesn't mean someone's not going to take a loss and that someone's going to be the lender that's holding the note coming due for maturity," he added.
But whether the more recent loose underwriting creates another wave of distress down the road remains to be seen.
"We'll see how well they manage their business, and a lot of that isn't going to be proven out until years after the loans to see how they perform," said Renna.
