CRE Fundamentals

Wells posted their CRE Chartbook a few weeks ago (you can request it, and other reports via wellsfargo.com/economics), which contains an amalgamation of a number of useful charts and data from various sources. They also have some summary commentary on each sector. I pulled out a few interesting charts below:

CMBS is a dwindling piece of the pie, losing 1.7% net issuance during the 3rd Quarter 2012, although GSE deals gained ground.

There are still some problems to get worked out... This chart shows the status of all CRE loans, not just CMBS.

Delinquencies have improved dramatically. (Also all CRE)

Retail prices seem lofty, perhaps JCP should re-evaluate a REIT conversion.

CMBS 2013 Outlook

The CMBS market has certainly enjoyed a revival during 2012 and there are a number of reasons to be optimistic about 2013 including the pick up in originations, continued low rate environment, and improved fundamentals within outstanding CMBS deals. Morningstar notes that the consensus is that "it's gotta be better than 2012". Some quotes from RBS and CS reports can be found here. The best write-up we've seen so far is Nomura's, and you can contact your sales coverage there for a copy of the 12/6/12 2013 Outlook: The Road to Recovery (If you don't have coverage there, and are a client of ours, send me an email and we'll get you a copy with their permission).

Some of the points others have highlighted as positive include:

1. The mix of maturing loans shifts from the heavy burden of 5 and 7 year loans originated between 2005 and 2007 to 10-year loans originated in 2003, which results in lower term and maturity risk. Maturity risk should remain muted the next 2 to 3 years, but ramp up in 2016 and 2017 when 10-year loans from 2006 start to mature. Further, as Nomura points out, prices are back to 2005 levels (still down 26% from the peak), so fewer 2005 loans are not "under-water".
2. Issuance could exceed $100 billion (Nomura >$100 b, Morningstar - $50-75b), although this is partly driven by the deterioration in underwriting we've witnessed in 2012. Nomura breaks it out by $41b in Conduit, $10b in Agency, and $53.2b in Agency.
3. Delinquencies have likely peaked - Nomura
4. Capital availability has led to increased transactions ($200b in 2012, up 8% - Nomura)
5. Fewer modifications expected as climate improves. This is due both to easier availability of credit to borrowers so they can lend their way out of problems, but more towards the ability of lenders to foreclose on properties and sell them.

Some negative counterpoints include:

1. $40+ billion in defaulted loans are still in the pipeline. We should see increased loan sales from this pool.
2. Deal losses will continue to grow as delinquent loans are resolved. Nomura is looking for an increase from 2.9% deal-level losses on 2005-2008 vintage loans to 5% by the end of 2013.
3. Dodd-Frank - pretty much everyone made a passing reference to legislative risks, but there was less focus than on other risks.
4. Prices are too high, and the easier credit is going to cause more bonds to pay off at par faster than premium buyers are expecting - RBS & CS. I certainly wouldn't be buying premium front or next pays right now either. RBS recommends buying further down the stack, and that is in line with what we did late in 2012 for some strategies.

New rules regarding treatment of MBS debt on bank balance sheets

A recent ruling by the Comptroller of the Currency, FDIC, and Federal Reserve adopted some new rules for the CRE world and are set to take effect next year. The two major implications of the rule are that more capital must be held in reserve for both banks taking positions in CMBS, and a formula has been enacted to calculate the risk level of a debt security, negating the former method which was based on the rating agencies. For now the formula is only in place for securitizations, corporate debt, and other debt on banks’ trading books but it may spread to include all bank holdings of these securities. 

This formula, which is called the “Simplified Supervisory Formula Approach,” was born because of terms in Dodd-Frank stating that ratings cannot be used to determine credit risk. Under the terms, any bank involved in debt securities must analyze and evaluate data on the underlying loans to determine the credit risk of the holding. One exception to the SSFA rule is the case where a bank already has an approved internal model and will be allowed to continue using that instead of the new formula. The majority of banks do not have this approval though, and will now have until January 1, 2013 to get set up. This could have an adverse effect on CMBS and RMBS pricing performance as well as liquidity in times of turmoil. The real problem is that regulations such as this do nothing to prevent the type of crises that we experienced in 2008 and 2009, while at the same time they vastly increase costs to the bank and at some level this will discourage banks from participating in the mortgage market. 

While it is logical to us as money managers that we want to scrutinize loan-level data when making investment decisions in MBS, regulating as much on a bank is at best unfair from the perspective that they do not have the same requirements in other securities. For instance, if the bank were to buy GE corporate debt (AA- rated), they are not regulated in a manner that forces them to analyze all of its subsidiaries or even GE’s top level financials. In fact, under the legislation there is an investment in the corporate debt of GE Capital (AA-) is treated no different from CIT Group (B+); despite vast differences in their credit quality they each receive a flat 8% “specific risk weighting”. An even better example would be ETFs – the bank could easily invest in a theoretical ETF, whose underlying holdings were solely subprime mortgages or corporate junk bonds, and never have to analyze the ETF’s holdings, whereas buying the bonds directly would require them to adhere to this needlessly onerous regulation.

Eminent Domain is not a solution to the housing problem

During the second quarter a plan to use eminent domain to “condemn” underwater mortgages began making headlines after San Bernardino County California and Cook County Illinois both indicated they were at least evaluating the plan.

The basic idea is that County residents who are underwater, and owe more than their home is worth, but not delinquent or actually under any financial distress, would have their mortgages taken over by the municipality. The municipality would allow them to refinance it at a much lower balance with a new lender. All of this would be arranged by a “helpful” intermediary, which also happens to be the same party that is trying to sell the idea of the plan, which would effectively force the losses on the mortgage lenders, give the homeowners a big free write down on their mortgage and better terms, and give the intermediary a big fee in the process.

The intermediary has been pitching the idea to large pension plans and money managers for over a year now, and has been soundly rejected by most with even a basic understanding of market dynamics.

The most obvious pitfalls of the plan start with the fact that it is not helping struggling homeowners, and in fact is targeted specifically at performing mortgages. It also runs contrary to even the most basic tenets of property, mortgage, and even standard contract law, and would likely result in decades of litigation. Finally, no lender would ever lend in a county that implemented a plan like this in the future without additional assurances that the collateral for their loan was secure.

This would be a devastating "solution" for the citizens as well as the investors in the mortgages, which include all of us as taxpayers, pension holders, and retirement assets in fixed income assets.

Our perspective is that we do not think that this plan will ever actually be executed, but is an example of another poorly thought out legislative “solution” to counter mortgage market problems. These kind of regulatory/legislative risks continue to be a concern.

2011 Insurer Loan Originations Up 55% from 2010

Insurance companies have once again grown their commercial lending operations, this time almost back to pre-crisis levels. Results for 2011 are out (See Figure 1), and show that $51.7 billion of originations were completed by the top 30 companies, up 55% from the 2010 figure of $33.3 billion. At the height of the lending boom in 2007, insurers peaked at $56.6 billion. The surge in lending in the last two years has been instigated by the ability of insurers to offer more secure and competitive interest rates to borrowers compared to CMBS shops. Furthermore, Metlife’s Mark Wilsmann indicated that from a relative-value perspective commercial properties are currently seen as a more attractive investment for them compared to other fixed-income opportunities of the same risk.

Figure 1. Origination Amounts by Top 30 Insurers ($Billions). Source: CMAlert

Maiden Lane III Sale Puts Pressure on the CMBS Market

On April 23, Deutsche Bank and Barclays agreed to buy the $7.5 billion of CDO bonds being marketed by the Federal Reserve Bank of New York (FRBNY). As has happened in the past with other Maiden investment vehicles, these Maiden Lane III bonds are being auctioned off to re-coup an investment made by the FRBNY when it seized assets from AIG in return for a bailout in 2008. It is speculated that the consortium paid between 66 and 68 cents on the dollar for the pool while the second place group bid 65 cents. Barclays and Deutsche had a pricing edge going into bidding because their group already owned the subordinate classes and had an interest-rate swap counterparty position on the CDOs, meaning it would be easier and cheaper for them to deconstruct the CDOs, and sell off the underlying CMBS bonds to the market.

When news first broke of the Maiden Lane III offering, consisting mostly of AM and AJ bonds, pricing slumped and many traders headed to the sidelines to wait out this unusual glut of supply being dumped on the market. Things have returned to normal after the sale, but some volatility may still persist as the winning group sells off small pieces of the deal it did not pre-sell to large investment groups.

Big REITs, Little Stores

Llenrock posted an interesting snippet about the changing tenant dynamics in the retail space, here's an even shorter excerpt...

Despite popular opinion, many local businesses and neighborhood stores, either due to the nature of their products and services or by the sheer convenience of being “right down the street,” are not significantly affected by online retailers like Amazon. As Kimco’s CEO explained to Jim Cramer a while back, local businesses such as dry cleaners and convenience stores offer increased income while filling the small vacancies in REIT-operated shopping centers. Finally, the big guys and the little guys are teaming up.