Redwood exit signals CMBS origination pull-back
The US CMBS market has encountered a rocky start to 2016, with new issue pricing spreads performing unpredictably. A number of other concerns have cast doubt over profitability on the origination side, prompting suggestions that lenders may slowly thin out.
Redwood Trust is one high-profile casualty of CMBS market volatility, having recently announced its plan to discontinue loan originations for CMBS distribution (SCI 10 February). The REIT’s ceo, Marty Hughes, cited increasing risks and “diminishing economic opportunity” in CMBS loan origination as the core justifications for its decision to pull the plug on the business.
In contrast, RAIT Financial outlined its intent to stay in the market during its 4Q15 earnings call. However, it says that it will take a more cautious approach in line with an ailing market and projections that it does not expect to make gains from CMBS origination. The company’s tone suggests that similar announcements by other players further down the line would not come as a surprise.
“The reasons why REITs and other lenders are departing or scaling down is a combination of the perfect storm,” explains Tracy Chen, portfolio manager and head of structured credit at Brandywine Global. “You have a wall of maturity for legacy CRE loans, risk retention rules and new issue spread volatility.”
In particular, the 5% risk retention requirements set out by the Dodd-Frank Act is a driver of the market’s instability. CMBS conduit lenders are working to raise the necessary capital in time for the 4Q16 period in which the regulation officially kicks in, but the uncertainty that it is causing is proving challenging.
“This shadow of risk retention is in part what is prompting the price volatility,” says Ann Hambly, 1st Service Solutions founder and ceo. “Add in the anxiety around potential further interest rate hikes, as well as an election year that is affecting real estate prices, and suddenly you have a very unstable market.”
Hambly explains that investor pricing demands have been particularly unpredictable in light of the market conditions. Spreads have widened as of late, leaving dealers without the assurances of profit.
In many cases, the option is either to sell at a low price or fail to offload their deals at all. The implications of these factors are starting to creep in and the results could become more profound.
“We could certainly see more CMBS conduit lenders like Redwood quit the market,” suggests Chen.
Lenders such as Ladder Capital say that there is still money to be made in CMBS, noting that it has participated in one deal already this year with positive results. However, the company also explained in its recent earnings call that the level of volatility has left conditions too risky for it to conduct large-scale lending operations on 10-year loans.
“Obviously the issuers who hold the necessary skin in the game will be the ones who retake a larger share in the market,” says Hambly. “But these conditions could also continue to expose one-trick ponies in the market. Some don’t have the platform to offer borrowers other types of loans.”
As lenders continue to pull out or scale back their operations, consolidation could in turn drive homogenisation of the US CMBS product. As larger, more established issuers regain a stranglehold on the market, the quality of loans is expected to increase.
Lending activity is already shifting away from certain property types, lower leverage and higher lending rates. The market is also seeing tougher underwriting demands from B-piece buyers, with loan kick-outs increasing for properties deemed to be potentially problematic.
In turn, the increased quality of CMBS properties could become too expensive for smaller dealers to maintain, prompting origination liquidity to further dry up. Although REITs account for only 5% of the lending market in CRE origination, issuance is widely forecast to steadily drop off as the year progresses.
“We will almost certainly see more concentration of players,” adds Chen. “However, we may see other alternative lenders raise capital to get into this market, such as distressed credit funds and hedge funds.”
Regardless, Chen predicts that issuance will drop by roughly a third, accompanied by extensions for legacy loans due to the difficulty of refinancing. Hambly agrees that issuance will likely take a hit as CRE lending volumes lower.
“You couldn’t pick a worse year for it to happen,” she says. “There’s still nearly US$80bn in loans that are set to mature, but the current unpredictable circumstances means many may not be able to refinance.”