Viewpoint: Investor power calls for a revolution in CMBS

Generally, there is an encouraging convergence of opinion among originators, servicers and investors on what should be done to help the CMBS market  to recover. But debt-driven property investors, who held the reins in the past few years, have not voiced their opinions lately. Perhaps they are just grateful when any debt finance is made available. Property investors seeking debt to finance or refinance deals generally accept that lenders are under pressure from regulators, higher funding costs and balance sheet constraints. As a result, extra ‘features’ are being added to loans, limiting the flexibility borrowers had in the past. When structuring and selling loans, lenders must listen to debt investors’ concerns and needs, potentially adding hurdles reflected in the loan documentation borrowers have to accept. In other words, the driving force of the structured debt industry has shifted from borrowers to investors.

Originators, in the middle, are less aggressive than before and, since successful placement depends on rigorous analysis from debt investors, have shifted their allegiance to the latter’s side. The financial crisis uncovered some bad practice, but also flaws and oversights in CMBS structures and loans, triggering a push for change. But the fear of stepping onto untested ground has prevented any revolutionary moves. So while most cheered Deutsche Bank’s Chiswick Park CMBS, others criticised its absence of real change. But I doubt other originators would have dared to do more at their first attempt to revamp the industry.

Even in the US, where CMBS has significantly reappeared, innovation has been limited. New deals offer more comfortable financial ratios and covenants, increased amortisation and more prudence with pro-forma cash flows, rather than revolutionary structural changes. Investors’ comfort with the same old CMBS perhaps derives from a feeling that the market has bottomed out and the underlying real estate risk has been dealt with. Besides, in the US, the residential sub-prime market and CDOs, not prime  markets, have been blamed for CMBS’s demise.

In Europe, too many economies at different stages in the cycle, too many legal and fiscal frameworks and a fear of a double dip recession mean that this confidence has yet to return. But originators in Europe must be more proactive than in the US. The greater transparency demanded by investors must be accompanied by genuine real estate monitoring and more efficient powers at loan and bond levels, so problems can be detected.

The Commercial Real Estate Finance Council, ECB working groups and industry associations will produce best practice guidelines and templates to tackle these issues, hopefully pushing all market players to adopt them. But CMBS notes are still too expensive to be a cost-efficient alternative to traditional borrowing. Until a set of well-defined, universally accepted rules emerges, tougher underwriting criteria, plus other ‘health checks’ and pro-active monitoring and servicing, are the only tools originators have to issue CMBS at spreads that allow them to work profitably, while meeting the return needs of real estate borrowers and risk-sensitive investors.

Regulators’ insistence that issuers retain a piece of CMBS deals is intended to align originators’ and investors’ interests. It sounds controversial, but originators should probably go further and adopt the private equity model, which combines alignment of interest with portfolio management, sourcing, negotiating and structuring deals, then managing them until maturity. CMBS originators could then propose bespoke private deals suited to clients’ investment demands, defining the characteristics of desired products by choosing sectors, geography, durations and risk levels, or even offering inflation-linked or protected products. This would attract the widest potential sources of capital. The consequences for the CMBS industry would be huge, but cannot be ignored by those who wish to stay in this business.