The CMBS market has been in a period of upheaval, with dramatic spread widening on bonds and a resulting much more expensive cost of capital for real estate borrowers who depend upon this channel for their debt financing. Market participants today wonder whether we’ve entered a period like the summer of 2011, when spreads on bonds last widened this dramatically and then snapped back within a year to provide tremendous returns for those who were courageous enough to purchase bonds at the time when there was panic selling. Or, people wonder, is this recent downturn a prelude to a structural or systemic problem, like what was experienced in 2007, when spreads widened and sucked investors in, only to punish those early responders with a much more dramatic price collapse in the next 24 months.
Cutting to the chase, today is much more like 2007 than 2011. There are two significant structural, or systemic changes that the market is adjusting to. The first has to do with the greatly reduced liquidity for bonds, all bonds and not just CMBS. This reduction in liquidity is a direct result of the regulatory changes in the banking industry, which has brought about a significant consolidation that has led to fewer market makers, and has also brought about stricter capital guidelines, which punish these remaining market makers for holding inventory. This reduced market making has been especially profound for the important credit-intensive mezzanine bonds, which have mostly traded to hedge funds and whose interest in them was mostly dependent upon their ability to liquidate them in an orderly manner when they wished to exit. Further contributing to these bonds’ relative unattractiveness to hedge funds today is the fact that without market-makers insuring an orderly market price swings for bonds can now fluctuate wildly, as a single sell order can take a bond’s price down ten percent or more while a buyer is sought. With hedge funds having to mark their inventory to market, these types of price swings make the product highly unappealing.
The second important change that the market is adjusting to is the retention rules that are about to be imposed, which would have either the issuer of a CMBS deal or it’s B-piece buyer commit to hold an investment for a minimum of 5 years. While the logic for this rule may indeed be well founded in that it will surely improve the credit quality of CMBS loans, it’s passage will create at least a hiccup, as new buyers and new capital is organized that is willing to price that liquidity give up.
Today’s CMBS dislocation is structural and not cyclical. It will have some tangible negative effects on many market participants – including CMBS origination shops, owners of CMBS bonds, and real estate borrowers who benefited from the availability and pricing of capital from the CMBS machine. It will create voids, and thus opportunities for others who can organize themselves with appropriate capital structures to avail themselves of them. I’m not expecting a complete collapse of pricing like was experienced in 2008/9, however, I also do not expect this to be the obvious buying opportunity that the summer of 2011 brought about.