When the commercial real estate market crashed late in 2007, the worst loans went bad early.
Since then property values have largely recovered and underwriting has loosened, putting many borrowers in a better position to refinance when their loans came due. Yet other borrowers are treading water; they continue making payments, but their property values have not fully recovered, and they have not paid down much principal or boosted cash flows.
Their day of reckoning is fast approaching.
The sheer volume of loans maturing this year and next — $232.4 billion, according to the data provider Trepp — leaves some borrowers scrambling for funds to refinance their loans, which repay most of their principal in a final balloon payment.
By comparison $70 billion of CMBS loans matured in 2015 and just $37 billion in 2014.
The wall of debt is coming due at a particularly bad time, as lenders that underwrite loans to be sold to securitization conduits are grappling with new regulatory requirements to hold on to the economic risk in their deals. Several conduit lenders have exited the market this year. Underwriting is also tightening again as lenders rein in the most questionable practices, such as underwriting to projected (as opposed to current) income.
Analysts at JPMorgan Chase estimate that net issuance of commercial mortgage bonds was negative $57 billion in the first nine months of the year. Some of the underlying loans that came due were refinanced by other kinds of lenders, such as commercial banks or insurance companies.
Others are in default or headed there. In September 4.78% of commercial mortgages in CMBS were behind on payments, an increase of 10 basis points from August, according to Trepp. The September jump represents the sixth time in the last seven months that the rate has increased, after hitting a post-crisis low in February of 4.15%.
The majority of troubled loans were taken out in 2006 and 2007, just before the real estate bubble burst, when property values and investor confidence were both high. "The underwriting was a little shoddy, to say the least," said Steve Kuritz, a managing director at Kroll Bond Rating Agency.
Many are suburban office buildings, which are losing big tenants as large corporations relocate to central business districts.
In April a $165.5 million loan backing the former headquarters of CA Technologies in Islandia, N.Y., was shifted to a special servicer that handles troubled commercial mortgages on behalf of bondholders. Though CA continued making contractual lease payments after vacating the building in 2014, it appeared unlikely that the owner would be able to refinance and make the final balloon payment in August. So the loan, part of the collateral for the $4.24 billion Goldman Sachs Mortgage Securities 2006-GG8, is designated an "imminent monetary default" by Trepp. (In late August, CA agreed to a sale-leaseback agreement to new private-equity investors headed by CRIC Capital and Prudential Real Estate Investors.)
Also of concern is a $265 million loan secured by an office tower in Stamford, Conn., that formerly housed part of UBS' wealth management business. The property, 400 Atlantic Street, is 73% occupied and the loan is still current, but it is an unlikely candidate for refinancing when it matures in 2017 because it is so far underwater. The property has a loan-to-value ratio of 198.19%. The loan makes up 5.39% of another Goldman deal, the $7.56 billion GS Mortgage Securities Trust 2007-GG10.
UBS's departure from another Stamford building, 677 Washington Street, is responsible for putting a $165 million loan in special servicing in January. The borrower, CWCapital Management, is reportedly seeking a workout for the 700,000-square-foot building. The building's loan balance is five times larger than the property's value, and the debt service is covered by UBS lease payments that cease at the end of 2017.
The loan was securitized by the former Lehman Brothers and UBS in LBUBS 2004-C1.
All told, 37% of CMBS loans backed by office properties that mature over the next two years are poor candidates for refinancing, according to KBRA, because they have LTVs of 85 or greater, as calculated by the rating agency.
Regional malls are also vulnerable to tenant turnover; many have lost anchor tenants as retailers succumb to competition from e-commerce. KBRA has weak refinancing outlooks on 27% of loans backed by retail properties. Kuritz said that regional malls, in particular, "scare" CMBS investors.
Even a strong, iconic mall backed by a national owner can run into trouble.
Philadelphia Mills (formerly Franklin Mills), a mall owned by Simon Property Group that occupies more than 1.18 million square feet, has been in special servicing since 2012. The loan was modified, splitting it into two separate notes. The senior, $112.9 million A note is listed by Trepp as an imminent maturity default though it is current, 91% occupied and has a debt-service-coverage ratio of 168%. However, it has an LTV of over 144%.
Struggling malls pose outsize risks to mortgage bond investors because the loss severities can so high. The liquidated loans on 30 malls that have gone under since 2008 lost 75% of their principal on average, according to Moody's Investors Service. That is almost twice as severe as the 45% average for all CMBS loans liquidated over the same period.
"Very few of the top tenants in malls 20 years ago are still strong performers — or even still in business — today," the rating agency stated in an August report.
To be sure, the majority of CMBS loans coming due this year are well-positioned to be refinanced. More than 80% have a debt-service-coverage ratio above 140%. And at today's rates, interest payments would be much lower than at the 6% coupons prevalent in 2006 and 2007.
But there is no mistaking that both the outstanding 2006 and 2007 vintage loans are of lesser credit quality than CMBS loans made today, according to Mark Gallagher, a senior strategist with CBRE. "A lot of these were full-term, interest-only loans" that did not amortize, he said. Many were underwritten with "fairly aggressive pro forma assumptions" about future rents that did not materialize.
Gallagher said that CBRE has grown "quite a bit more pessimistic" in the ability to refinance 2007 CMBS vintage loans, in particular. "In our study, we came up with a figure of 29% of [deals maturing in 2017] that could face some sort of challenge to refinancing."
Loans that ran into trouble immediately after the credit crisis were often modified because at the time there was little appetite among real estate investors for distressed properties. Typically a loan was split into two notes, an A note that the borrower could repay under existing cash flows, and a subordinate B note with a deferred payment. (These B notes were often called "hope notes"; investors hoped that they could avoid a loss on the notes if the property's value or tenant revenue eventually increased.)
More recently, rising property values have made it easier to liquidate troubled loans. This allows mortgage bondholders to recover at least some of the principal right away.
A property that goes through what is known as a "discounted payoff," or principal reduction, may be difficult to refinance in the conduit market. "It's tainted," said Ilan Bensoussan, sector specialist and trader at Semper Capital Management.
Instead, the borrower needs to get a bridge loan, which typically has one- to three-year tenor and can be securitized in commercial real estate collateralized loan obligations (CRE-CLO). Some bridge lenders "will finance at 50, 60 or 70 LTV. … The borrower makes payments for 6-12 months and then refinances the loan into a conduit," Bensoussan said.
Bensoussan says that the CRE-CLO market is poised to grow in the next year, partly because of the number of 2007 vintage loans coming due and partly because this market is well prepared to comply with risk retention. CRE-CLO issuers retain as much as 30-35% of the risk in a deal, so the impending requirement to hold 5% is not a problem.