“We should have learned our lesson and sworn off CMBS forever”: McNellis, commercial real estate developer.
By John E. McNellis, at real estate developer McNellis Partners. This essay is taken from his forthcoming 3rd edition of Making it in Real Estate.
I was leaning against the bar at an industry cocktail party a couple weeks ago when a guy walked up to me, stuck out his hand and said, “I’m Ethan Penner”. I asked him who he was. Ethan was taken aback by my ignorance.
“I’m the guy who invented CMBS,” he proclaimed.
“I hate CMBS,” I replied. “I’ll never do another CMBS loan.”
“Yeah, well, it saved CRE.”
“Maybe, but I’ll never do another one. They suck.”
“I wouldn’t either,” said Ethan, and I liked him better. When I asked what he was doing at the function, he said he was trying to raise money for his gubernatorial campaign. I wished him well and he moved off to work more fertile fields, leaving me to ponder CMBS loans.
CMBS actually stands for “commercial mortgage-backed security”. In short, a CMBS loan is one originated by a big bank or financial institution—e.g. JP Morgan Chase and Prime Finance—then bundled together with another 100-150 of its loans into a mortgage pool totaling about $500 million to $2 billion. That pool is securitized by Wall Street and sold as bonds to anywhere from, say, 50 to 200 investors. After securitization, each individual loan in the pool is administered by a master servicer. If things go wrong with a loan, it is transferred to its “special servicer”.
Giving Ethan his due, he may not have saved CRE, but his clever invention did go a long way toward providing our industry badly needed liquidity. About 10-15% of all CRE loans are now securitized by CMBS.
The Bigs love CMBS. Why wouldn’t they? They reap enormous profits from originating these loans—generally 1-2 percent of the total pool—and then selling them off. Their only real risk is that the securitization market goes bad before Wall Street can peddle their pools. If this happens, the originators are stuck holding the bag.
Borrowers love CMBS, too…at least initially. CMBS’s undeniable attraction may be best understood by comparing it with its competitors, life insurance companies and balance sheet lenders. The Life Cos generally have better terms—lower interest rates, longer terms and so on—than CMBS, but they have much higher underwriting standards. This means they wouldn’t even consider a loan that CMBS would be delighted to do. If the two were auto lenders, the Life Cos would lend on Mercedes Benz while leaving the Toyotas to CMBS. Thus, the biggest appeal of CMBS vis-à-vis life insurance companies is its relative availability.
Balance sheet lenders—banks that keep rather than sell off their loans—are not as fussy as the Life Cos and will often compete for the CMBS borrower, but aside from their pricing, their terms are usually tougher than CMBS. The CMBS lender will charge more, but will lend more dollars (say, a 70% loan to value as opposed to 60%), grant a ten-year term, sometimes interest only, and not require a personal guarantee. A bank considering that same loan would likely limit its term to five to seven years and require both principal amortization and a guarantee.
Thus, a CMBS loan is easier to obtain than a Life Co loan and often more attractive—again, at least initially—than a balance sheet loan. In truth, for the beginning developer or the experienced one with a less than stellar project, CMBS may be the only way to go. Both the Life Cos and balance sheet lenders put considerable stock in a borrower’s track record and financial statement.
So far so good, but if you study a set of CMBS loan documents—roughly the length of Moby Dick—you will discover landmines sprinkled throughout, and perhaps have second thoughts about this product’s appeal. Here’s a quick summary of just a few of those traps:
The loan cannot be prepaid during its first two to five years, the so-called “lockout period.”
You will need the master servicer’s approval—which can drag on for months—if you wish to sell the property and have your buyer assume your CMBS loan. Your buyer can only be a “bankruptcy remote SPE”—a single purpose entity formed solely for the purpose of owning the single asset—thereby substantially restricting the buyer pool. You will pay a one percent assumption fee plus all of the servicer’s legal fees, title fees, rating agency fees (everything but their country club dues). These fees can total $25-100,000.
If you happen to default under CMBS—the paths to default are myriad—your base interest rate will leap by five percent or more.
Having done a number of CMBS loans over the years, we knew what we were getting into when we borrowed $6.2 million from Wells Fargo’s CMBS team in 2010 to refinance one of our Safeway centers. As an aside, we went with Wells rather than other CMBS lenders because it had been our primary bank for over 30 years and we’d hoped that our excellent, longstanding relationship would temper our CMBS experience. It didn’t. Why? Because CMBS lenders’ hands are tied by their complex agreements with the bondholders. They have zero discretion in working with borrowers.
This loan slumbered peacefully for five years until a crew of private equity pirates acquired Safeway, took it private and merged it into Albertson’s. Safeway lost its credit rating overnight and alarm bells went off at the master servicer’s offices. The servicer advised us that, pursuant to clause 47 (e) iii on page 67 of the loan agreement, Safeway’s loss of creditworthiness was a “trigger event” and that we would be in default if we didn’t immediately deposit $875,000 to offset it.
We pleaded, arguing that this demand was totally unreasonable. We pointed out that Safeway had never missed a rent payment, and that the loan could hardly be more secure, its outstanding balance less than a third of the project’s value. The servicer was implacable, insisting that we either deposit the funds or be in default. We had no choice but to comply.
Fortunately, we were in a position to do so. A less seasoned developer might have taken a bullet from this trigger event. It’s worth stressing again that there is no negotiating with CMBS servicers. They charge you a small fortune to go strictly by their book. Had this been a balance sheet loan, Safeway’s credit loss would never have triggered such a demand. In fact, none of the traditional lenders who were financing our other Safeway centers at the time batted an eyelash over this issue. Even if they had, we would have been able to hash something out with a real banker instead of dealing strictly by email with impersonal clerks doing a great job of imitating bots.
We should have learned our lesson and sworn off CMBS forever. But we didn’t. We borrowed $4.5 million to finance a Rite Aid in 2018. This loan ticked along quiet as a time bomb until Rite Aid also lost its credit rating. Pursuant to another obscure provision buried deep in the loan documents, the servicer implemented a “cash trap” through which it swept every penny of rent thereafter paid by Rite Aid into a non-interest-bearing account. This meant that we had to come out-of-pocket to pay all of the property’s ongoing bills. As of this writing, Rite Aid is dead, our loan balance is $4,450,000, the servicer is holding $500,000 in that cash trap account, and has charged us $3100 in fees thus far for doing nothing and an additional $660 a month for a loan that has never been in monetary default. We haven’t missed a single payment.
Given these sad tales of woe, you may forgive me for comparing CMBS loans to base jumping. Arguably the most dangerous sport in the world, base jumping—the leaping off buildings or cliffs—has a fatality rate of about one in every 60 to 100 jumps. But this means the daredevils do walk away up to 99 percent of the time. The same is true of CMBS. If everything goes well with your project, if life doesn’t force you to sell early, if your major tenants stay healthy, if you’re able to pay off the CMBS at maturity, then you too will walk away and look forward to your next jump.
Our fatality rate with CMBS was not, however, one in 100, it was two in ten. My point? Do enough of these loans and sooner or later, you just may slam into the rocks at terminal velocity. By John E. McNellis.
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Lipstick on a pig sold to the greater fool.
perhaps, but the case against CMBS as presented as a toxic security is weak. Mortgage backed securities are risky, no matter what the salesman says.
Not sure what the issue is.
were do I sign up to be the master servicer??
sounds like great gig
The master servicer is appointed by the issuing bank, and then can be voted on by investors. Thus, if you own a lot of the issue, you get to vote on the special servicer. Starwood (STWD) owns the largest special servicer. Seems to be a good gig being the special servicer, and a bit of a rate kicker when you can buy the securites and then appoint yourself.
I do like STWD. Their special servicer is a small piece, but it has no real assets and pretty much just makes money without a lot of risk.
Thank you for this beautiful explanation with personal examples.
It was interesting to hear how *borrowers* can be periodically screwed by CMBS…but I am almost 100% sure that in the long run CMBS buyers (ultimate creditors) get screwed worse – more intensely and systematically.
1) Basically it boils down to adverse selection – either only the worst/riskiest loan deals make it all the way down to CMBS (with insurance and bank underwriters only taking the comparatively safer loans…leaving only the dross for CMBS).
2) Decades of ZIRP leading to decades of yield starvation, eroded away *all creditors* protections. When risk free Treasuries yield 2% for years on end, institutional investors (maybe needing 7-8% returns to meet *their* liabilities) lined up to strip off traditional protections away from essentially *all loans* – ZIRP induced competition turned well-secured loans into pseudo-secured crapola. Almost everywhere.
3) Decades of ZIRP also widely induced over-valuation dementia, as blind application of discounted cash flow/net present value analyses parlayed ZIRP into insane over-valuations of (pseudo) loan collateral (CRE, RRE, C&I, everything)
4) So however troublesome CMBS’ residual protections may be, CMBS borrowers were *initially* handed *wayyy* more money than their properties were really worth…due to #3. With a hell of a lot more “outs”/looser terms than would have *ever* been obtainable pre-2002, pre ZIRP, pre CMBS due to #2.
5) And those pseudo-collateral, ZIRP-subsidized insane over-valuations made it much easier for borrowers to pull cash *in the interim* out of their mortgaged properties and make ruthless delinquency/default much more tempting – again due to #2 and #3.
So I really don’t think CMBS *borrowers* are the most screwed parties here – the creditors are.
But the true villains are likely the loan originating middle-men/broker/banker/bookie/hucksters…who “underwrite” an ocean of crap loans then sell them into the public markets as fast as is humanly possible – dumping off as close to 100% of the crappy risks that yield starved creditors will let them.
These are the same middle-men, bookie slime-bags that destroyed the CDO market in 2008 (adverse selection in underwriting again) and then subsequently fought like absolute hell to fully repeal the risk-retention CECL rules that would have forced them to eat some of their own poisoned cooking.
The pending nightmare has essentially identical dynamics to that of 2008 (and 2030, and again and again until the US economy is fully destroyed – then the scumbags will cash out their Yuan/bitcoin/gold and move to Abu Dhabi or Singapore or Switzerland).
A brilliant, zen-like summary of our financial system. Show me the incentive, I’ll show you the outcome. The incentives now are are mostly dark and nefarious in the process of generating endless fees.
It’s amazing how unstable and risky financially engineered products can be.
That is, until the magic moment Big Daddy Government bails them out after they’ve gone toxic, printing trillions of dollars to gobble them up for the purposes of “saving the economy,” and then nationalizing them in perpetuity.
“My startup is in the pre-bailout stage….”
Just doesn’t roll off the tongue the same.
“It’s amazing how unstable and risky financially engineered products can be.”
It’s not a bug, it’s a feature – Ben Bernanke
But but but ‘inflation is transitory’ Carlos. Don’t you know nuthin!
Great article thank you very much.
From other Wolfstreet articles, I had the impression that the banks kept the good stuff for themselves and put the worse credits into CMBS which they then sold to unsuspecting investors who were chasing yield (or desperate for yield in the ZIRP days).
From this article, it sounds like it can be a self reinforcing spiral – the CMBS servicers won’t work with borrowers, which leads to defaults when there would not be one under a normal bank, which can apply even to good credits.
“it sounds like it can be a self-reinforcing spiral – the CMBS servicers won’t work with borrowers” ~Milking profits and cash flow, pulling on their short hairs they are. Great article! stressful positions to be in. Blue owl capital is offering AI asset-backed securitization, ABS same concept as CMBS CDS on ABS will be the future news headline, sorry sounding like a broken record. I am unplugging for the weekend.
Have great weekend!
CMBS loans are risky and they come with lots of structure to protect the investors. Even if you do not have a payment default, a tenant or borrower that loses its credit rating is a material issue. If that happens, loan has just lost a significant portion of its market value, prompt payments notwithstanding. You hear this all time “I never missed a payment” but if your credit goes into the toilet, something did happen.
I do not mean to be cavalier in pointing out that part of capitalism’s promise has been documented by the very bastion of capitalism’s dogma, the Ivy League economists
that a downturn in the red hot economy is inevitable, the question is when
I wonder who gets all the extra fees. I bet it’s not the investors.
A big portion of the fees goes to the banks that originate and securitize the loan and to the servicer that the collects the payments, etc., from the borrower.
The same “crap underwriting” banks who sell off the maximum amount of loan risk as fast as is humanly possible.
And who fought like hell in Congress and the Courts against ever having to eat some/any of their own poisonous cooking.
Let’s call it for what it really is
CLL
Commercial Liar Loans
The same stinking pot of crap sold by Wall St.
Now where are the Fed “regulators”?
Regulation ha, it’s the boom & bust Wild West! Buyer beware.
I remember circa 2012 a client was trying to sell a property with a pre-great recession CMBS loan and under the terms of the note, he was required to make a “defeasance deposit” of cash sufficient to allow the CMBS investors to purchase treasuries with sufficient yield and length to guarantee the investor’s equivalent return for the remaining duration of the loan in order to get out. With treasury yields crashing post great recession, the amount of the “defeasance deposit” was astronomical.
Why should creditors have had to bear risks that the borrower was going to profit from?
Did the borrower pull equity/cash out of the deal during the “good years”?
Was the only reason the borrower got the loan in the *first place* because of that and similar creditor protections?
That 2 in 10 loan fatality rate says CMBS are Russian Roulette, not base jumping.
Sounds to me like the banks have better lawyers than either the borrowers or the CMBS buyers. Everything’s set up as a trap to make sure that if things go bad, it’s the borrower or the buyer who suffers, but not the bank.
“it’s the borrower or the buyer (creditor) who suffers, but not the bank.”
Exactly.
But the fuel that makes this endless insanity recurring (for chrissakes) is the yield starvation induced by decades long ZIRP. Otherwise, no sane creditor would buy these crap CMBS post-2008.
CMBS is attractive for borrowers looking to return as much equity as possible in a refinancing. Many balance sheet lenders are not comfortable providing max cash out on a non-recourse loan (which basically functions as a put option on the property – if all goes well, the borrower continues to collect cash flow, if not, they will just hand over the keys). CMBS doesn’t care as long as you pass their UW standards at origination (which as the article points out, are easier).
on a non-recourse loan
I suggest that an old guy like me would have to be an idiot to invest in a potential investment scam
It’s quite possible that the two out of ten failure rate of CMBS may MORPH into 3,4 or even 5 out of ten, or worse. What a party it would then become!
At a default rate of 50%, tremendously pain should be felt by the cmbs holders, and that should create turmoil throughout the entire investor food chain.
But we hear nothing. Alls well here, nothing to see; move along….
You see inflation is transitory!
Meet the new $100
Same as the old $10
Same as the old $1
We won’t get fooled again!
Wolf – the bubble has to deflate or pop somehow. On another site- “Historic mansion on San Francisco’s Billionaires’ Row sells for half of asking price.” Half off! Now, this is a “mansion” but could almost qualify as CRE (5 stories, 11,000 square feet, 10 bedrooms, 6.5 bathrooms). Sold for $17.75 Million.
“Half price, everybody! Half price!”
The seller puts the mansion on the market and slaps a magic number on it. Eventually, sometimes after years, a willing and able buyer emerges, and they make a deal. So “half of asking price” is meaningless.
The better comparison would be the current selling price to the previous one, which might have been decades ago.
If borrowers had a better understanding of what happens when a loan is securitized, they would not be surprised by the rigid structure of a securitized loan.
These loans are not held by the originators, they belong to a syndicate of investors, who just want to collect your payments, not hear about your problems. The servicer works for the new investors, which can number into the thousands. These investors hold tranches with differing terms and durations. They can not change the terms of the loan because it is impossible to get them all to agree and all of them may not be affected in the same way by the change. Some investors may have already exited the deal, the rest hold differing stakes in the income stream. These loans are complex deals.
And not infrequently subject to default – ruthless or otherwise.
Great article, thanks for posting these occasionally.
At the very core of it, how are CMBS any different than the toxic CDOs which almost took the banking system down?
Are you guys telling me that these sophisticated borrowers didn’t read their loan agreements and the investors never got a prospectus?
Why that’s a shocking revelation!