A publication of CRE Finance Council CRE FinanCE W The Voice of Commercial Real Estate Finance Rld Autumn Issue 2012 is Sponsored by Autumn 2012 Volume 14 No.3
CMBS Opportunities: Any Floating-Rate Port in a Storm Edward L. Shugrue III Chief Executive Officer Talmage, LLC A s CMBS new issue and legacy bond prices continue to rally against a backdrop of historically low interest rates, absolute value has been more challenging to uncover in fixed-rate CMBS than at any time since the financial crisis. Consequently, as an alternative, investors should consider floating-rate CMBS transactions as a means of generating Alpha. Chart 1 Historical GG10 A4 Spreads (bps) Source: Bloomberg With new issue CMBS AAA dupers priced at their tightest spreads since mid-2008 (they are currently quoted in the swaps + 100 bps area), investors are essentially financing the senior 70% of the borrower s CMBS capital stack at a paltry 2.7% (given a 10-year U.S. swap rate of approximately 1.7%). While purchasing AAAs at S+100 bps may appear compelling as compared to pre-crash equivalent spreads that ranged from 18-30 bps over swaps, the all-in compensation level for investors is vexing. Furthermore, the rally in credit spreads and Treasuries has created dollar prices ranging anywhere from 110-115% of face amounts for legacy fixed-rate CMBS AAA bonds that will only repay par at maturity. As a total-return driven investor, at Talmage, LLC, we have been rotating out of new issue dupers and into floating-rate legacy securities with three primary focuses: 1) single borrower transactions; 2) large loan pooled CMBS with a limited number of remaining assets that can be individually underwritten; and 3) front-pay CRE CDO whole loan and non-cusip transactions that are beyond their re-investment period. Given the multiple uncertainties facing the global economy, particularly in the Eurozone, a stagnant U.S. economy, stubbornly high CMBS delinquency rates, and the lowest interest rates in more than 60 years, we are emphasizing shorter-term duration floating-rate CMBS investments in defensive capital structures. The Case for Floating-Rate CMBS Now While there is no timetable for when U.S. interest rates will increase, as is clearly demonstrated below, interest rates are at historically low levels and ultimately have more upward runway than remaining tightening. In this regard, while the give-up in current coupon may be difficult, floating-rate CMBS tied to one-month LIBOR (currently around 25bps) that resets monthly, effectively hedges the investment against an increasing interest rate environment by passing along the increased coupon to the investor on a monthly basis. Further, unlike fixed-rate investments, floating-rate securities are much less dollar price sensitive to changes in interest rates for two primary reasons: 1) their rates reset monthly with LIBOR; and 2) floating-rate transactions typically have a shorter duration than most fixed-rate CMBS. While floating-rate CMBS typically do not offer call protection, as their underlying assets tend to be more transitional, since most floating-rate CMBS currently trade at a slight discount to par value, the early repayment accelerates the unamortized purchase discount and enhances the bond s total return. Lastly, as noted below, since most floating-rate transactions are comprised of discrete pools of assets or single borrowers, a comprehensive asset-by-asset underwriting is more easily performed than in a typical conduit multi-loan transaction. The Case for Single Borrower Transactions Single borrower CMBS transactions allow investors to make very specific credit bets at targeted attachment points along the capital structure, depending on an investor s risk tolerance and yield requirements. Importantly, unlike a typical multi-asset conduit transaction where diversification protects the senior classes (but challenges the junior classes with di-worse-ification), single asset transactions provide for asset continuity throughout the capital structure. As noted below in the GSMS 2007-EOP securitization (EOP), the largest floating-rate single-borrower CMBS securitization, depending upon the investor s comfort with the underlying credit, they can acquire EOP risk anywhere from $61 per square foot for the Class As to $200 per square foot for the junior most Class L. When compared to a recent fixed-rate conduit transaction (we use the recently priced COMM 2012-CCRE2 transaction that priced in August 2012 for illustration purposes), we find the relative attachment points, compensation and duration of EOP, especially for the E through L classes to be particularly attractive. CRE Finance World Autumn 2012 28
CMBS Opportunities: Any Floating-Rate Port in a Storm Chart 2 GSMS 2007-EOP Capital Structure ($Millions except PSF Data) Floating Rate Single Borrower Transaction transactions were downgraded by the rating agencies during the financial crisis (often to below investment-grade) and have since been paid down materially, there is often a ratings arbitrage opportunity for what once were junior-pay classes that have now migrated to first or second-pay tranches. As illustrated below in the COMM 2005-F10A Securitization that originally consisted of 22 assets representing $1.7 billion of Trust debt, by 2012, all but two of the loans had been repaid and the Trust balance had been reduced to just $75 million. Due to the significant repayments at the Trust level, the Class G bonds (originally the 10th pay certificates) had become the new front-pay bonds. Due in part to rating agency lag, the Class G certificates remained rated BB-, despite being the senior-most bonds in the CMBS Trust and having an estimated 17% loan-to-value. In fact, when one of the remaining assets in the Trust (10 Metrotech Center) was sold out of foreclosure later in the year, the Class G and H bonds were repaid in full. (1) Includes LIBOR Floor of 0.75% Source: Trepp/Morningstar Chart 3 COMM 2012-CCRE2 Capital Structure ($Millions) Fixed Rate CMBS 3.0 Conduit Transaction (1) Reflects Yield-to-Maturity for classes priced on August 8, 2012 Chart 4 COMM 2005-F10A Capital Structure ($Millions) Large Loan Pooled Floating Rate Transaction (2) Total does not sum as it includes all of the classes offered by the Trust Source: Trepp/Commercial Mortgage Alert The Case for Large Loan Floating-Rate Transactions with Limited Remaining Assets Another area of opportunity, in our view, is in legacy pooled large loan floating-rate transactions. Often originally comprised of between 10-20 large floating-rate loans with different sponsors, these transactions, over time, have been reduced to vastly smaller pools often of five or fewer loans. Additionally, since many of these Source: Trepp/Morningstar There are approximately 40 large loan floating-rate securitizations currently outstanding in the CMBS universe. In addition to underwriting the credit of the underlying Trust assets, special consideration must be given to the impact of potential loan extensions and special servicing resolution and work-out fees and their respective impact on duration and anticipated yield-to-maturity. A publication of Autumn issue 2012 sponsored by CRE Finance World Autumn 2012 29
CMBS Opportunities: Any Floating-Rate Port in a Storm The Case for Front-Pay CRE CDOs Another overlooked area of focus for us is the front-pay CRE CDO market with an emphasis on whole-loan transactions and non-cusip CDOs (meaning, CDOs comprised of whole loans, Mezzanine loans and B-Notes) that have passed their reinvestment period and have begun to sequentially amortize. Following the financial crisis, there is almost no dirtier word than CDO. Most CRE CDOs have been significantly downgraded since issuance and many are rated below investment-grade. Further, many classes of CDOs are held by Structured Investment Vehicles (SIVs) that have either been seized or are being liquidated. All of these factors allow most CRE CDOs to trade at compelling discounts. From a diligence perspective, we have focused on whole loan CDOs as a proxy for conduit transactions but with greater credit enhancement levels and lower dollar prices. Additionally, when underwriting a CRE CDO, we carefully review the collateral manager, their actions and reporting. In this regard, we target certain issuers who are particularly thoughtful and aligned managers and who continue to have skin in the game. An additional benefit of CRE CDO transactions is that in most instances when they fail their interest coverage and overcollateralization tests, all of the CDO s excess principal and interest (including interest otherwise due to PIK-able classes) is directed to the front-pay bonds until the earlier of their repayment or the tests being cured. Chart 5 ROCK 1 CRE CDO 2006 Capital Structure ($Millions) Floating Rate CRE CDO Transaction short duration. As with the large loan pooled floating-rate CMBS transactions, for CDOs past their reinvestment date, their collateral has paid down to a handful of assets that are relatively easy to underwrite and offer compelling short-term investments correlated to one or two underlying transactions. Conclusion Given the historically low interest rate environment and given the premium dollar prices currently associated with fixed-rate conduit CMBS, Talmage is bullish on floating-rate CMBS securities for five primary reasons: 1. Floating-rate CMBS are effective inflation hedges that capture upside in an increasing interest rate environment; 2. Floating-rate CMBS are one of the last remaining CMBS securities that can still be purchased at a dollar price discount, providing potential asset upside (on offense) and protection against price depreciation in an increasing rate environment (on defense); 3. Floating-rate CMBS in single borrower transactions and smaller pooled transactions allow for high precision underwriting, essentially allowing the sophisticated investor to buy real estate cheaper on Wall Street than on Main Street; 4. Floating-rate CMBS typically offer a shorter, more defensive duration of three-to-five years, as opposed to longer-dated fixed-rate assets; and 5. Multiple arbitrage opportunities exist in a more pronounced manner for floating-rate CMBS than in conduit transactions in terms of ratings actions, capital structure and information. Since the floating-rate CMBS market is dwarfed in size by the fixed-rate conduit market and since most dedicated CMBS buyers, such as life insurance companies, tend to prefer fixed-rate CMBS to better match up with their liabilities, floating-rate CMBS assets tend to be overlooked and can present nimble investors with excellent relative and absolute value. In a sea of richly-priced paper, floating-rate CMBS provides a welcome port in a storm. Source: Trepp/Talmage As noted in the table above, we are attracted to Prudential s Rock 1 CRE CDO due to the thickness of the A1 class, its robust credit enhancement, thoughtful management, asset quality and anticipated Edward L. Shugrue III is the CEO of Talmage, LLC ( Talmage ). Talmage, and affiliates, is an independently owned and operated commercial real estate investor, special servicer and advisor created in 2003. Since its formation, Talmage has made in excess of $10 billion of real estate debt investments, acted as the special servicer or Operating Advisor on over $10 billion of successful CMBS resolutions and has had an advisory role in over $30 billion of such transactions. Talmage is headquartered in New York City. www.talmagellc.com CRE Finance World Autumn 2012 30
Investments special servicing advisory commercial real estate Talmage manages $1.7 billion in commercial real estate debt assets across the country and operates a robust large loan Special Servicing platform. Since 2003, we have made in excess of $10 billion of investments, acted as the Special Servicer on over $10 billion of transactions and advised on over $30 billion of loan restructurings and modifications. Put our market reach, research and investment and advisory teams to work for you. Why buy off the rack when you can have bespoke? Investment Management: Customized Separate Accounts Closed-End Accounts Open-Ended Accounts CDO Management Large Loan Special Servicing Special Situation Advisory Talmage. Let our experience work for you. Talmage, LLC 430 Park Avenue New York, New York 10022 212.209.1388 talmagellc.com