A new regulation for Commercial Mortgage Backed Securities, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, is scheduled to go into effect in December. The bill, is made up of a new set of risk retention rules, and will require CMBS lenders to retain a portion of the value of the loans they issue as opposed to selling all them off in bonds. The risk retention rules were designed to protect issuers from risky lending, a factor which was evident in the crash in 2008.
The new bill requires lenders to hold on to about 5 percent of the loans they issue, which will result in fewer CMBS lenders and an overall reduction in the amount of loans being originated. This regulation requires issuers to use more of their own capital, driving down profit margins for lenders and increasing the total overall cost of capital. Smaller CMBS lenders who do not have the capital resources or capability will likely be priced out of the market, leaving only larger CMBS lenders.
Before the Great Recession, there were around 40 different CMBS lenders throughout the U.S. After the crash, the number of lenders dropped down to 10 at one point. As the market has recovered a bit, CMBS lenders number around 20. The new bill will cause a similar impact on the number of CMBS lenders as smaller ones will leave the market and larger ones will become more selective in the projects they finance. The timing of this new regulation is horrible for the CMBS community.
In 2017, over $145 billion of CMBS loans will mature. Upwards to 45% of those loans will not be able to be paid off at maturity and will need to be refinanced. Many of these matured loans will have to be refinanced with other sources. This will drive the demand for financing from other capital sources, such as life insurance companies, credit unions, banks, and agencies. As the CMBS lenders adjust to the new regulatory landscape, they will likely exercise greater caution in underwriting and originating loans, thus adopting a more conservative approach. In the past, CMBS was an active option for higher leveraged loans, as other lenders shied away from those credits.
Also, CMBS lenders were often the go-to source for larger deals in secondary and tertiary markets. With these new changes, it may be tougher and cost more for investors to obtain financing in those markets. This result may drive demand for properties in primary costal or gateway markets, where deals require less leverage and borrowers can turn to other lending options for lower interest rates. We can expect the cost of loans in the non-primary markets to increase.
One exception to the CMBS rule is for qualified loans. Loans that meet a qualified status will not require the lender to hold 5 percent of the loan. A qualified loan requires the amortization and loan to value lower. An example would be a 10-year loan must have an amortization of 25 years or less. Leverage cannot exceed 65 percent and a debt coverage ratio must be in the 1.5 to 1.7 range.
The overall result is that we will see more demand for financing deals that credit unions would not normally see with a more active CMBS market. We should also note that in many cases the other options for financing may have higher interest rates. This may help us command a higher rate for these future deals.