Interview with Richard Hill, Executive Director of Research, Morgan Stanley
by Christina Zausner, Vice President, Industry and Policy Analysis, CRE Finance Council
On October 30, 2014, Christina Zausner of CRE Finance Council sat down with Richard Hill of Morgan Stanley to discuss his group’s recent research piece, “The State of the CRE Credit Cycle” and his conclusions about the differences between CMBS 1.0 and 2.0.
Why did you go back and compare CMBS 1.0 to 2.0?
We are constantly being asked where we are in the credit cycle. We therefore wanted to compare and contrast legacy CMBS deals (2008 and prior) to CMBS 2.0 (2010 and later). What we found is that it’s an apples to oranges comparison in many respects and it’s really hard to find an analogous point to where we are in the credit cycle.
So what are the major things that are different about today?
The biggest difference in our view is the prevalence of loans secured by Class B and C properties located in secondary and tertiary markets. While legacy CMBS included some of these property types, it wasn’t to the degree that is observed today, in our view. This may speak to the greater idiosyncratic and refinancing risk present in today’s CMBS 2.0 deals.
How would you as an investor view 1.0 vs 2.0?
The question many investors are asking themselves is if they’d prefer Class A properties in primary markets with too much leverage that was prevalent in CMBS 1.0 or Class B properties in secondary markets with more prudent leverage that is prevalent in CMBS 2.0. Our analysis found that historically secondary market properties have higher default rates leading to higher cumulative losses regardless of their underwritten metrics. It sounds simple, but our key recommendation in our report was to make better quality loans on higher quality properties.
The good news is that the credit enhancement offered on CMBS 2.0 bonds is much more robust than is found in legacy CMBS deals. For instance, “A-” rated CMBS 2.0 bonds now typically provide more credit enhancement than the 10-12% credit enhancement of CMBS 1.0 AJ bonds that were originally rated “AAA”. In our view, this may help to mitigate bond losses even if cumulative loan losses increase at some point in the future.
Something else that is different is the regulatory environment. How do you think that will change the landscape?
We don’t think most CMBS 2.0 loans have significant term default risk over the next several years, but if interest rates normalize above 4% they may be difficult to refinance. Over the past several years, the market has been primarily focused on debt yield as a measure of default risk, but we believe we should start placing more emphasis on a debt constant that would incorporate the effects of rising rates in the future. Having said that, in our view, rates on Treasuries could remain below 4% and then we wouldn’t really have to worry about interest rates. But for now, it has to be part of anyone’s due diligence.
And then secondly, there’s pure regulatory reform, like risk retention and Basel. All of this will mean that CMBS may become more expensive to issue, resulting in the cost of financing widening, which would in turn make CMBS originations less competitive to alternative lenders such as REITs, life insurance companies and banks. This may incentivize CMBS lenders to originate lower quality loans at wider spreads in order to maintain market share, but this may face push back from a smaller group of b-piece buyers who have the capability and the desire to hold bonds for a minimum of 5-years. New structural alternatives may emerge, such as higher coupon b-pieces, to make the bonds more appealing to investors.