Moderators: Stephanie Petosa, FitchRatings and Lisa Pendergast, Jefferies LLC

About Our Investors

By way of introduction, we queried our investors about where in the CMBS capital stack they participate and why, and whether their individual companies focus on CRE debt and equity and/or have a CRE lending arm. Our goal was to gauge the level of dialogue that exists between the various CRE-focused investment areas in each of their companies and the effect that has on their CMBS investment decisions.

Thomas Chang, Principal, Prudential Fixed Income. We have roughly $27 billion1 in CMBS assets under management (including the notional amount of our CMBX), split fairly evenly between proprietary and third-party institutional/retail assets. The majority of our holdings are 2.0 AAAs, but we are also active in investment grade single-asset/single-borrower (SA\SB) securities, legacy AMs\AJs (both IG and below IG), agency CMBS, IOs, and CMBX. We have become one of the largest players in the new-issue conduit market since our reverse inquiry drove the creation of the 10-year front-pay tranche in 2012. Our CMBS team is part of the Structured Product Group of Prudential Fixed Income, which has approximately $575 billion of assets under management. Our affiliate, Prudential Mortgage Capital Company (PMCC), is an active commercial mortgage lender and a large originator of whole loans. We have regular conversations with PMCC about the health of CRE markets and the lending environment. Another affiliate, PREI (Prudential Real Estate Investors), actively invests primarily in a broad range of real estate investment equities. 1. Assets as of 12/31/15.

Marc Peterson, Managing Director, Principal Global Investors. We manage about $7.5 billion of CMBS net, split between legacy and 2.0. Our 2.0 activity is focused mainly on non-super senior investment grade. We have also been a consistent buyer of XA IO positions. Our portfolio is split between the Principal’s general account and third-party affiliated and non-affiliated separate accounts for insurance companies and pension funds. Principal is somewhat unique in that we have expertise in all four quadrants within real-estate: public and private, debt and equity. We also manage a large equity real-estate portfolio. We are a large commercial mortgage lender and hold over $10 billion in U.S. and global REITs. CMBS is the fourth quadrant. We have over 50 underwriters and 50 asset managers who cover the largest markets in the country and have regular conversations on what’s going on in their markets. These conversations are focused on how specific market trends may impact the risk profile of CMBS loans that secure new-issue deals or that we have exposure to in our portfolio. 

Harris Trifon, Portfolio Manager, Western Asset Management. Our CMBS portfolio is over $10 billion in size. We have exposure to 1.0 and 2.0 conduit markets across the stack from AAA down to below-investment-grade securities. We also have a pretty sizeable portfolio of large loans, single-asset/ single-borrower CMBS; again ranging from AAA all the way down the stack. Our portfolio also has meaningful exposure to the agency CMBS sector.Much of our exposure in that market is in the different variety of IOs although we do have a fair amount of P&I bonds – both guaranteed and credit. We’ve also been slowly expanding our holdings on the private debt side. Looking forward, I think we’re going to continue to rotate more into that part of the market. We don’t have equity exposure, either on the public or private side, and we don’t have a CRE lending arm. 

Steven Schwartz, Managing Director, Torchlight Investors. Torchlight is a debt-focused investment manager and a special servicer. We raise third-party capital primarily from U.S. pension funds. We are currently deploying capital from our fifth debt opportunity fund. This fifth fund, which will have its final close this quarter, will be somewhere between $1.3 and $1.5 billion of committed equity. The fund invests across real-estate debt products – everything from first mortgage debt to subordinate debt to preferred equity. We also invest in CUSIPs – from non-rated bonds all the way up to AAA if we thought that was an appropriate opportunity. As an opportunity fund, we look for double-digit returns – we have very flexible capital. Somewhere between a third and a half of what we’ll do in our fifth fund could be in CUSIPs. That could grow if the opportunity looks better or shrink if lending looks better. Lastly, we are also a special servicer and it provides us with some unique insights into what’s going on in commercial real estate. 

Randy Wolpert, Principal, Eightfold Real Estate Capital, L.P. Eightfold is an approximately four year-old investment manager with just under $1 billion of committed capital, specializing in below-investment-grade CMBS. We have a total of six funds, four of which are solely focused on CMBS, three of those are fully invested, and we are in the process of investing our fourth fund. We have two additional funds that are focused on real estate investments other than CMBS, primarily joint venture equity, one of which is fully invested. We invest primarily in the control pieces of CMBS 2.0 deals of which we own approximately three dozen issuances. We owned and still control some CMBS 1.0 positions, so we do cross both CMBS vintage markets. We do not directly lend to borrowers, although we can and have done some subordinate debt and preferred equity deals in our real estate funds.

To our readers. Please keep in mind that this Investor Roundtable was conducted on April 6, 2016 as the CMBS market was just emerging from a period of severe market volatility, significant CMBS spread widening, and an origination market grappling with how best to proceed in preparing for the risk retention required under Dodd-Frank that kicks in this December.

 Today’s CMBS Marketplace – Fair to Middling

 Lisa Pendergast: Our first question is a kind of a loaded one, so my apologies. On a scale of one to five, how would you rate current CMBS conditions? One is best – most opportunistic – and five is worst – least opportunistic. Just looking for a quick read on investor sentiment.

Harris: I am going to take your difficult question and give you a not so difficult answer: ‘3.’  

Lisa: So Harris is middle of the road. 

Harris: I think the risks balance both the up and the down side. Liquidity, decline in issuance, challenging secondary market, trading conditions, late in the commercial real-estate cycle skewing to the down side. To the good, you have nominally wide spreads, which are pretty attractive given the overall risk profile of this sector.

Thomas: My answer is between ‘2’ and ‘3’, maybe a ‘2.5’. There are definitely some attractive opportunities out there – especially after the spread widening over the past year. The fundamentals on commercial real estate remain solid, and the underwriting on conduit loans is still reasonable. Spread volatility has been much higher than expected recently, but investors just have to be disciplined about identifying bonds that have widened due to market technicals versus widening due to poor fundamentals.  I am concerned about the declining liquidity in the sector since it takes more effort to sell and to source bonds given limited dealer inventories.

Marc: I would echo what Thomas said. I was leaning toward a ‘2.’ Just because if you look at the return versus how we perceive risk in real estate, it feels like the market is mispricing that risk. Yet, I think I’m probably closer to ‘2.5’ to ‘3.0’ just on liquidity and uncertainly around regulation and risk retention and what that means for originations. As a buy-and-hold investor, this is a very opportune time to be in the market. So from that perspective I’d be at a ‘2,’ but general conditions and the potential risks put me closer to ‘2.5.’

Randy: I’d say a ‘3.’ I don’t think it’s a great market, but it’s still a market that we can find deals that make sense for our investors. There are still favorable aspects to the market such as subordination levels and yields/pricing. But there are also issues such as volatility and liquidity and some of the collateral can be challenging. Despite those issues, we feel that we can identify deals with favorable after loss returns. 

Steve: I think we’re at ‘2.’ Maybe a little better or at least getting a little better. On the CMBS investing side, spreads have widened out to a level that makes it attractive to invest not only in B-pieces but higher up the stack.  As a B-piece buyer, we feel that sellers are being much more interactive as they build their pools. There’s a lot more discussion about what the pools will look like and a much greater willingness to shape pools in ways that work for everybody.  I think that’s great. And looking at underlying property fundamentals, I think they look okay. I don’t know how long it will last, but I think it’s a solid ‘2’ for now.

Biggest Single Factor Affecting CMBS Decisions

 Stephanie: Can you tell us what the biggest single factor affecting your CMBS investment decisions is today? 

Steve: I think it is our ability as a B -piece buyer to have constructive conversations with issuers before pools get finalized. 

Randy: For us, we are focused on the quality of the collateral and the structure of the underlying loans, especially the larger ones in the top 15 to 25. There are deals we can’t do because we are uncomfortable with the risk of a larger loan. Typically if we like the composition of a pool we can figure out how to make a deal. 

Marc: Loan and property quality. 

Thomas: Definitely relative value. We have a dynamic allocation approach where we continually discuss and compare the relative value of other sectors such as CLOs, non-agency mortgages, esoteric ABS, corporates, and high yield bonds in order to optimize our investment decisions.

Harris: Relative value and liquidity.

Water, Water Everywhere, But Not Enough to Drink – CMBS Liquidity

 Lisa: So we’ve briefly touched upon liquidity concerns but let’s dig a little deeper. What are your thoughts on the quantity and quality of the liquidity that’s provided today. How does it compare to what was provided in the past – both pre-crisis and coming out of the crisis? How does that liquidity factor affect the way in which you invest and manage your portfolios today?

Harris: I don’t think it’s any secret that liquidity in our market has been very challenged over the last couple of months. I think liquidity is materially less than it was say even a year back. Much of that is clearly a function of the changing regulatory environment and the impact that’s having on the dealer community. First, the volatility we’ve seen in markets, particularly over these last three or four months, has had an impact on the active investor community and their participation in the CMBS market on a day-to-day basis. Secondly, because of the volatility, even apart from the regulatory environment, the dealer community is just extremely reluctant right now to warehouse any kind of risk even for top-of-the-stack ‘AAA’ cash flows. And, it its exacerbated as you move down the capital stack. So, all of that is just bad for our market.  Outside of buy-and-hold accounts, there clearly is a changed calculus for actively managed portfolios. Liquidity plays a bigger role in the relative-value decisions we’re making, and not just within CMBS but across competing products whether it be in the structured-credit universe or in other products like corporate credit.

Marc: Yes. I think along those lines, especially with total-return accounts. It comes down to who’s rating the deal. Having a credit position without a major CRA has turned out to be a tough trade through the recent market volatility. And, given the current forces impacting liquidity, I don’t think that changes anytime soon.  Regardless of the quality of the pool or how it’s rated, just who or who does not rate a bond can play a big part in that investment decision. These are things you have to think about that we haven’t had to think of before. I think part of the spread widening and improving CMBS relative value has been driven by liquidity and the concern of will you be able to trade bonds and who you’re going to trade them with. 

Lisa: Marc, what is your sense as to corporate liquidity versus CMBS liquidity? Has CMBS liquidity fallen to the level of corporates or has corporate liquidity actually improved? I was always a ‘pound-the-table’ proponent of the enhanced liquidity found in the CMBS market relative to corporates; highlighting large conduit deal and class sizes and the large number of investors with some pre-crisis transactions boasting 60 different investors or more. That certainly has changed.

Marc: As we talk to our corporate guys, we get a pretty good feel for how those markets trade. I think CMBS liquidity has deteriorated relative to corporates. But, if you look at how BBB CMBS trades today relative to high yield, it’s still better. You can still move bigger size in CMBS than you can in high yield. So, I think that relationship is still there. But, if you move up in credit, even in AA bonds that are not rated by a major, trading becomes very difficult. I think corporates are trading better in that space. So, that relationship has changed. 

Thomas: We discuss this issue often as we sit next to our IG corporate team.  We have seen liquidity in the high-grade space across all Fixedincome sectors getting spotty – both for CMBS and for corporates.  Personally, I would say CMBS liquidity is still slightly better than corporates, yet the liquidity on CMBS is starting to converge to that seen in corporates – particularly with respect to a greater new-issue focus with limited support in secondary-market trading.

Lisa: Has anyone started to use CMBX to express longs instead of buying cash bonds because of the improved liquidity there? I never really thought I would hear myself ask that question. Fact is that I’m asking it, I’m seeing it. Marc your thoughts?  

Marc: I know we’ve started to think about it. We’ve always been much more comfortable with selecting our securities and picking the bonds that we own in our portfolios. But we’ve had to consider if we had a large amount of cash and wanted to get it invested in the market in this environment, CMBX is the most efficient way to do it. 

Thomas: We have been more involved in trading CMBX given the much better liquidity. It’s doable to buy and sell a few hundred million of notional in AAA CMBX in a single day, but highly unlikely in the cash market. We regularly monitor the basis between CMBX and the underlying cash bonds and try to take advantage of those opportunities.

Mixed Reviews on CMBS Underwriting, Collateral Quality

 Q. Stephanie: We’ve been talking about credit quality having on impact on investing decisions; can you tell us what you think about current CMBS credit conditions, especially today versus 1.0? Specifically, I’m asking about the quality of the underwriting, the quality of the loan, and the collateral securing that loan.

Randy: There was a point four or five months ago when I thought that maybe we were turning the corner and we were going to start to see higher-quality loans and lenders not pushing the envelope so much, but that did not come to pass. We are buying the worst loans in any deal so it is rare that we do not have issues with loan quality. The good news is that the rating agencies have not only held firm on subordination levels but also are increasing those levels, which is obviously important for our investment. Competition seems to have caused lenders to stretch to the point where there are a lot of loans that don’t make sense; many could at the right leverage levels or with the right structure.  So, to the extent your question was about conduits being the lender of last resort, we’re not really that concerned because every property, if it’s leveraged correctly, can work within the CMBS structure.  What concerns me is that borrowers may be fleeing CMBS because they feel like they can’t count on their deals getting done or getting done where they were quoted. We know they are coming for proceeds, non-recourse, and speed. But they currently not getting all of those and now there are alternatives. That’s what’s a little concerning, especially when we’re hearing about borrowers getting re-traded at the last minute because of market volatility.

Steve: I’ll take the other side of that Randy. I think there’s been a modest improvement in loan quality and spreads seem stable, at least for the moment. Yes, I think it was very difficult to price loans when every deal priced wider so CMBS lenders had to go back to their borrowers at the closing table for the most current pricing. Either that or lose money. I think that’s passed. We’ve seen a few conduits price recently and things are tightening again. It might take some time for borrowers to come back to CMBS, but they will. 

Randy: I think you’ve still done some damage, right? Borrowers seem to be shying away and it’s not clear whether current stability will hold. It’s only been a couple of deals and that’s good but those deals were different from some of the other deals that have come to market and priced wider.  

Steve: I think we are in a period where pools look a little bit better. Some of the potential offenders are not closing without a B-piece buyer saying ‘that loan is ’okay.’ In the last couple of deals that we’ve looked at, originators are not closing tougher loans or are expecting the tougher loans will be removed. I’m hoping that’s not a temporary thing, that we’re transitioning from a period in which lenders were a bit more aggressive to a period where pools have better loans with better structure. So, I’m a little more optimistic about deal quality this year. 

Stephanie: What are your thoughts on the pools that have more banks issuing collateral, not that there aren’t still pools with the full slate of contributors.

Harris: I would echo some of the last comments. I think — on the margin — there’s been some improvement in collateral quality, as well as in embedded leverage and the structural features of some of the product that’s shown up recently.  I think being cautiously optimistic is probably the right frame of mind now, with the caveat that nobody really knows whether this is just the eye of the storm or a stabilized environment on which we can build.  I think definitely there’s marginal improvement from what we were doing as a marketplace, say, a year back. I’m hopeful the trend will continue. I also think everyone on this call would probably admit that even the product created, say, a year back or so at its worst was still materially better than the product created right before the credit crisis in late 2007 and 2008.

Marc: I would agree. Especially the improving quality of cash-flow underwriting, which turned out to be one of the key risks in 2007. It’s been interesting. We’ll go through a period of time during which we get hung up on the quality of some larger loans, then we’ll go through a period of time – like we have in the last few offerings – where we conclude the quality is better. You can see where conduits are having success in pushing underwriting or originating loans in certain markets compared to competitors. The difference between now and pre-crisis is if the market doesn’t like those trends it starts to push back.  I think at least these last few deals have made us a little more optimistic that underwriting is getting more consistent and originators can be successful with relatively more conservative assumptions.  We see pockets of higher-risk loans, but in general we are comfortable with current underwriting standards. For sure, a couple of large loans still can hang us up and take us out of a deal.  

Thomas: We think that credit quality in recent deals has stabilized. Given the current low interest-rate environment, we believe term defaults will likely remain low due to fairly high debt service coverage ratios (DSCRs). The real question is what the interest-rate and cap-rate risk premium environment will look like when those loans mature in 5 to 10 years. I think credit quality is meaningfully better than pre-financial crisis. In addition to the B piece buyers or even BBB investors scrubbing the credit, we have also noticed more AAA buyers spending time looking at loans carefully. We are in a very different environment from 2006-2007.

Are CMBS Rating Agencies Getting it Right?

 Lisa: Steph is the rating agency in the room, so she can’t ask you these questions, but I can. Are the rating agencies getting it right this time around? How much of your analysis and investment decisions depend on a rating – be it from the perspective of what that rating says about credit quality, liquidity, or finance-ability?  

Steve: I’ll take a crack at it. For B pieces, we don’t put a lot of faith in the rating agencies, not because they’re getting it wrong necessarily – they’re getting it more right than wrong – but because we do our own credit work. We stipulate a minimum size based on our view of the collateral. We have observed that over the last quarter, for liquidity, it is helpful to have certain agencies on the deal. And, as we’ve started to invest in BBB- and A-rated credits, it’s become very important for us to see certain rating agencies on those bonds, like Fitch.

Thomas: I can still remember some lengthy conversations we had with dealers and rating agencies questioning the AAA ratings for legacy AM and AJ back in 2006/2007. I think the rating agencies have improved their processes following the crisis. We rely on our own internal risk assessment to evaluate bonds so the NRSRO ratings are never an important factor for us. Nevertheless, they still play a role with respect to some of our clients’ investment guidelines and regulatory considerations.

The Role of the B-Piece Investor in CMBS 2.0

 Stephanie: So a question to our B-piece panelists: Are you kicking out more loans? Are there more price adjustments? Or are you going back to originators and saying we’re not taking the loan unless you do X, Y, and Z?

Randy: It’s all of the above. There are plenty of loans that we look at and just can’t take. We try to identify those upfront and sometimes that means we can’t do a deal. Sometimes it means that we can do the deal but only if the originator can remove the loan from the pool. There are also situations where we discover things during our diligence that require adjustments or removals. But we do not kick out loans just because we can. We have multiple open conversations with originators about why we don’t like loans.  And there’s a lot of back and forth because you won’t be taken seriously as a B-piece buyer in the market if you’re just kicking out loans because you can.

Steve: The Street is more cautious. Since 2011, the percentage of loans on a tape that actually close has been dropping precipitously. It got as low as less than 10% in a recent transaction. The benefit from the increased discussions between issuer and B-piece buyer is that when you express an interest or lack thereof in a loan that hasn’t closed, you have an opportunity to talk about the terms on which you would be interested. The issuer can try and make that happen or choose to not close the loan. I think we’re seeing a lot more of the latter. I don’t know that I’d call them kick-outs necessarily; instead I view it as just being more collaborative around risk management.  

Stephanie: Steven, of the loans you see that end up not being closed – and you’re saying they’re not a kicked loan – do you see them again restructured?

Steve: We have. Sometimes we see the same loan on two different tapes at the same time. The same loan could be in a deal Randy’s looking at and in another deal that I’m looking at. Issuers are hedging their bets, because Randy and I don’t like or dislike the same things all the time. It’s also not unusual to see a loan that didn’t close reappear later with different terms, possibly at a lower dollar amount, with more amortization or better reserves.  Everyone is trying to keep warehouse periods to an absolute minimum – it’s the best hedge. There is more ‘just-in-time’ loan closing than ever before.

Stephanie: That’s what we’re seeing, too. Right around 10% of the loans are closed on the first tape, and often we see loans roll from one deal to the next.  

Randy: Definitely. That’s a dangerous thing for the industry and no one’s really focused on it. If you’re scrambling to close a loan, there’s a higher likelihood that mistakes are made, corners cut. Is it better to have risky loans not close or to have them close with originators having to hold them on balance sheet and/or suffer losses because they can’t get them securitized? I could argue that the hard feedback of suffering an actual loss may influence behavior more than simply being told don’t close a loan that has been quoted and or put under application.

Steve: The question is do you think borrowers are getting the feedback? Or are lenders just getting loans under app, hanging on to them, and waiting to see what happens in the B-piece process, and then just saying, “Well, I’m not going to close your loan.” That’s bad for the industry.

Randy: With reps and warranties eroding if there are mistakes or omissions, lenders are going to fall back on the watered down documents and maintain it is not their problem. That scares me a little bit for the industry. Neither Steve nor I are supposed to be the credit committee or backstop for lenders.  The business is supposed to be a principal business. Lenders should take principal risk. And some still are, but there are plenty of originators who are not. 

Will Risk Retention Really Improve Credit Quality?

 Stephanie: Let’s talk risk retention from both the IG investor and B-piece buyer perspective. Will risk retention have an impact on credit quality?  

Steve: Yes, I think it will have a positive impact. The issuers we talk to are focused on figuring out risk retention. If it’s the horizontal solution, issuers are being collaborative with B-piece buyers on structure so they can be sure there will be capital available for their deals on terms that make sense. At the same time, many are working to figure out how to hold a vertical strip.  My expectation is that one of the byproducts of risk retention is that credit quality improves whether it’s a horizontal solution or a vertical solution.

Randy: It could go the other way if CMBS becomes a more expensive product. Risk retention is clearly a tax on CMBS whether the issuer is retaining, relying on the B-piece exemption, or something in between. The question is who leads the market and how do various capital sources price their loans. Will borrowers move away from CMBS because it’s too expensive? I think every originator believes he is making a good loan that will perform, even if Steve and I don’t share that belief, so I am not sure that credit quality actually changes if issuers retain bonds. If it’s a collaborative effort among the buyers and originators, maybe that has the positive effect Steve mentions.

Lisa: Let’s move on to our investment-grade investors. What do you think about risk retention and its impact on credit?

Marc: I’m hoping it does make credit quality better. I know Randy’s commentary on what kind of loans and properties conduits can and eventually will be able to compete on is a concern. Hopefully underwriting can help compensate for that.   I just think inherently it’s going to have to bring credit quality much more into play just given the long-term holding period the issuer or B-piece buyer is going to be facing. I would be interested to see how risk retention that has come into play in other markets has worked out.

Harris: I would agree. I’m cautiously optimistic that risk retention will be a positive for credit, although it’s not completely clear to me that it will be. The competitive issue that Randy mentioned is spot-on. I would also add that it is not clear how risk retention is going to vary from one deal to the next. So it’s not clear how the dealer community is going to respond and whether that’s going to be a programmatic response or whether it’s going to be a dynamic response in terms of changing what the retained piece is going to be from one deal to the next.  Until there’s a bit more clarity I’m not sure that risk retention translates into a slam dunk improvement in credit quality for CMBS.

Thomas: I agree with Harris. We hope it’s positive for credit quality, but the degree of benefit will depend upon the form of retention along with the party actually retaining risk.  Lisa: To our B-piece investors, how does risk-retention might play out initially? As noted in today’s discussion, risk retention could take the form of a vertical strip, horizontal strip, or some combination. What’s your best guess as to what the market looks like come December 24, 2016 and go forward?  

Randy: To Harris’ point, I think there will be multiple ways deals get done until there is a clear winner economically. But we know there are participants who cannot or do not want to retain bonds. There are others who can but the economics must make sense. And some of that will have to be done on the fly because it isn’t clear what the illiquidity premium is or whether yields are blended lower because a B-piece buyer is buying less-risky investment-grade bonds. Steve and I both have investors who target certain returns and it doesn’t feel like they will be willing to accept lower returns. Because of that, full or partial retention by issuers may make economic sense so some deals may be business as usual.

Steve: In the end, I think the risk retention solution most issuers will embrace is the horizontal strip. I worked at a big bank for many years and capital was very dear. Even though it’s been a few years, I imagine that’s still the case, if not more so. Besides, if it makes sense to hold 5% vertical strip, why not hold 25%? I don’t think that’s the business, the banks want to be in – they already have balance sheet lending businesses. At the same time, I don’t think that B-piece buyers will be able to price the horizontal piece wherever they want because at some point CMBS lending becomes uncompetitive. That’s not good for business either. On balance, I think using the simpler horizontal approach is ultimately where this shakes out.  That said, it may be mid-2017 before the risk-retention issue settles down. The next six months could be a bit of the Wild West.

Marc: I have a question for Randy and Steve. If you think about risk retention and what it’s bringing to the market so far – not able to finance, not able to hedge, not able to trade – does that really change your projected payback period? I don’t know how much you’re able to finance your position, especially the unrated and the single-Bs, but does it materially change the holding period, or at least that payback period, as you’re projecting your returns? Will risk retention change your risk tolerance or risk profile even though you have to retain it for 10 years instead of how long you’re expecting to hold it now? Is that really changing?

Steve: There’s still price discovery to be done and that affects pay back. But we always assume we hold to maturity. We’re a private-equity fund and we have capital that’s discretionary and available for a long enough period of time to satisfy the risk-retention rules. That said, we’re mindful of the restrictions the new rules impose and we’re confident we’ll be participating in the market post risk retention.

Randy: I’d say the same thing. We were one of the first guys back in the market, and we bought deals that we assumed we would have to hold and only later did we have the luxury of liquidity. To me, the issue isn’t so much about having to hold – if someone is telling us we have to, we can handle that. I think the bigger issue is the amount of capital that has to be raised and formed to be able to buy 5% of the deal’s fair-market value. That’s a lot of capital, and significantly more than has been formed historically around our sector. Based on current deals and the lack of liquidity in the market today, it would require double the capital, substantially more if yields tighten and liquidity returns. We have spoken to many investors and even though far more understand CMBS than we’ve ever encountered, investing in below-investment-grade bonds is not easy to explain and it’s not an asset class that has typically attracted investors who commit capital on a scale that could be necessary. Whether or not there is sufficient capital to maintain volume post  risk retention will directly affect pricing to borrowers.

Marc: You’re going to need more yield to get more capital into the market.  

Randy: Well, there may be limited investors, right? There just won’t be the demand.  

Marc: Right. That will limit the market. No, that’s interesting.  

Randy: And then it will drive up pricing to borrowers and it’s a vicious cycle. And that could be a little scary and I think that’s going to be a question that needs to get answered.

Steve: Randy, I think that is a real issue. And, again, I think collateral quality will improve. Also, issuers have to get comfortable, really comfortable that the Eightfolds and Torchlights of the world are going to do what they say they’re going to do. Coming up with a mutually agreeable structure is a tremendous upfront investment of both time and resources. What are issuers going to want? What certifications? And then what do B-piece buyers want? What yields? What kind of credit quality to commit capital and buy a B-piece? I wonder how much capital will be ready on day one to be deployed into these horizontal structures. I think a number of issuers are trying to lock that capital up today so that they can keep the lights on and not have to go to a vertical structure.

Looking to the Future, What Does the CMBS Market Look Like Five Years from Now?

 Lisa: Let me ask a quick go-round to everyone. Five years from now, given this discussion and concerns about risk retention and the overall onslaught of new regulations, is the CMBS market bigger or smaller than it is today?

Marc: I think five years from now, in 2021, the CMBS market should be smaller given relatively lower issuance levels in 2011.

Thomas: Yes, I think the market share of conduit lenders is going to be smaller.  

Harris: I agree. It’s smaller.  

Randy: But I’m hoping it’s going to be the same as last year and CMBS market share won’t shrink too much. It doesn’t seem like CMBS can just go away. It feels like it fills a need. The question is how big that need is going to be.

Steve: I think it will be the same or bigger. 

Lisa: You’re thinking about $100 billion, right? So a 2015 kind of number?  

Randy: It feels like that allows for maintaining the critical mass needed to keep a number of people in business and meet the demand of borrowers who either want or need the product. And, of course satisfy investment-grade buyer demand.