Everyone loves a comeback story. Whether in sports or business, an underdog often finds itself with more than its rightful entitlement of fans or market share. But not unlike the New York Yankees, who recently found themselves statistical underdogs when trailing 3-0 in the best of seven ALCS series and had the majority of the sporting world rooting against them, many have trouble cheering for a comeback when they believe the underdog is responsible for derailing its trade. To some they're the best in baseball, but with a $200m payroll - a figure that places them at the top of the league and more than double the league average - the Yankees are a team that's easy to hate. To the misinformed, commercial mortgage backed securities (CMBS) are the New York Yankees of Canadian real estate finance.
Canadian commercial property owners have relatively few sources of term financing compared to their US counterparts. Of course, it helps that the US commercial mortgage universe is roughly fifteen times the size of the Canadian market, but even on a dollar adjusted basis, Canadian borrowers are hardly spoiled for choice.
In pursuing commercial mortgage financing, Canadian borrowers have long had the option of turning to a portfolio lender. Portfolio lenders lend with the intention of holding a mortgage from funding through to maturity. It's a category dominated by a handful of financial institutions, insurance companies and public and private investment managers, that has managed to scoop up the majority of the Canadian commercial mortgage origination market year over year since the early days of real estate finance. A borrower's other option is to finance through a conduit. That is, a lender who lends with a view to selling the mortgage on or shortly after funding. Prior to 2007 the majority of commercial mortgages originated by conduit lenders were packaged into CMBS structures and sold to institutional investors.
What is CMBS?
Simply put, CMBS is a vehicle through which fixed income investors lend to real estate borrowers. A typical structure involves the pooling of a series of individual commercial mortgage loans that are securitized to create mortgage backed bonds. These bonds are structured to appeal to different risk appetites and sold to institutional investors in search of risk/reward characteristics and liquidity otherwise unavailable through investment in whole loans. CMBS acts as a link between the fixed income capital markets and the commercial real estate market and in its simplest form is just another tool for connecting sources of real estate capital with users of real estate capital.
And here's why it's a good thing for borrowers - a healthy, functioning CMBS market leads to a larger and more stable pool of mortgage capital resulting in increased competition amongst lenders. The result? Borrowers have greater access to mortgage capital at more attractive rates.
Although it enjoyed early success, and is currently on a path to recovery, the Canadian CMBS market hasn't been healthy for years. Canadian CMBS issuance was virtually nonexistent between mid-2007 and mid-2012 and a market that once accounted for over 25% of all new commercial real estate debt in Canada now represents a modest 8% of the outstanding commercial real estate debt market.
So what 2007 development derailed the $4bn annual Canadian CMBS industry? I'll give you a hint. It's the same offender still shouldering a healthy share of blame for today's economic malaise. The answer, of course, is US subprime and the resulting asset backed commercial paper crisis. The Canadian CMBS market floundered when investors lost confidence in structured products.
The Canadian experience
It's been four years since the Yankees last won the World Series, but people still love to hate the team that's carried the largest payroll in baseball since 1998. Conveniently, 1998 also marks the year in which the first Canadian CMBS deal was brought to market.
Conduits were born in the early 1990's in the city the Yankees call home. Having spent their early years focused on domestic product, conduits began migrating north in the late 1990's. Once established in the Canadian market, they quickly became a popular source of financing for Canadian borrowers. Although vastly different in size (at its peak the US CMBS market was more than 50 times that of the Canadian CMBS market and nearly half of all US commercial mortgage originations were bundled into CMBS structures), the Canadian and US CMBS markets enjoyed similar growth during the 2000's. Both markets enjoyed a roughly four-to-fivefold increase in issuance volumes between 2000 and their respective peaks in 2006 and 2007.
But despite growing at a similar clip, the underlying performance of Canadian CMBS loans has been far superior to that of US loans. While the US CMBS market continues to hover around the 10% delinquency mark, Canadian CMBS loan delinquencies have yet to exceed one half of one percent. Perhaps most telling is the loss performance of Canadian loans. Since 1998 more than $24 billion of Canadian CMBS has been brought to market. Of the more than 3,200 loans backing these offerings just 20 have experienced losses resulting in an aggregate principal loss of just $21m, or 0.09% of total issuance. This works out to a loss of less than one, one hundredth of one percent on an annualized basis; stellar performance by any measure. Industry experts have attributed this to a wide number of factors, including but not limited to borrower recourse, prudent borrower behaviour and generally conservative underwriting practices when compared to the US.
The Yankees are perennial World Series contenders. Since 1995, the team has won the World Series five times and missed the postseason only once. The year they were shut out of the playoffs, 2008, happened to be the same calendar year in which the Canadian CMBS market registered its first zero on the new issuance front in over a decade. But with access to a capital pool placing them in a different league than many of their so-called competitors, the question was always when, not if, the Yankees and CMBS would make their respective comebacks.
The Yankees, who depend on the deep pockets of a private owner, were able to bounce back immediately and captured their 27th World Series title in 2009. CMBS, with its dependence on a more unpredictable source of capital in the form of the capital markets, had a tougher time getting back on its feet. The market was virtually non-existent between 2008 and 2011. But by early 2012 with secondary market CMBS offering attractive yields relative to similarly rated structured products, nearly 15 years of incredibly strong underlying loan performance and a convalescing CMBS market south of the border, the capital markets were beginning to co-operate. With these improving conditions, it was only a matter of time before CMBS made its Canadian return…
In July of 2012 Institutional Mortgage Capital led a $240 million CMBS offering backed by 31 fixed-rate loans secured by 33 commercial properties across Canada. The deal put an end to the near 5-year draught on the diversified new issuance front and was well received by investors. The Canadian CMBS market then took yet another step toward recovery in early October when a $249 million issue was brought to market by CMLS Financial Ltd. These bonds were backed by 26 fixed rate loans secured by a portfolio of 27-high quality retail, office, industrial, and multifamily properties across Canada.
Although a long way from the $4bn per year industry it once was, it would appear that Canadian CMBS has found its footing. Market indicators including, loan spreads, bond spreads, borrower demand for CMBS loans, investor demand for CMBS product and recent US activity, suggest the $489m of Canadian CMBS brought to market over the past 4 months is just the beginning.
Admittedly, one could argue that with only two conduit lenders currently originating and securitizing commercial mortgage loans, the Canadian CMBS market has yet to return to normal conditions. Not open to debate, however, is that the return of Canadian CMBS and the resulting increase in mortgage capital benefits both conduit and non-conduit commercial real estate borrowers alike.
Is a CMBS loan right for you?
CMLS Financial is continuing to build its program with a second CMBS issue slated for the first half of 2013. Generally, loans that fit the program are backed by commercial properties with stabilized cash flows, strong occupancy histories, attractive lease maturity profiles, and few planned expansions or modifications throughout the term of the loan. CMBS is especially attractive to borrowers looking to diversify their lending relationships and loan exposure thresholds and investors looking to maximize cash flow from their investment properties by increasing the amortization period.
Sam Brown is an Associate Director in the securitization and investment management arm of CMLS Financial Ltd., Canada's leading private fully integrated provider of lending products and services to the real estate and real estate finance industry.
Sam Brown, CA