To have the need for 2.0 of anything, by definition, 1.0 could have been better.
Certainly that was the case with many of the internet’s first sites, and it is the case with Commercial Mortgage Backed Securities.
CMBS 1.0 had all sorts of problems, including:
- Too many lenders chasing too few deals resulting in high-leverage and low-cost debt financing that inflated the equity markets. Classic “Bubble” behavior that tolerated incomplete or inaccurate broker/borrower disclosure.
- The diminishment of the “B Piece Buyers” credit check as a result of the CDO arbitrage opportunity that existed from 2004–2007.
- Conflict of Interest between the issuers and the rating agencies.
- Inadequate reporting requirements and tools to effectively share true credit risk with all interested parties.
- And a whole lot of other things. …
Some of these items have a way of fixing themselves. There are no more CDOs, so B Piece buyers care about credit again, and no one would say we have too many lenders right now. The rating agency issue is a bit tricky given the historical roles of these companies; regulators will likely help decide their future role/revenue model. That leaves us with reporting requirements and standards as the only things we can truly affect as we wait for the market to return.
So what would be different about CMBS 2.0?
Lots of things but, primarily, a standardized real estate underwriting and data platform.
The “math” associated with real estate loan underwriting is basically broken up into two items: Notes and Properties. After modeling the Note to include the debt repayment terms (the liability) and the Property to model the net cash flow available after collecting the rent on the leases and paying expenses (the asset), the user can determine the Debt Service Coverage Ratio (or DSCR = Cash Flow From Property / Cash Requirement of Notes). The higher the DSCR, the safer the loan. The lower the DSCR, the riskier the loan.
On a typical CMBS loan, the debt side stays constant as most loans are fixed rate. On floating rate loans, interest rates and, therefore debt service requirements, change. As an industry (CMBS 1.0), we do a good job on the debt side of the equation, so that is not the problem.
Strengthening the property side
Since rental rates change and tenants come and go, the property side of the equation changes all the time.
As an industry (CMBS 1.0), we did not do an adequate job on reporting on the property side. The problem can be pinpointed to a lack of reporting on rent rolls and the inability for investors to run models on existing CMBS pools based on current rent rolls.
The good news is borrowers need to submit updated rent rolls as often as once a quarter, so the info is contractually available. The bad news is the Investor Reporting Package (IRP) does not require disclosure of the rent roll. So, the master servicers do not provide them electronically and the existing investor / CMBS bond modeling systems do not handle rent rolls adequately for underwriting because, historically, an underwriting was nothing more than last year’s income and expense number (as adjusted, or not, by the servicer).
There are many paths to fix the property reporting deficiencies, and the issue raised above is not a new problem for the industry. To date, standardization efforts have been waged by the CMSA and the MBA. Being actively involved in these industry efforts, I can say the timeline to reach standards is still measured in years, not months. In good times, that may have been acceptable. Not today.
The power of a common underwriting platform
When we all share a common underwriting platform and have open access to required data, we will have much-needed transparency, and every member of the CMBS market will enjoy improved processes:
- Borrowers and brokers who are either looking for a new CMBS loan or reporting on an existing CMBS loan could enter the required data and report it to the lender or servicer in a standardized format.
- Existing borrowers would send their rent rolls and operating statements to the master servicer in an XML format that seamlessly updates the terms of the new rent roll in the investor system.
- Mortgage brokers could put together packages that feed directly into the lender’s system.
- Lenders would be able to analyze credit risks of new loans for internal approval and share that data efficiently with the rating agencies and investors.
- Investors would have access to updated surveillance reports conducted by the rating agencies, and they would be able to create their own versions of the cash flows for their bond books.
- Appraisers could create their valuation models using the same objective data as the lenders.
- These all seem like good enough ideas. …
We are building CMBS 2.o now
We are working to make CMBS.com the common CMBS platform. We are promoting acceptance by offering free accounts for all existing CMBS borrowers and individual user accounts for as little as $49/month.
Will it work? Will the borrowers come and register their loans? Will investors gain unique insight into the bonds? Will brokers prepare debt and equity marketing packages on the standard? Will the old-line banks get off their proprietary systems?
Who knows? Stay tuned.
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Jim Flaherty is CEO of CMBS.com and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.