Understanding the elusive B-piece buyer in conduit financing.
Even though a deal may look promising, CMBS lenders must abide by certain guidelines and will pass on the deal if major risks are identified. Although the lenders want to finance deals, they are concerned about the B-piece buyer's scrutiny of their loans. Consequently, B-piece buyers in the market today wield significant power over CMBS transactions because without them a CMBS securitization will fail.
When commercial real estate loans are securitized, the loans are placed in a trust which then issues bonds secured by the collateral. These bonds are then sold off in a payment sequence similar to a champagne waterfall where various bond classes enjoy different priority of payment.
For instance, the highest rated tranche, typically AAA-rated, is the first to receive its interest and principal while other classes with lower ratings just receive interest. After the AAA-rated tranche receives its entire principal, the second highest rated tranche, usually AA-rated, is the next group of bonds to be paid off until it receives all the interest and principal due.
Below the AA-rated tranche is the A-rated tranche which is next in line to receive all its payments, followed finally by the BBB-rated tranche. The above-mentioned four tranches are known as "investment grade" and are easily sold to bond investors such as banks, insurance companies, private and public trusts. Below BBB-rated bonds, there are BB-rated bonds, and those bonds that are so risky that they are unrated. Collectively, these bonds below BBB-rated are classified as "below investment grade" and are known as the B-piece.
The B-piece buyer, therefore, takes on the most risk in a CMBS securitization because they are exposed to the first risk of loss. Upon the occurrence of any defaults, the B-piece buyer is the first to take a financial haircut. Consequently, because losses on collateral loans are first deducted from the principal balance of the junior class, B-piece investors protect themselves by conducting meticulous due-diligence on every single loan in the CMBS pool.
If the B-piece buyer kicks a particular deal out of a portfolio, the lender must warehouse that loan on their balance sheet until variables change making it acceptable to the B-piece buyer. Thus, B-piece buyers are the dominant consideration when any CMBS lender underwrites a deal. If a lender feels that the B-piece buyer will have a problem with accepting an individual deal in a pool, the lender will refuse to do the loan. In order to decrease chances of a loan rejection, it is imperative that real estate professionals understand the concerns of the B-piece buyers. By doing so, the lender's concerns can be anticipated, and various credit enhancements can be presented to mitigate the risks.
These preemptive steps will demonstrate your understanding of the deal, and by extension, will motivate the lender to work with you. The following sections outline some of the major concerns faced by B-piece buyers.
A primary concern for B-piece buyers are loans structured without escrows to help prevent losses in the event of delinquency. The typical CMBS underwriting calls for monthly tax and insurance escrows impounded into a reserve account to ensure taxes are paid and proper insurance coverage is maintained. Loans which lack full coverage for earthquake or flood can result in huge losses if the loan defaults as a result of a force majeur.
In addition to tax and insurance escrows, $.15 per square foot are required for structural reserves and between $.65-$1.15 per square foot for tenant improvements and leasing commissions. These reserves are collected annually and capped at a dollar amount sufficient to mitigate risk. Statistically, almost every loan that goes into default is a result of deferred maintenance or lack of leasing. In many cases, the borrower either lacks the funds or refuses to spend the money to maintain the property.
Even though a property may have solid fundamentals, bad borrowers who have demonstrated poor performance in the past on workouts or under stressful situations are a worry for the B-piece buyers. In addition, borrowers who have cashed out of a deal pose a problem as well since they are notorious for neglecting their properties due to lack of incentive to maintain the collateral.
Other potential red flags include potential partnership disputes or problem-prone ownership structures such as: tenants-in-common, buyers who are not U.S. citizens, sponsors that are over-leveraged on other investments which may cause a diversion of cash flow, and finally, borrowers that cannot produce quality financial statements, financial reports, and/or rent rolls.
In case of a deteriorating economy, B-piece buyers need to know the credit strength of tenants currently in-place on the property in order to avoid the risk of re-tenanting. As such, being aware of a company's recurring cash flow, debt levels and maturity schedules is helpful in determining a major tenant's ability to maintain occupancy. In addition, knowing the tenant's historical performance and sales will be helpful in assessing the tenant's plans to stay or leave a particular location. Another major tenant concern to B-piece buyers is the location of competitors, for example the location of a Wal-Mart in relation to a retail center. The B-piece buyer will want to know how long the Wal-Mart has been there and how it has affected the retail center and the surrounding market. Single tenant buildings may also be problematic if the tenant's credit rating is less than investment grade. In order to address potential issues under these circumstances, proof of the tenant's historical monthly sales over a period of years is required.
A property's age is another major concern for the B-piece buyers especially when it comes to multifamily properties. There are numerous multi-family properties that are old and unless they can keep up with their immediate competition, they will lose tenants to newer buildings with better amenities. When the occupancy declines, the borrower may stop making debt service payments. To remedy any functional obsolescence, reserves must be escrowed.
A property located in a weak or remote market is also a concern--except when the tenant is the government or a high investment grade tenant on a bulletproof lease and a fully amortizing loan. Additionally, demand generators for the property need to be clearly demonstrated. Whether it is an anchor (or shadow anchor) of a retail center, the risk of losing that tenant affects not only the immediate space but also the in-line tenants that feed off the major tenant's traffic. Thus, reserves to mitigate the rollover of a major tenant are necessary.
Properties should be stabilized, particularly recently completed construction projects or renovations, to convey significant market acceptance. Typically, 2 years of demonstrated operating statements is sufficient.
The B-piece buyers are less interested in what a property appraises at and more interested in its true fundamentals such as how that particular asset competes within the competitive subset of properties in a given market. Appraisals must be self-contained and must discuss, in detail, absorption rates, supply/demand factors, and rental/sales comps.
CMBS loan origination requires a substantial amount of due diligence--a process to which many borrowers may be unaccustomed.
However, in order to access non-recourse, highly leveraged, fixed rate financing offered by the capital markets, borrowers must play by the rules. As a borrower, one must cooperate with a lender by presenting a detailed asset summary that illustrates why a loan is a sound investment decision.
If there are potential risks in a deal, address them upfront rather than waiting for the lender to identify a red flag.
Lenders are deal makers who understand real estate, give credit to strong fundamentals (low LTV, financial strength, high debt coverage ratio, borrower experience, etc) and therefore will consider the merits of every transaction.
BY RONEN ABERGEL
PRODIGIOUS CAPITAL FUNDING, LLC
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|Title Annotation:||INSIDERS OUTLOOK|
|Comment:||Understanding the elusive B-piece buyer in conduit financing.(INSIDERS OUTLOOK)|
|Publication:||Real Estate Weekly|
|Date:||Mar 14, 2007|
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