CMBS Tranche Wars: The Next Wave of Zombie Real Estate

Remember how the residential real estate markets froze-up beginning in late 2007?  Well, the same thing is now happening in commercial real estate.  Read on….

Commercial mortgage backed securities, also known as conduit loans, are pools of loans for investment grade shopping centers, office and industrial buildings that have been packaged together as a single security by Wall Street ibankers and then divided up into a series of vertical cash flows called tranches. The individual tranches are then sold to a wide variety of investors throughout in the world.  Each tranche has a different rate of return, with the highest rate of return going to the tranche that takes the first losses, and the lowest rate of return going to the tranche that takes the last losses.

For a more detailed, and somewhat prescient discussion of CMBS, check out a 2001 article written by Jeffrey Steiner and Jim Butler of Jeffer, Mangels, Butler and Marmaro at www.entrepreneur.com/tradejournals/article/84184169.html.  Eight years ago they wrote, “Given the pervasive “success” of CMBS financing, it is nothing short of amazing that so many borrowers and their advisors appear to have little understanding of the process, structure, and practical implications of their securitized debt or how to deal with it when times get tough.”  They were right.

Over the next few years about 450 billion dollars of commercial real estate loans in CMBS pools are reaching maturity with rising vacancy and without a significant source of replacement debt to refinance these commercial loans.  This is paralyzing the market for commercial investment property, pushing down prices of performing property to ever lower values through lack of demand, while buyers patiently wait on the sidelines for this tsunami of non-performing CMBS financed commercial property to be foreclosed and put up for sale (I like to think of it as recycling, like green investment). This is the same thing that occurred with residential mortgage backed securities (RMBS) that froze up residential real estate markets beginning in 2007 – and we know how that’s turning out.

CMBS have become so dysfunctional that we’ve seen CMBS loans that haven’t made a mortgage payment in 18 months and are not yet in default, much less foreclosed and put up for sale.  But wait, the Wall Street ibankers that packaged up these securities are uber-smart. They wouldn’t let someone miss an interest payment without a good reason. Well, as it has been explained to me, there are two primary reasons for this.

First, a CMBS pool is a treated by the IRS as a tax pass-through entity as long as the loans are performing. When a relatively small portion of these loans go into foreclosure, the tax pass-through status goes away, making them subject to double  taxation, which is a bad thing.  So the tranches with the last losses (which are still getting paid) are highly motivated to keep properties from being put into foreclosure.

Second, the base value of these pools was insured through the purchase of insurance policies called credit default swaps (yeah, the stuff that pretty much sunk AIG).  When pool properties stop making mortgage payments, they can be given to the issuer of the credit default swap (which, cleverly enough, is why they’re called swaps) in exchange for a cash payment from the issuer of the swap. So, as you would expect, the tranches with the first losses (which are not getting paid) are highly incentivized to put the non-performing properties back to the issuers of the credit default swaps in exchange for cash.

These two positions are badly misaligned.  Throw in a deteriorating economy with very little liquidity and waves of credit tenants that are going out of business at an ever increasing rate, and you’ve got a bona fide mess. Of course, every tranche has an attorney, and so we now have the tranche wars.

What’s the plan? Word is that CMBS master servicers (the financial equivalent of property managers) plan to essentially do nothing until the market and values comes back, cleverly avoiding the whole problem. Since there’s still a lot of cash flow, the goal is to put much of this property into receivership to capture the cash flow in the interim, while they wait out the market. It isn’t clear to me yet whether the courts will allow receivers to remain in place for the many years it may take for the economy to recover, nor is it clear that you can find a way to put in a receiver and avoid putting the loan into default – that’s for the attorneys to sort through.

Since denial and inaction rarely are a good business strategy, I remain confident that the ibankers who created the mess will find a creative (and profitable) way to clean up the mess.  Stay tuned….