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Dan Thomas
Managing Director,
Client Solutions Group
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Wednesday, July 07th, 2010.
Overview
The growing problems within the commercial real estate market are front and center after playing second fiddle to the residential market for all of 2008 & 2009. Monthly CMBS delinquency rates have steadily increased from 1.66% in March 2009 to 6.4% in March 2010, with delinquency projections of close to 11% by December 2010! During that same period, loans moving to special servicing also have increased dramatically from roughly $20 billion in March 2009 to $80 billion in March 2010. This market disruption has resulted in changing dynamics within the commercial servicing sector. Servicers are losing servicing income through involuntary prepayments (defaults). Additionally, the low interest rate environment has reduced the interest income component of commercial servicing. Lower originations, particularly in the CMBS sector, have impaired servicers’ ability to replace lost loans with new servicing. The effect of all these factors has been to increase the demand for all types of commercial servicing.
Supply / Recent Transactions
Transaction volume in the commercial servicing market in Q4 2009 and Q1 2010 was still extremely light in relative terms, mostly due to the lack of new CMBS issuance. One bright spot for the market was the issuance of seven Freddie Mac Capital Market Executions, which had a combined unpaid principal balance of approximately $6.2 billion. The auction of both the master and primary servicing for those securitizations was very strong with bids significantly higher than anticipated.
There have been several notable Commercial Servicing transactions that have occurred over the last two quarters that are part of company sales. Centerline Capital was purchased in part by C-III Capital Partners, LLC, which is an investment vehicle of Island Capital. Centerline is an Agency and Special Servicer with a portfolio of approximately $9 billion. In another large transaction, an investment group led by Dallas, Texas based ORIX USA Corporation and including Stonehenge Partners of Columbus, Ohio, acquired Red Capital Group from PNC Bank, N.A. The approximate size of the commercial MSR portfolio in that transaction was $11 billion of predominately Agency servicing as reported by the Mortgage Bankers Association. Another notable company transaction as reported in Commercial Mortgage Alert publications in April & May 2010 editions, was that CW Financial Services and its servicing unit CWCapital are in the final round of auction. CWCapital is both a Primary and Special Servicer with a portfolio of approximately $11 billion of primary servicing and $160 billion of Special, $11 billion of which is currently actively managed. Interested parties as reported by the publication have been several new entrants into the commercial servicing field including; Fortress, Ladder Capital, Starwood Capital, Vornado Realty and Apollo Capital. These nontraditional investors in the commercial servicing market have been especially interested in the Special Servicing unit of CW Capital and others such as LNR Property Corp. Special servicers have strong access to borrowers and investors and potentially an inside track on the disposition of the collateral backing defaulted CMBS bonds. Those operational and relationship dynamics have made Special Servicers extremely attractive to real estate investors looking for opportunity in this distressed commercial real estate market.
Market Values
Market values continue to remain strong from prior periods. This strength has been mostly driven by demand and the lack of supply available to market participants. Additionally, MIAC has seen several of the top buyers increasingly use more aggressive pricing assumptions in their bids. The five major factors influencing commercial servicing values ranked by importance to cash flows are prepayments, the cost to service, the earning rates on escrow, P&I and reserve balances, discount rates, and ancillary income. Listed below is an approximate range for each assumption based upon discussions with market participants and the recalibration of recent market trades for Agency and CMBS primary servicing:
Assumption Large Servicer Mid-Level Servicer
Prepayment Rates 0 - 3.50 % 0 - 3.50%
Cost to Service $1,000 - $2,000 $4,000 - $6,000
Earnings Rates 2.50% - 4.00% 0.50% - 4.00%
Discount Rates 7% - 12% 10% - 15%
As expected, the large servicers that are owned by depository institutions continued to be at the more aggressive end of the range for every assumption category. MIAC does not see any factors in the marketplace in the foreseeable future that would change that dynamic.
Outlook for 2010 & Beyond
Servicing prices should remain stable for all types of commercial servicing for the remainder of 2010. MIAC believes that market demand will remain strong for the majority of the asset classes in this sector provided that earnings rates do not drop to zero and stay there for an extended period! As noted above, delinquencies and default rates are rising dramatically and they will continue to have a significant impact on the commercial servicing market due to the loss of servicing revenue. MIAC has conducted a default price sensitivity analysis on a large sampling of approximately $300 billion of mixed Agency and CMBS primary commercial servicing rights. Based upon that analysis, we estimate that the overall value of the portfolio would drop 4.2% - 6.4% if defaults doubled over the next year and remained at that level for 18-24 months. Individual portfolio attributes would yield higher or lower results, but the model dynamics are pretty clear: higher defaults yield lower values.
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