KKR Real Estate Credit has completed a milestone acquisition for its commercial mortgage-backed securities B-piece portfolio, acquiring its 50th non-investment grade tranche of a CMBS deal.
The acquisition is indicative of the New York-based manager’s long-term approach to the market and the relative consistency of this segment of the commercial real estate debt markets, said Matt Salem, head of real estate credit.
“On the ground, we are seeing transaction volumes start to come back and we believe the lending opportunity is here today, whether we are making a loan or buying securities,” Salem said.
This uptick in transaction volume presents opportunities for the debt and equity side of the firm’s business, both within CMBS B-pieces and across KKR’s broader real estate portfolio, added Chris Lee, co-president of KKR Real Estate.
“We touch approximately $245 billion of real estate across our real estate equity, direct lending and securities portfolio. Every day we are out lending on or operating real estate and this informs us about what is happening on the ground and makes us a better lender and investor,” Lee said.
The New York-based real estate private equity manager became a B-piece buyer in the wake of the global financial crisis, spurred by the implementation of the Dodd-Frank regulations around risk retention.
The implementation of the Dodd-Frank regulations around risk retention require that a CMBS issuer or qualified B-piece buyer retain 5 percent of a deal, with the expectation of a minimum holding period of five years. When KKR started its lending business, the firm was primarily originating first mortgages and transitional mortgages. But Salem said KKR soon began to think about the opportunity CMBS B-pieces offered.
“We started to look at the CMBS market as those new rules were going into effect and realized that they would be impactful. We thought having skin in the game would create a better kind of credit, similar to what the regulators wanted. We also thought it would mean lower loan-to-value ratios and safer loans,” Salem said.
The B-piece market has unique attributes which dovetail with the historical role B-piece buyers have played in CMBS deals, Salem added.
“What is unique about the CMBS market is the way in which the industry worked with the regulators to make sure there was more than one type of investor able to solve the rules around risk retention. In CMBS, this means an issuer, or a B-piece buyer, can participate,” Salem said. “The B-piece function has effectively re-underwritten the risk, acting as another credit function within the market.”
Ultimately, the firm concluded that there would be significant relative value in the risk retention pieces of CMBS deals and raised a dedicated fund.
“At that time, no one quite knew how it was going to play out because it was all so new. We became the first investor to buy a B-piece subject to these regulations and helped to draft some of the relevant documents,” Salem said. “And we have found the business has been a good one for us because the investment thesis, the underlying credit and the opportunity have been consistent.”
There was another factor as well. “It is also helpful that there is a small buyer base, without too much excess capital to drive up pricing,” Salem said.
Now and then
There is a significant difference between the CMBS B-pieces of today and the ones from the previous cycle. Some of these differences revolve around changing collateral concentrations as different sectors face negative headlines, while others are tied to the amount of leverage, Salem said.
“The B-pieces we are buying are not the CMBS 1.0 deals from 2006 or 2007 that had a lot of default issues. The credit has really changed [since then], and we continue to be active,” Salem said. “We are seeing low leverage of around 50 percent in deals today. Pre-GFC, this market was a 70 percent LTV market.”
One recent area of innovation has been around the length of loans. Historically, fixed-rate conduit loans carried a term of 10 years. But as rates have risen, more borrowers are opting more for five-year loans.
“An entire pool of five-year loans is a new construct in the market,” Salem said. “When the product first came out, we didn’t love the pricing and stayed in the 10-year part of the market. Recently the five-year part of the market has seen yields rise by 400 basis points, which led us to step into the market.”
The firm owns or lends on approximately $245 billion of commercial real estate, with an approximately $46 billion servicing portfolio and a $31 billion direct mortgage portfolio. It has so far observed a very low delinquency rate in its CMBS portfolio.
“Our cash flows are effectively 100 percent of what we were initially modeling. We are getting more information as we re-underwrite the portfolio, with updated occupancy and rents. That is more indicative than a default rate,” Salem said. “We can harvest that information and it can help make investments elsewhere.”
One area which has been challenging has been relatively low issues, with Salem explaining higher rates and broader macro issues have affected issuance – and the supply of new B-pieces. This has been mitigated by the firm’s ability to buy B-pieces in the secondary market.
“When you think about ebbs and flows, that means there is more opportunity in the secondary market. Our team can shift and take advantage of the volatility in the pricing that goes on, for example, as mutual funds sell bonds,” Salem said.
Still, KKR believes issuance will rebound as rates settle. “CMBS, along with alternative lenders, will be a primary outlet for loans and debt,” Salem said.