The conduit market was once the workhorse of the US commercial real estate finance market. But since the global financial crisis of 2008 new originations and issuances have steadily slowed. Today’s commercial real estate borrowers are increasingly prioritizing financing options that offer more flexibility and less aggravation.
The numbers tell a stark story. In October, Bank of America raised its expectations for SASB issuance – a single loan made to a single borrower and collateralized by a single property – to $70 billion in 2021, up from $60 billion originally, and boosted collateralized loan obligation issuance projections to $45 billion-$50 billion from $35 billion-$40 billion, over the same timeframe. But it is keeping its projection of $30 billion-$35 billion of conduit issuance for 2021 unchanged, according to Alan Todd, managing director and head of commercial mortgage-backed securities strategy at Bank of America. The bank is bearish on conduit issuance into next year because more borrowers need transitional financing that would not qualify for a conduit execution. He says borrowers also want a more customer service-oriented experience.
Todd’s analysis is supported by anecdotes and observations throughout the commercial real estate finance market. Although there is a consensus that the conduit market will live to fight another day, it is unlikely to return to its pre-crisis height in 2007 when issuance topped $200 billion, says Rick Jones, chair of law firm Dechert’s global finance group. “The conduit market is never going to go away, but it’s hard to imagine it becoming a $200 billion business again,” Jones says.
In the years leading up to the global financial crisis, borrowers increasingly opted for conduit executions. The rationale was that favorable pricing and higher proceeds made up for the lack of flexibility in a conduit loan, Jones explains. But in practice, borrowers became frustrated with the restrictions around conduit loans, which included the need to get approval from a loan servicer for any material changes.
Jones says making changes to loans is nigh-on impossible because of the real estate mortgage investment conduit laws that govern commercial mortgage-backed securities and prevent any material alterations. Because lenders sell the loans as part of securitization processes, they are out of the game as soon as the ink dries.
The pandemic has also meant the traditional asset classes that have made up the bulk of conduit deals – offices, retail properties and hotels – have been difficult to finance with a conduit execution because many properties have needed to be repositioned and conduit loans can only be originated on stable properties. Jones says this is another factor that contributed to the drop in issuance.
But the biggest factor behind the shift has been the rise of debt funds and other alternative lenders that have in-house servicing platforms. These lenders execute via CLOs, which are not governed by REMIC laws, to securitize loans. This has meant sponsors are able to negotiate changes to loans more easily, Jones says.
“The CRE CLO servicing experience is vastly better than the conduit experience because of the innovative changes the CRE CLO [issuers] have made: shortening the reporting lines, shortening the timeframes, and creating flexibility that’s beyond the servicing standard,” says Jones. “People love the flexibility of the [floating-rate] space. They can get out, it’s short-term, they can reprice and [they] appreciate the more flexible servicing experience.”
Story behind the story
Conduit deals are a subsegment of the commercial mortgage-backed market and are typically composed of fixed-rate loans of about $5 million-$100 million on stable properties in the major sectors. Conduit issuance peaked at $230 billion in 2007, shortly before the global financial crisis brought the entire CMBS market to its knees. Issuance halted then. When the market re-emerged, deal sizes were smaller, in part because borrowers were wary of engaging with conduit lenders because of the difficulties they had had modifying these loans during the downturn.
Meanwhile, over the past decade, both CRE CLO and single-asset-single-borrower loans have become more popular with lenders and investors alike. Although CRE CLOs are like conduit deals because they are pools of smaller loans, SASB deals are usually backed by a single, high-profile asset or similar quality portfolio with a prominent, grade A sponsor.
The SASB market has been the execution of choice this year for high-quality, class A office properties and large US and global industrial portfolios. The growth of the SASB market has also affected the conduit market because issuers are no longer splitting large loans into multiple parts, notes Marc Peterson, a managing director at Principal Global Investors.
“For a while following the pandemic, conduits couldn’t do retail or hotel loans so there were fewer loans to make,” Peterson says. “Transactions were also slow to come back, which reduced the overall demand for debt. Part of [the slowdown is because] on the SASB side, when you had a big loan, part of it would go into a SASB deal and part of it would go pari passu into a conduit deal. Now more of the loan is going into SASB deals and fewer pari passu loans spread out across conduit loans.”
Less attractive conduits
It is impossible to talk about the drop in conduit issuance without discussing interest rates, market participants tell Real Estate Capital USA. Interest rates have been low for the better part of a decade, reaching nearly zero as a result of the pandemic.
But one of the draws of a 10-year, fixed-rate conduit loan for a borrower is protection from spiking rates, a prospect that has seemed far-fetched for a long time. “The combination that’s driven [the conduit market] off the road into the ditch is the interest rate environment,” Jones says. He explains that the security around rates was the final factor that made the hoops of the conduit market worth jumping through, but that this is no longer the case.
“Back in the day, the conduit market handled both floating-rate and fixed-rate financings and now the CRE CLOs have taken up that mantle”
“Because of the very amiable interest rate environment that has been stable for years, there is not that much premium attached to the certainty of a long-term fix on your interest rate,” he says. “If you thought interest rates were going to go up 200 basis points in two years, that’s when you say, ‘Gee, so maybe I’ll lock in a 10-year conduit loan at
3.9 percent and sleep at night.’ But when the case for paying that premium goes away, the relative value of the floating rate market goes up and the relative value of the conduit market goes down.”
Even with the prospect of higher rates, Jay Neveloff, a partner at law firm Kramer Levin, says he is not sure lower pricing is worth it for borrowers because of the documentation requirements, the need to work with servicers and special servicers after securitization, and the potential for disagreements between different classes of bondholders. “If you save 35 or 50 basis points, is it worth the cost of going through the documents?” he asks. “Is it worth the cost and brain damage of dealing with the servicer and special servicer? Is it worth dealing with all of the dynamics between the tranches?”
The lack of issuance combined with lower interest rates has meant that traditional investors that have acquired bonds from conduit deals have to look farther afield to SASB and CRE CLOs, market participants tell Real Estate Capital USA.
But the question is a nuanced one. Nu Suwankosai, head of credit investments at Canadian institutional investor Oxford Properties, explains that although CMBS investors want to buy conduit bonds, they are also concerned about getting locked into a low-yielding investment.
“The conduit market has been out of favor with investors because people are hesitant about adding duration in a low-rate environment,” Suwankosai says. “One of the benefits to CRE CLOs right now is that they can be fixed- or floating-rate, and floating-rate is where investors are interested. But let’s also not forget the big picture. The conduit market, CRE CLOs and SASB deals will all have a great year in terms of issuance, at about $150 billion. I haven’t seen these levels in a market since the pre-financial crisis.”
This broad uptick in issuance has meant that investors that might have bought conduit bonds have other options for their portfolios. Marc Peterson, managing director at manager Principal Global Investors, notes that, as of late October, the firm had only received one announcement of a conduit deal.
The firm is now having to think about SASB and CRE CLOs. “The transitional nature of the collateral [in CRE CLOs] and [the issuer] being able to replace the collateral doesn’t fit what we’ve been doing, which is taking static pools and underwriting the loans so that we know what we’re going to be living with,” Peterson says.
He chalks up the lack of supply of conduit deals in part to a competitive landscape for debt: “I would have thought that with spreads where they are right now, you’d find a pickup in supply because conduit lenders could be more competitive. We’ll have to see what’s coming.”
Other investors, like Karlis Ulmanis, a portfolio manager at opportunistic manager Dupont Capital, choose to look at legacy conduit deals for business as supply has dwindled and yields have dropped. Ulmanis particularly favors mid-2010s vintages that have large coupons and high-quality portfolios as issuers sought to lure back investors following the global financial crisis.
“I would have thought that with spreads where they are right now, you’d find a pickup in supply because conduit lenders could be
more competitive. We’ll have to see what’s coming”
“I don’t see a lot of value in the new issue market,” Ulmanis says. “The spreads are tighter than I’d like them to be for me to put money there. I’m focused more on the legacy issues, where I see the opportunities, where you have stressed holders of these bonds that are needing to sell. That’s where I make a lot of my money [and] my excess profit.”
One reason why bond investors like conduit deals is stable performance over the long term. A November report from New York-based Kroll Bond Rating Agency found conduit loans had a cumulative loss rate of 4.6 percent from 1995 to June 2020. The study looked at 104,247 loans totaling more than $1 trillion that were originated for securitization.
KBRA also found that, since 2007, the loan-to-value ratio of conduit loans has been trending lower while debt service coverage ratios and debt yields have been rising. The report stated the debt yield on individual conduit loans had risen from 1.41x in 2007 to 2.68x in 2020. This meant that since 2007, default rates have been meaningfully lower, noted Larry Kay, a senior director.
The conduit market may be facing challenges, but market participants who spoke to Real Estate Capital USA do not think all is lost.
Oxford’s Suwankosai says that while there have been headlines around declining conduit issuance, the bigger story may be the rise of the CRE CLO market and the options available to borrowers.
“The rise of the specialty lender [and CRE CLO issuance] has been a huge story,” he says. “That market could hit as much as $70 billion this year and that is three times the average of the last couple of years. It has really been an elegant solution for borrowers. Back in the day, the conduit market handled both floating-rate and fixed-rate financings and now the CRE CLOs have taken up that mantle. They can do the heavier transitional stuff and now, as we near the end of covid, they are a perfect solution.”
Filling a void
Oxford has been CMBS borrowing, frequently tapping the SASB market for large-scale acquisitions. Suwankosai sees a larger theme around the commercial real estate financing markets, citing the ample liquidity for high-quality transactions.
“Everyone is talking about the amount of money floating into real estate,” he says. “The private equity firms are buying massive portfolios and the only thing you can finance things efficiently with are CMBS. I don’t want to call CMBS a necessary evil, but as we look across all of the financing markets – the banks, the insurance companies and the CMBS lenders – we find that CMBS has filled that void perfectly.”
Ultimately, the prospect of rising rates could once again see borrowers kicking the tires of the CMBS market more intently.
Pat Jackson, chief executive of real estate finance company Sabal Capital Partners, cautions that it is easy for people to beat up on the conduit market right now because of the impact of covid-19. “There are so many variables that have come into play these past 18 months and the reality is there is a lot of capital looking to do deals,” he says. “These deals have to make sense at the end of the day.
“There are a lot of issues – whole asset classes that make up big chunks of conduits are out of favor, cap rates are compressed because there is so much money chasing yield at almost any price, and everyone is trying to balance prudence with investing.”
Sabal, which typically invests in the b-pieces of conduit deals, stands apart from the naysayers with a more positive outlook for the conduit market. “Our expectation is that next year is going to be a great year for the conduit market,” Jackson says. “I think we’re rolling to the other side of the dark side of the moon and now we’re headed back to earth.”
Conduit debt has fallen from grace among commercial real estate borrowers since they were associated with the leverage issues that caused the global financial crisis. A combination of improving confidence in other lending methods and low interest rates has kept conduit loan volumes ebbing. But there are reasons to suspect improving fortunes for this once popular debt category. It might not be considered top-shelf, but it is still on display.