As new issuance of CMBS notes has dropped and there has been a tightening of credit standards in the space, B-piece notes are becoming more attractive to some investors who are increasingly looking for higher yields on the margins—particularly if they are buying these bonds close to trough.
“To the extent you have appetite and you're willing to take on the risk going into hopefully a recovery in the next couple of years, that's fairly appealing,” said Stephen Buschbom, research director at New York-headquartered commercial real estate data provider Trepp.
For example, New York-based Greystone Special Servicing has worked regularly with B-pieces—both buying them in the secondary market and taking on new issuance as well. But in August 2022, the firm announced that it purchased the B-piece of a new $1.09 billion conduit deal from Wells Fargo, Morgan Stanley, Bank of America and NCB. The transaction marked its first purchase of a CMBS B-piece in the new issue market and the firm’s executives indicated they were planning to continue pursuing such deals in the future.
In May, New York-based Basis Investment Group also acquired the B-piece in a new $1.025 billion CMBS pool. The 24 loans in the pool were originated by Wells Fargo, Citibank, Morgan Stanley and Bank of America and marked the second time ever that a CMBS offering consisting fully of five-year mortgages came on the market. The pool is collateralized by 134 office, retail, multifamily, hospitality and self-storage properties across the country. Basis Investment Group executives cited the pool metrics, the quality of the collateral and attractive yields as reasons why the firm was interested in the deal, the fifth such transaction for Basis.
According to Rob Russell, president of Greystone Special Servicing, “In the last 18 months, we've seen investor demand grow, and a lot of that is because the yield has risen.”
When Russell began working in the CMBS space, the yields on B pieces were in the mid-teens; now they are close to 20%, he said. Meanwhile, tighter credit standards and stronger underwriting on CMBS deals have also made B-piece notes more attractive. Loan-to-value (LTV) ratios on CMBS pools now average about 60%, below what they have been historically, Russell noted. That means there is a far higher amount of equity in these transactions.
“And if you look at the underlying deals, a lot of the refinances are what we call cash-in refinance, where the new loan didn't quite cover the old loan, and the borrowers come up and put more money into the transaction. From a credit perspective, you always love to see that,” he added.
Given their riskier nature, there are still just a few investors regularly buying B-piece notes. But Matt Salem, partner and head of real estate credit at private equity firm KKR, noted that he has, in general, seen a greater global interest in real estate credit.
“There's a consensus that there's relative value in the market, that it's a safer place to play, but still you can get some really interesting returns right now, and so that's attracting people to the market,” Salem said.
That dynamic extends to CMBS B-piece notes as investors are looking for attractive opportunities with higher yields.
“From what we've seen in the yields in our space, and the credit has been a little bit better, I think that's attracted people to the market because yields have increased considerably over the course of the last six to nine months,” Salem said.
KKR, one of the largest buyers of B-piece bonds in the market, has shifted its investment strategy in this new environment, according to Salem. While the firm continues to buy B-piece notes in the primary market, overall market volatility has impacted pricing and created higher yields on investments through the secondary market, he noted.
“There actually is primary issuance happening in the market. In fact, we're buying a B-piece right now,” Salem said. “But we've spent a lot of time in the secondary market recently trying to take advantage of what we think [are] really attractive returns in that market.”
KKR has shifted its B-piece investment strategy in another way as well. Historically, the firm has participated in buying securities subject to risk retention rules, meaning they are signing up to hold these notes in their funds for five years as required, and getting compensated for that illiquidity risk. And while there are different ways that risk can be held, KKR focused on deals where the firm took all of this risk on itself.
Now, is focusing on buying pieces of the deal that are below investment grade, free to trade.
“We think the market is very attractive and we want to try to invest more capital,” Salem said.
A drop in new issuance
In addition to higher yields, another reason for the increase in interest in B-piece notes stems from the “dramatic” drop-off in new CMBS issuance so far in 2023, according to Salem.
Year-to-date, new CMBS issuance in the U.S. has totaled $11.2 billion across 19 deals, compared to $43.9 billion in new issuance across 56 private label deals during the same time period last year—a roughly 74% plunge in total dollar amount, Buschbom said.
The drop is due in part to the slowdown in new acquisitions in the market in recent months and the tightening of credit standards. The CMBS space has also seen an increase in spreads, particularly after the recent troubles in the banking sector and debt ceiling negotiations rattled the market, which likely also muted new issuance, Buschbom said.
While Buschbom anticipates that issuance will pick up toward the back half of the year, it’s unlikely it will catch up to the levels seen in 2022. Trepp is projecting a 30% decline in CMBS origination volume year-over-year in 2023.
This decline in new issuance and market volatility may lead to fewer opportunities for B-piece investors, who are taking on riskier, but potentially more lucrative positions in the CMBS stack, as they are holding the first-loss position, Buschbom noted. On the one hand, it’s tougher to underwrite and accurately price deals as the volatility doesn’t make it easy for anyone to have confidence in how to price riskier assets, he said.
At the same time, this environment can also bode well for B-piece investors. Once issuance ramps up, the tighter lending standards will mean that whatever gets securitized should, in theory, feature more conservative lending terms and more equity to “absorb losses or any value declines,” Buschbom said. “That should be attractive to B-piece investors at higher yields, so I suspect that there will be some fairly strong interest to the extent there's [so] much dry powder on the sidelines.”