Many CMBS borrowers are asking why CMBS conduit loan spreads are relatively high for 65%-70% LTV hospitality loans. Part of the answer can be found in the way the buyers of subordinate CMBS (often referred to as b-piece buyers) look at the pricing and risks of hotel loans.
As a refresher, the b-piece buyer acquires the most risky bonds from a CMBS issue. The bonds are subordinate to the senior CMBS and incur the first principal losses from loans that default in the CMBS issue. The subordinate CMBS incur a principal loss when a defaulted loan is resolved with a principal recovery that is less than the outstanding balance on the loan. When less-than-full principal recovery occurs, the subordinate buyer takes a loss dollar-for-dollar with the amount of principal lost on the defaulted loan. As a result, the b-piece buyer receives the highest rate of interest on the subordinate bonds that it buys to compensate for the risks. In addition, the b-piece buyer (or its advisors) has the right to review each loan that is included in the CMBS issue and “kick out” any loans that it deems to be poorly underwritten or pose a default risk according to the b-piece buyer’s analysis.
Prior to 2007, it was common to have one or two loans kicked out of CMBS issues in which a typical issue tended to contain 150-200 loans. The originator would commonly stick the kicked-out loans in their next CMBS issue, usually successfully. With the tighter underwriting standards in CMBS underwriting today, it is uncommon for loans to be kicked out.
That said, hotels loans have been one of the worst performing in pre-2007 CMBS. The delinquency rate as of November 2012 was 12.24%, according to Trepp, nearly unchanged from the 12.28% reported in November 2011. In addition, principal recovery on hotels tends to be less than for other real estate asset classes because of the specialized nature of hospitality properties. So b-piece buyers, rather than kicking hotel loans out of CMBS issues, are requesting and receiving downward “price adjustments” on hotel loans, reducing the profit to the issuer. B-piece buyers are particularly critical of small balance, limited-service hotels located in tertiary markets with 65% LTV. As a result, issuers are quoting these deals with wider spreads than other asset classes to maintain profitability after these loans are “price adjusted” by b-piece buyers.