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Frequent valuations can be essential for pre-recession risk management of CMBS B-pieces

Rising values for commercial real estate (CRE) have supported prices for commercial mortgage-backed securities (CMBS) for years. But with increasing talk about a cyclical peak in property values, or even a recession within the next couple of years, CMBS investors as a whole and B-piece investors in particular are starting to think about how they can prepare for the possibility of price declines.

“At some point, the rosy scenarios for CRE are going to fade and CMBS being priced for perfection is going to go away,” said Chris Kennedy, a managing director at MountainView Financial Solutions, a Situs company. “Everyone should be focused on managing their exposures, especially B-piece holdings.”

B-piece securities are the most junior classes in CMBS structures and will be the first to absorb any losses stemming from the potential default of collateral loans. The B-piece buyers, by investing in the lowest-rated and riskiest bonds, typically buy the bonds at a sharp discount to face value. In an ideal environment where loans don’t default, the investments generate handsome returns.

Even in the best of times, however, loans sometimes sour, and investors who have been through previous economic cycles know that defaults can come quickly in recessions. It’s therefore in the best interest of B-piece investors to keep a close eye on any signs of distress in the market. One simple way to do that is to increase the frequency of the valuations of their holdings in the period leading up to a potential recession.

“A lot of CMBS investors, especially hedge funds and private-equity funds, already have to obtain marks on quarterly basis, due to internal risk management policies,” said Kennedy. “Considering the leverage inherent in the assets, all B-note investors should consider quarterly and even monthly valuations an essential risk management practice.”

While there obviously is a cost for valuations from a provider such as MountainView, Kennedy states that one of the firm’s clients believes more frequent independent third-party valuations of B-piece holdings translates to peace of mind and believes the valuation cost – a few hundred dollars per bond – is extremely affordable.

The bond and whole loan valuation team of MountainView provides monthly valuations on more than 3,500 unique bond CUSIPs and more than $1 billion of CRE whole loans. Situs RERC, a wholly owned subsidiary of Situs, conducts fair value assessments on over $200 billion of gross asset value of properties per quarter throughout the U.S. and can provide high-level valuation assessments on a portfolio of CRE assets.