The CMBS Risk Retention Rule 2016: What it means to REPE

Capital access is the crux of the real estate industry. When real estate owners have access to credit and equity, developers can work on new projects, building sales and acquisitions can move forward, and loans can be refinanced. Without access to capital, it is very difficult for investors and developers to move forward with their businesses.

One of the key capital sources in the real estate industry is the cash provided from investors who buy bundles of mortgages. These bundled mortgages are packaged into Commercial Mortgage Backed Securities (CMBS), which are bonds that are supposed to pay a steady return throughout their lifetime. Investors began purchasing CMBS loans in the 1990’s, and most people know about CMBS because of the massive flurry of activities in the CMBS sector leading up to 2007.

Before the Great Recession from 2007-2009, CMBS was not governed under any specific regulations other than general securities laws (particularly Regulation AB). However, CMBS was largely blamed for the financial crisis, along with subprime lending and excess private debt levels. As a result, the CMBS industry virtually shut down post-2007, and has since been making a slow recovery. The industry has been taking regulatory changes as they come, and is currently facing a major policy change called the “Risk Retention Rule.”

The Risk-Retention Rule becomes effective on December 24, 2016. The main takeaway of this rule is that real estate project sponsors will be required to retain 5% of the credit risk of every CMBS transaction they are involved in. This intent of this rule is to better align the sponsor’s interests with investors.

If you recall from earlier blog posts, CMBS loans are split by class based on their desired levels of risk and return. Typical CMBS “tranches” look like the following:


The higher the rating, the more likely the CMBS bond owner is to get paid; this is because they are accepting less risk and less return. As you move down the tranches, returns become higher, but are less likely to be paid back in the event of default of the debt.

The new Risk Retention Rule mandates that sponsors have three options when it comes to retaining their portion of the risk:

The sponsor can retain 5% of the vertical interest in the transaction. This means they will accept a small amount from every tranche of the debt
The sponsor can retain 5% of the horizontal interest in the lowest tranche of the transaction
The sponsor can retain 5% of the fair value of the transaction through an L-shaped interest (partially vertical, partially horizontal).
There is one exception to this rule: the B-Piece buyers, who purchase the lowest tranche, can pair up and buy the sponsor’s 5% vertical or horizontal tranche. If horizontal, the B-Piece buyers will purchase the lowest tranche.

With this exception, B-Piece buyers have restrictions, and lots of them. For example, they must hold the bonds for a minimum of five years, and can only sell the bonds to another qualified B-Piece (sophisticated) buyer.

So how does this affect REPE?

In general, these regulations make CMBS less competitive from a pricing perspective, and therefore less appealing to borrowers. REITs and private equity funds have the opportunity to step in and originate financing where CMBS is no longer convenient or cost-effective.

Hedge funds were typically CMBS buyers pre-crisis, and they made money by quickly flipping their CMBS investments for a profit. However, with the new regulation, flipping the investments will no longer work. Hedge funds will likely stay out of the market. They will be replaced by banks, insurance companies, and government entities (Fannie and Freddie). Real estate private equity funds will be increasingly likely to get assumable financing directly through banks and life insurance companies, without necessarily opting for a CMBS loan.

Ultimately, the new Risk Retention Rule does not necessarily achieve its goal of reducing systemic risk. Rather, it transfers the risk to different parties, as it has in years past. The rule was intended for real estate sponsors to keep more skin in the game. However, most transactions will likely use the loophole and sell 5% of the deal to B-Piece buyers. Who is left holding the bag?

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