Being last in line doesn’t always mean getting the worst seats. Buyers of the most subordinated tranche of a commercial mortgage-backed securities deal, for example, get a front-row view of the debt they hold, and those seats have become increasingly valuable. Buyers of the most junior debt, the B-piece, are in “first loss” position. So the B-piece buyers are first in line when it comes to structuring and monitoring these riskiest pieces of a mortgage-backed security, which are an essential component in securitizing commercial real estate loans. The B-piece investors can “kick out” loans tied to potentially problematic properties, and CMBS pooling and service agreements typically give B-piece holders a key role in monitoring the performance of each loan, in making decisions about problems in the underlying assets, and in appointing special servicers to carry out those functions. By bringing real estate expertise and credit-assessment skill to the investment process, the B-piece buyers are “the market’s ‘true’ gatekeepers,” says Joseph Philip Forte, a partner in the New York office of law firm DLA Piper. The rewards for effective gatekeeping can be substantial. Investors are earning loss-adjusted returns of between 13 percent and 18 percent from securities backed by real property collateral monitored by the investors’ agent. That’s an attractive investment in today’s yield-starved markets. In comparison, U.S. high-yield bonds—essentially unsecured debt—were trading at a 6.1 percent yield in early April, just 10 basis points from the all-time low reached in May 2013, according to Bank of America Merrill Lynch index data. Some seasoned B-pieces have even been upgraded by rating agencies this year as principal paydowns and workouts on riskier properties improve credit quality. More fund managers have begun to recognize the potential rewards of being last in line, fueling a steady increase in the number of players in the highly specialized field and, in turn, an increase in the value and number of transactions. New investors began appearing in rankings of B-piece activity in the CMBS market during 2013. In 2013, 11 participants completed 45 B-piece transactions with a value of $53.1 billion, according to Commercial Real Estate Direct, which compiles issuance data and allocates deal credit on the sector. That was up from 27 transactions completed by eight participants, totaling $32.2 billion in deal value in 2012. Activity was on pace to surpass 2013 levels by the end of the first quarter, as CRED recorded 13 transactions by six participants, totaling $14.8 billion in deal value.

Major Players

The most active player in the B-piece sector in the first quarter of 2014, Rialto Capital Management, acquired four deals worth $5.0 billion. Based in Miami, the Lennar Corp. affiliate has consistently been among the market’s most active participants. The concentration of B-piece investing talent in Miami reflects Lennar’s long involvement with distressed real estate investing and securitization. Rialto was formed in 2007 when Jeffrey Krasnoff rejoined Lennar from LNR Partners. LNR was the original 1989 distressed CRE business of Lennar; it was spun off as a listed company, taken private by a group of funds including Cerberus Capital Management LP, Vornado Realty Trust, and Oaktree Capital Group LLC, and ultimately acquired by Starwood Property Trust in 2013. Along the way, former Rialto executives formed B-piece investing firm Raith Capital Partners, and several LNR executives departed to form Eightfold Real Estate Capital. Rialto did not reply to calls and emails requesting comment for this article. Rialto, LNR, Raith, and Eightfold hold four of the top five spots in the B-piece league table for the first quarter of 2014. The fifth, Ellington Management Group, partnered with LNR on three of its four deals completed during the quarter. Ellington declined to comment for this article, but confirmed its collaboration with LNR on investments of 25 percent of the B-piece of GS Mortgage Securities Trust 2014-GC18; 85 percent of the B-piece of JPMBB Commercial Mortgage Securities Trust 2014-C18; and 60 percent of the subordinate bonds of GSMS 2014-GC20. Other recent investors include Cerberus Capital Management, Saba Capital Management, Perella Weinberg Partners, and AllianceBernstein. The credit expertise and service capabilities that come with B-piece firms are becoming strategically critical to the large real estate companies. One major investment bank believes Rialto could be worth more than $800 million and sees it as one of Lennar’s affiliated businesses, with the potential to drive the homebuilder’s stock about 20 percent higher over the next year. In his results statement for the quarter and year ended Dec. 31, 2013, Barry Sternlicht, chairman and CEO of Starwood Capital Group, said the LNR acquisition was a key part of a “transformative” year for Starwood, the largest commercial mortgage REIT in the U.S. The acquisition “added significant scale to our operating platform, diversified our revenue sources, and provided a proprietary channel of originations,” Sternlicht says. In short, Sternlicht has achieved vertical integration—just as the commercial real estate debt market enters a period of potentially heavy securitization and refinancing that will drive revenue across the businesses acquired from LNR. An estimated $130 billion of CMBS debt is set to mature each year in 2016 and 2017 alone. With LNR now integrated, Starwood Property Trust will have access to pricing of troubled properties in the structuring process, along with recurring revenue from the special servicer business, which is reportedly the largest manager of distressed U.S. commercial real estate loans. By providing clear visibility into the real estate debt scheduled to mature in the next few years—the primary feedstock for CMBS and B-piece issuance—the LNR acquisition has landed Starwood in one of the premium seats, and perhaps created the leading gatekeeper.