Last year, CMBS issuance levels reached volumes not seen since the 2008 financial crisis. The momentum continued into the first quarter of 2022, until volatility erupted after the invasion of l Ukraine by Russia at the end of February. The sector then faced further headwinds as the Federal Reserve began aggressively raising interest rates to counter inflationary pressures that showed little sign of easing. So what’s around the corner for CMBS?
Presenting their near-term market forecasts, Huxley Somerville, Managing Director and Co-Head of Fitch’s US CMBS Group; Kevin Mammoser, Managing Director, North American CMBS, at DBRS Morningstar; and Jim Manzi, senior director of global structured finance research at S&P Global Ratings.
Overcoming one major hurdle, another follows for the US CMBS sector.
Hospitality and retail CMBS were initially hit hard by the impact of the pandemic. However, overall the industry has weathered the challenges well and delinquencies, which have been tracked for the past two years, are now below 2%. There has also been a dramatic increase in CMBS loan resolutions with only 25% of loans ceded experiencing losses.
That said, CMBS faces another set of daunting challenges with the pandemic now in the background: economic uncertainty and high inflation.
Fitch’s deteriorating macro outlook and rising headwinds anticipated through 2023 led Fitch to recently revise its outlook for hotel, multifamily and industrial properties, moving them from “improving” to joining office and retail to “neutral”. However, while risk and uncertainty have increased, the overall performance of US CMBS assets is neutral as real estate cash flows continue to recover from pandemic lows. Inflation and weak economic growth will result in sluggish nominal net operating income, but the overall effects will be a bifurcation of performance within each property type.
For example, demand will remain strong for Class A office buildings, especially those that are newly constructed and close to transit hubs. These properties will have cutting-edge technology, environmental certifications, flexible layouts and amenities that returning workers will find appealing.
Older properties, with rigid layouts and outdated fixtures and machinery, are at risk of becoming obsolete unless significant capital expenditure is invested in them. While other leases are up for renewal, Fitch expects to see continued weakness for older properties. Office was the only major property type that saw its net operating income decline between 2020 and 2021, down 1.1%.
While our retail outlook is neutral, there is a good chance it will “deteriorate” if macroeconomic headwinds – rising rates, persistent inflation eroding consumers’ purchasing power and potential recession – slow. consumer spending considerably. These headwinds will directly affect retail sales which, post-pandemic, had improved. Again, a performance bifurcation is expected, needs-based grocery stores, mass merchandisers and Class A malls are expected to perform well, while older Class B and C malls continue to struggle.
For loans close to maturity, their weighted average coupon is currently below market rates. This can pose a challenge for some loans if there has been limited amortization or growth in net operating income over the term of the current loan. We expect to continue to see a slight increase in the volume of special services as defaults occur and higher interest rates make refinancing more expensive for borrowers.
The US CMBS sector has largely moved away from the crippling global pandemic. He is now preparing for a different challenge.
In the current uncertain environment, DBRS Morningstar believes that the outlook for CMBS issue volumes is bleak, although credit fundamentals are relatively strong and are expected to remain so for the most part.
After a year 2021 that ended with CMBS issuance volume at levels not seen since before the Great Financial Crisis, the first quarter of 2022 continued the trend with considerable activity levels. However, Russia’s late February invasion of Ukraine sparked market volatility that caused credit spreads to widen dramatically, creating one of many headwinds for CMBS issuance for the rest of the year. year and until 2023.
The second headwind is the sharp rise in interest rates over the past 12 months, and particularly over the past six months, driven by the Federal Reserve’s tightening of monetary policy in an effort to contain oil levels. inflation that persisted longer than expected. As the 10-year US Treasury yield moves ever closer to 4%, interest rates on commercial real estate loans have more than doubled from end-2021 levels, and bridge loan coupons are above 5% for the first time in 10 years.
Beyond simply high interest rates, intense and prolonged market volatility has made it extremely difficult for lenders to provide accurate prices to borrowers who last longer than a day, with many deals collapsing in the process. request and subscription. Conduit volume, already depressed earlier this year, slowed in Q3 2022 and is down about 65% from Q1 levels.
Single-asset, single-borrower (SASB) volumes declined somewhat less as short-term floating rate debt was favored over what borrowers perceive as currently high fixed rates. However, with the yield curve now inverted, variable rate borrowers are also feeling the pain.
CRE’s secured loan bond (CLO) issuance, which had exploded in 2021, fell the most, with third-quarter 2022 volume more than 75% below first-quarter levels. The combination of this sector being seen as the most sensitive to widening credit spreads and issuers having the ability to keep their loans funded on warehouse lines with a variety of banks until they are forced to reduce their exposure or market conditions improve has led to many seasoned recurring issuers sitting on the sidelines or spacing out their trades more than usual or favoring the use of reinvestment options in their existing trades.
Looking ahead, there does not appear to be a catalyst for volume to return to 2021 or Q1 2022 levels in the short to medium term. The current rate environment will almost certainly have an impact on the pricing of commercial real estate assets, as cap rates (cap rates) have historically had a fairly strong correlation with the 10-year US Treasury yield.
From a credit perspective, the story is much less bleak. Delinquency rates continue to decline, with the CMBS delinquency rate hitting a post-pandemic low of 2.88% in July. Although the special maintenance rate has increased, for the first time in almost two years, it is still at a relatively modest level of 5.08%.
Additionally, many of the new specially managed loans are retail assets that have been struggling for years and were expected to struggle with refinancing even before the rate hike. DBRS Morningstar expects defaults at maturity to increase due to the higher rate environment, but the amount of 10-year fixed rate loans maturing in 2023 is relatively modest to a little over $25 billion and the average coupon is over 4.5%, well above the extremely high rate. low rates observed in 2021.
In addition, recent vintages of conduit deals that would have carried the highest valuations backed by the lowest cap rates also feature fairly modest overall leverage levels, with pool loan-to-value ratios often below 60. %. As a result, these basins resist a drop in values more easily than some older vintages.
While defaults and losses in CRE CLO transactions have been almost non-existent, DBRS Morningstar believes that the upward drift in cap rates and the incipient weakening of multi-family fundamentals create the potential for losses going forward. That being said, since the collateral provided to these pools was considered higher risk to begin with, credit enhancement levels are often twice or more that of conduit transactions, protecting bondholders higher quality of these anticipated loss levels.
Our preliminary forecast for US private label CMBS issuance in 2023 is $70 billion, excluding CRE CLOs, and we expect this to be slightly down from the likely 2022 total of 75 to 80 billions of dollars.
Single-borrower transactions are expected to continue to dominate relative to conduits, given continued challenges in securing sufficient collateral for multi-borrower transactions and demand for shorter-term funding in an increasingly uncertain environment. Refinancing will be more difficult than in recent years, as higher benchmark rates and wider risk premiums indicate that loan coupons will be significantly higher than at origination for any maturing volume. This, combined with weaker cash flows for certain pockets of office, retail and housing, implies lower valuations, and therefore additional capital requirements, which may be harder to find in a risk/recession environment. .
One potential area of issuance support is for banks to pull back from lending, which could open the door to some CMBS origination opportunities. In addition, performance by property type remains mixed, with industrials, free warehouses and multi-family among those still posting significant appreciation in recent years.
On the credit side, for the office sector, we expect a new equilibrium in the medium term, but with a drop in demand for space (around 15 to 20% of rental volume), values and falling rents. We expect differences by property quality – for example, Class A will outperform Class B – and expect variances by industry and market.
Hotels in city centers that cater to business travelers may continue to struggle against multiple headwinds as the specter of an “official” recession may cause businesses to cut spending. Excess supply likely limits significant improvement in average daily rates in some markets (e.g. New York City), even though domestic hotel revenue per available room has recently topped comparable 2019 levels despite somewhat overall occupancy. little lower.