CMBS Market in ‘Dog Years'

Mike Sorohan msorohan@mba.org

July 03, 2018

Conventional wisdom suggests the commercial real estate marketplace operates in 10-year cycles--of which 2018 is Year 10. But new reports on commercial mortgage-backed securities performance indicate a market more in mid-cycle form.

DebtX, Boston, reported prices of commercial real estate loans underlying CMBS increased in May. The estimated price of whole loans securing the CMBS universe rose to 96.5% at the end of May, from 95.8% at the end of April. Prices were 98.9% in May 2017.

"The uptick in loan prices in the CMBS universe in May was driven primarily by a decrease in U.S. Treasuries," said DebtX Managing Director Will Mercer.

As of the end of May, DebtX priced $1.2 trillion in commercial real estate loans that collateralize U.S. CMBS trusts. From April, the median adjusted loan-to-value remained at 58%, and the median debt service coverage ratio was unchanged at 1.52. The median estimated loan yield decreased to 4.6%.

Meanwhile, Fitch Ratings, New York, suggested the CMBS market is operating in "dog years." CMBS Group Head Huxley Somerville noted though the U.S. commercial real estate cycle is nearing the end of its customary 10-year cycle, certain developments are making it resemble a cycle more at its midway point.

"Like dog years, the current commercial real estate cycle is really worth two years of the old cycle," Somerville said in a recent virtual investor video. "This means that what we're seeing in the markets is more akin to year five of the 10-year cycle. In other words, it is unusual this deep in a cycle to see construction activity as muted as it is and really only happening in areas of the U.S., where there is demand for it."

Somerville noted another somewhat unusual development in this current cycle is with CMBS underwriting, which he said has slowly improved over the past two years after reaching a low point in 2015. As a result, CMBS credit enhancement has fallen at a time in the cycle where it might normally have been nearing peak levels. The one non-surprise at this stage of the commercial real estate cycle is haircuts to CMBS cash flows, which Fitch has nearly doubled since 2011.

Wells Fargo Securities, Charlotte, N.C., said for CMBS credit, slowing but positive growth translates into a continuation of the currently stable environment with the greatest likelihood of defaults coming from markets with declining rents, which remain modest at this point.

"The biggest risks to CMBS spreads will continue to be macro-driven, rather than sector related," said Landon Frerich, senior analyst with Wells Fargo Securities. "While CMBS issuance is looking constrained, heavy volume across the broader fixed-income market amid increased central bank tapering in [second-half] 2018 presents a significant hurdle for spreads."

Frerich said while volatility entered the market in the first half of 2018, the year has largely played out as expected. "With the flattening of the curve, shorter fixed-rate paper and floating-rate bonds in non-agency and [agency] CMBS remain in demand," he said. At the long-end of the curve, AAAs have struggled, but demand continues to be strong down in credit in both non-agency and [agency] CMBS."

DebtX's Mercer said heading into 2018, the outlook for commercial real estate fundamentals was gradual deceleration, extending the trend already in place. "As we look to the second half of the year, we see little to suggest a significant departure from that path," he said. "Modestly rising construction deliveries amid softening demand should lead revenue growth lower across most sectors."

Somerville said one concern is interest-only loans and how commonplace they have become in new deals. "There are three times as many IO loans in new CMBS today as there were in 2011," he said. "Rising interest rates could negate any benefit of amortization for IO loans since they were originated in a low-rate environment."

Somerville also noted retail remains a concern from a property standpoint with class B malls proving to be particularly problematic. "This raises an interesting question: with the presence of retail shrinking in new CMBS, what loans are they being replaced with? Loans tied to hotels and suburban office properties, the performance of which can be more uneven over time for both asset types," he said.

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