CMBS risk post Covid is a reminder of the 2008 crisis.

CMBS in focus

Analysts are concerned with the troubled CMBS sector, as valuations suffer, lease income falls, occupancy rates are lower than pre-Covid levels. Furthermore the large exposures on banks’ and Insurance balance sheets, higher interest rates pushing credit costs up and the impending lack of liquidity in this market.

Mohamed El Erian – “the moment of truth for this sector includes the refinancing of some $1 trillion in holdings over the next 18 months — specifically, how smoothly the price mechanism and balance sheets reconcile challenged “stock” conditions with a potentially favorable “flow” situation.”

CMBS Funding and Refinance Risk

U.S. commercial-property loans set to mature in 2023 and 2024 total nearly $900Bln.

Against a backdrop of higher borrowing costs, falling prices and an increasingly risk-averse attitude among traditional sources of financing, commercial mortgages are maturing soon in a rigid capital-markets climate, and it is likely that some borrowers will have serious challenges refinancing.

(CMBS), (CLO) and investor-driven lenders are behind more than half of the approximately $400Bln in loans coming due in 2023.

CMBS lenders are the largest single source, accounting for more than one-third of the outstanding balance. Bank loans maturing this year (provided by international, national and regional/local banks) will account for a smaller share of loans coming due than CMBS alone.

In 2026 and 2027, banks are more prevalent.

The way new loans have been issued in the last decade provides insight into the upcoming maturity of CMBS loans. CMBS lenders were the leading provider of loans in 2013 and 2014, accounting for over a quarter of all originations. However, by 2016, their market share had decreased significantly as other lenders, primarily banks, increased their lending to the commercial real estate market.

As we move closer to the maturity dates of these loans, it becomes clear that banks dominate the share of maturing loans. In fact, more than half of the loans set to mature in 2026 and 2027 are from bank lenders.

Rating agencies concerns in 2023

Low confidence especially today where contagion effects spread rapidly and policy actions are closely watched. Despite recent downgrades of Pacific Western Bank and Western Alliance Bank in the US, Fitch’s global financial institution portfolio still saw net upgrades in the first quarter of 2023, suggesting that market observers have responded appropriately to avoid further contagion.

However, rating agencies predict that profits for banks may be more challenging in the coming quarters, as interest rates have likely passed the point where they help rather than hinder bank profitability. The impact of future developments at First Republic Bank on market sentiment will be closely monitored, and credit pressure could return in other areas as well.

One potential area of concern is the US commercial real estate market, where Fitch has been warning about a nexus of refinancing and cloudy fundamentals for months. With loans from post-GFC vintage CMBS transactions heading into refinancing and CRE loan market rates sitting at a good 200bps above current loan rates, Fitch predicts a significant increase in delinquencies for 2023, with specific sector refinancing success rate assumptions.

While 60+ day delinquencies currently sit at a comforting 1.8%, Fitch still expects them to rise to 4-4.5% by year end as the refinancing burden for CMBS 2.0 ramps up. Fitch believes that weaker assets in the office sector will experience permanent valuation impairment as the market reprices, similar to B-malls. This is due to secularly slower cash flow growth and higher obsolescence risk, including for some Class A office properties. The pandemic has accelerated and expanded the secular shift to lower tenant space demand.

CMBS Offices

Market signals indicate that US office REITs are trading at a median discount to NAV of more than 40%, suggesting an implied 200bps hike in cap rates for the sector, compared to optically stable cap rates per ACLI. The shift in CMBS loan underwriting standards that Fitch identified between 2013 and 2014 will pose an additional hurdle across the sector next year.

While the office market is more fragmented and arguably more liquid than malls, it faces far lower barriers to entry. Offices face more demanding green transition costs than malls but have better alternative use prospects. Investors’ exposures to these risks will vary, with CMBS transactions being among the most insulated of CRE exposures. However, commercial real estate still forms a substantial element of the balance sheets of smaller US regional and local banks, with CRE loans accounting for over 30% of total assets for banks with $1-10bn in assets, compared to just 6% for banks with assets over $250bn. Leveraged corporate loans continue to post benign trailing default rates of 2.0% in the US and 1.2% in Europe, but these portfolios are located at the foot of the rating scale for a reason.

Fitch’s view

Fitch ran detailed stress tests through both the US and European LF portfolios, that superimposed a sudden repricing to current interest rates.  The impact on the share of entities covering both interest and maintenance capex was stark, if entirely consistent with their very low ratings.  The analyses underlined both portfolios vulnerability to defaults, with a quarter of all ‘B’ category leveraged loans in the US and almost 40% in Europe falling below 1x coverage of interest and basic capex if refinanced at today’s market lending rates. Fitch also added a stress for lower EBITDA – our global corporate forecasts have indeed dimmed alongside everyone else’s – which increased the coverage fails further. Figures are similar for our APAC HY portfolio.

Almost half of ‘B’ category leveraged debt in Europe is fixed, for example, though this is much lower for ‘B-‘ names – and that the largest publicly-rated product using these ratings – the CLO portfolio – typically has a strong track record of avoiding the weakest names.

Private Label Issuance

The issuance of private-label commercial mortgage-backed securities (CMBS) has dropped to its lowest level since 2012. Private-label CMBS refers to securitized commercial real estate loans that are not backed by government agencies such as Fannie Mae or Freddie Mac.

The article cites data from Trepp LLC, a provider of CMBS data and analytics, which shows that private-label CMBS issuance totaled $4.2 billion in the first quarter of 2021. This represents a significant decrease from the $11.7 billion of private-label CMBS issuance in the first quarter of 2020.

The article suggests that the drop in private-label CMBS issuance is due to a combination of factors, including the economic uncertainty caused by the COVID-19 pandemic and the difficulty of underwriting commercial real estate loans in a rapidly changing market.

The decline in private-label CMBS issuance may have implications for both borrowers and investors. Borrowers may find it harder to secure financing for commercial real estate projects, while investors may have fewer opportunities to invest in securitized commercial real estate loans.