Outlook for the CMBS Market
Despite significant headwinds in the form of upcoming loan maturities and market forces, the tepid recovery of the CMBS market will persist in the near term.
Quarter-End Insights
- Commercial property fundamentals are gaining traction, in aggregate, leading to the slow recovery of the CMBS market. When the credit spectrum is delineated by property type, the multifamily segment stands out: It has potential to reach full recovery much faster than its cohorts, given that uncertainty surrounding the single-family housing market provides ample demand for existing stock.
- Issuance is tracking slightly below last year's pace, though a strong finish in the fourth quarter will push 2012's issuance slightly past 2011's.
- As with all financial assets, downside risks to our CMBS outlook include the worsening of European debt crisis and policy uncertainty surrounding the upcoming elections. More tangible threats to our outlook include upcoming maturity balloon dates, and the more medium- to long-term, risk of new construction outpacing fundamental absorption rates.
The CMBS market's tepid recovery continued in the third quarter, and we expect this trend to extend itself in the near term. The overall delinquency rate for "all deals," which excludes Canadian CMBS and agency deals, edged downward in August, to 9.9%. The overall delinquency rate still remains well above its prerecession average of less than 1%, and is still within close proximity to its postrecession peak of 10.3%, reached in May.
A quick look at the delinquency pipeline reveals limited upward pressure to top-line delinquency, as 30- and 60-day delinquency buckets remain stable. The rate of foreclosure is also in a holding pattern, but only as special servicers have increased foreclosure sales. Real estate owned, on the other hand, is on the rise, as a steady flow of loans shift over from the 90-day delinquency bucket. The rate of specially serviced loans is declining, largely the result of loan modifications (which are followed by a return to master servicing) and loan liquidations. As has been stressed in our monthly delinquency report, special servicers continue to play a key role in the level of delinquency reached, as potential maturity extensions, large loan modifications, lender financing (through discounted assumptions and modifications prior to foreclosure), and approved forbearance have the potential to slow or mitigate delinquency growth, and delay losses.
When broken down by property type, the delinquency figures underscore the current economic climate. Tepid job growth has kept the trend in the rate of delinquency for office properties on an upward trajectory. Slower job growth, which in turn has led to limited income gains, has ensured that retail delinquency rates also remain elevated. This domino effect extends to the industrial properties, where reduced demand for warehouse/distribution space has resulted in a still elevated delinquency rate. Although delinquency rates remain elevated across these property types, green shoots are apparent. Across the property spectrum, Vacancy rates are edging downward, leading to moderate gains in net effective rent across the board. Despite some volatility due to maturity defaults, the 30- and 60-day delinquency buckets have largely stabilized, the result of the slight increase in rents.
The multifamily sector, which witnessed a rapid acceleration in delinquency following the financial crisis, is the only property type exhibiting a sustained recovery. Although elevated, like the other major property types, the overall rate of delinquency in this sector has retreated by 3.5 percentage points since peaking early last year. This comes as little surprise, given that potential homebuyers, uncertain of the direction of single-family house prices, have provided ample demand for existing multifamily space. This trend, combined with stricter lending standards, has enabled agency CMBS deals (comprised solely of multifamily properties) to better weather the downturn in the economy. Overall delinquency for agency CMBSs is less than 0.05%, far below the delinquency rate for public deals.
Nationally, CMBS credit performance varies greatly. Not surprisingly, the areas hardest hit by the recession have displayed the greatest increase in delinquency. For instance, MSAs (metropolitan statistical areas) such as Las Vegas, Phoenix, and Fort Lauderdale have the highest delinquency rates across property types. Conversely, MSAs in the northeast boast amongst the lowest delinquency rates for office and retail property types.
Our distribution--and underlying trend--of CMBS tranche outlooks tell of a market in the early stages of recovery. We classify live bonds as "underperform," "perform," or "outperform." The current distribution of these outlooks is bimodal, with almost an even number of bonds classified as "underperform" and "outperform." With credit trends stabilizing, loans that have experienced solid amortization since issuance are paying off, and therefore seasoned bonds at the top of the capital stack are not expected to incur losses. These classes are, therefore, labeled "outperform." On the other hand, there are a large number of bonds at the lower end of the capital stack in which we expect losses, and are therefore labeled "underperform." We classify 48% of live bonds as "underperform," 13% as "perform," and 39% as "outperform."
The trend of outlook changes portends further healing within the market. Outlook changes to "perform" from "underperform" are increasing in frequency, as are those to "outperform" from "perform." The number of outlook changes to "underperform" from "perform" has slowed considerably this year. However, 13% of the outlook changes in the third quarter have been in this direction, as eroding credit support of certain deals increases the likelihood of tranche losses.
Overall, we expect the current economic environment of weak job and income growth to persist in the near term. In turn, delinquency rates will remain far above average into the foreseeable future, though they will continue to moderate, on average.
CMBS issuance is tracking just below last year's pace, but we expect a strong finish to issuance by year-end. In the first half of 2012, CMBS issuance totaled just over $26.5 billion, compared to $31.4 billion during the first half 2011. Nearly $8 billion in CMBS has come to market in September, with another $5.7 billion priced, just shy of last September’s issuance. There is another $2.8 billion in public issuance awaiting pricing, with yet another $6.1 billion coming down the pike. Therefore, total issuance--both public and agency--stands at roughly $45.3 in the third quarter. We do expect further issuance by way of more Freddie Mac K deals, placing an additional $8 billion of agency issuance in the market, and approximately $5 billion in a mix of conduit and single asset public deals in the fourth quarter.
Although we anticipate the CMBS market's cautious recovery to continue in the near term, risks to this outlook remain weighted to the downside. While spreads have tightened considerably across the CMBS bond spectrum, an escalation of the European debt crisis could result in another spread blowout, causing bond values to plummet and cap rates to rise. Property valuation would become increasingly murky, sending lending standards tightening once again, thereby depressing demand for commercial property. Greater spreads would also reduce the profitability of issuers, constraining the incentive for new deals to come to market. The addition of inventory in certain markets may also upset the delicate supply/demand balance, which has enabled the recovery of credit trends and capitalization rates. This has the potential to lift vacancy rates and lessen cash flow of existing properties, undermining the positive credit trends of late.
A more immediate and tangible concern is balloon maturity risk. A denial by special servicers of borrower requests for loan extensions, modifications, or debt restructuring, or a decision by borrowers to surrender the collateral, is still a legitimate near-term concern. Based upon this concern, and despite the ongoing liquidation activity experienced over the trailing 12 months, the delinquent unpaid balance for CMBSs still has the potential to surge above 10% as we enter 2013. This remains a reality under more heavily stressed scenarios involving additional large loan defaults, driven by several of these high-risk loans identified on the Morningstar Watchlist (especially those from 2005-2008 vintage transactions), along with continued/expected balloon maturity defaults where refinancing is not readily available. If the credit markets can't sufficiently handle the upcoming balloon maturity risk in existing CMBSs, or if additional distressed loans that are already on the Morningstar Watchlist experience default, we could easily reach this level.
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