VNQI - CMBS Market Dislocation Is Creating Opportunities
2023-07-01 05:50:00 ET
Summary
- Mezzanine conduit CMBS are trading at levels well wide of historical relationships to investment grade and high yield corporates, reflecting concerns about higher expected defaults and loan extension risk.
- The challenges facing office properties are well advertised with vacancy rates approaching post-GFC highs.
- Supply technicals are supportive, with issuance down about 80% year-to-date and running at the slowest pace since 2012.
By Jose A. Pluto, CFA
Uncertainty has its advantages.
Fears about commercial real estate fundamentals are creating interesting security selection opportunities in commercial mortgage-backed securities markets. Mezzanine conduit CMBS are trading at levels well wide of historical relationships to investment grade and high yield corporates, reflecting concerns about higher expected defaults and loan extension risk. Such valuations have seldom been seen outside periods of extreme market duress such as the immediate aftermath of the Global Financial Crisis ((GFC)) and March – April 2020.
Much has been made of the challenges facing commercial real estate, including higher interest rates, tightening financial conditions and fundamental challenges such as the transition to work-from-home. Regional bank failures have further contributed to fear of credit contraction, as regional banks are a large source of commercial real estate funding, accounting for almost 40% of such lending in 2022 per the Mortgage Bankers Association.
While challenges are readily evident, loan level credit performance will ultimately depend on property-specific considerations such as use case, geography and structure. The challenges facing office properties are well advertised with vacancy rates approaching post-GFC highs. That said, over 70% of conduit CMBS outstanding is secured by non-office property types including multifamily, hotels, industrial and retail. 1 The fundamentals underlying these sectors are driven by consumer spending, housing and secular growth in “last mile” distribution, and fundamentals have evidenced low vacancy rates and healthy revenue growth.
The CMBS market is starting from a stronger point today than during the GFC. The average conduit CMBS loan has significantly lower leverage (57% loan-to-value (LTV)) relative to pre-GFC era origination (average LTV of 69% from 2005 – 07). With healthy fundamentals for non-office sectors and lower starting leverage, we expect lower losses than experienced by the worst-performing GFC-era origination (2006 – 2007), when almost 30% of loans defaulted and were liquidated including a third of all office loans. 2 CMBS structures have improved, with a typical single-A conduit tranche today having approximately double the credit enhancement of a comparably rated pre-GFC deal, providing adequate support to withstand GFC-level average losses on the worst performing vintages.
Finally, supply technicals are supportive, with issuance down about 80% year-to-date and running at the slowest pace since 2012. The decline in issuance reflects slower commercial real estate transaction activity, which is down over 60%, 3 and a sharp decline in refinancing activity due to higher rates. Despite the large drop in issuance, the CMBS market remains open. May’s supply reached the highest monthly total this year and the upcoming issuance calendar has been rebounding.
1 Index Data
2 Bank of America
3 CoStar as of May 2023.
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CMBS Market Dislocation Is Creating Opportunities