MetLife Investment Management today published a first-of-its kind study that takes the longest-ever look at the historical performance of commercial mortgages, Real Estate Capital USA can exclusively report.
The New York-based insurer-backed investment manager’s Commercial Mortgage Lending report provides analysis on the longest-known dataset of commercial mortgage loan performance – ranging from 1957-2021 – and updates and expands a 2005 study the insurer completed with Moody’s Investors Service with 17 years of new data, said Will Pattison, head of the real estate research and strategy team within the risk, research and analytics group at MetLife.
The report offered several key takeaways for lenders and investors in the sector, including the thesis that debt yield might be an incomplete measure of risk, leverage affects loss severity, and while a loan’s vintage can have a significant impact on its performance, LTV is a more significant factor, said Will Pattison, head of the real estate research and strategy team at MIM.
Expanding the dataset
The expanded data includes additional performance data on commercial mortgage from MetLife from 2005-2021 as well as the performance of commercial mortgage-backed securities loans, supplied by Moody’s, from 1998-2022.
The report is significant in part because of its scarcity value – there have been relatively few large-scale studies of commercial mortgage performance over the past 40 years. Notable milestones include the often-cited Snyderman Study, published by Fidelity Investments portfolio manager Mark Snyderman in 1991, on defaults and the estimated impact on yields, and an updated version of that study published eight years later by Snyderman and Howard Esaki, then the head of CMBS research at Morgan Stanley.
The breadth of the data allowed MetLife Investment Management to observe the ways in which this cycle has been different from all past cycles, Pattinson said. This is especially apparent when looking at property type and markets.
“Specifically, gateway markets like New York or Washington, DC, or San Francisco have been struggling, while Sunbelt markets have not been and the office sector and the hotel sectors struggled probably the most during the pandemic, while the apartment and industrial sectors actually benefited from the pandemic,” Pattison said. “That’s unlike any of the prior downturns.”
Coming out of the Global Financial Crisis, Pattison noted the biggest change among lenders was likely the move from debt service coverage ratios to debt yields as the primary risk measure for commercial mortgages. Today, he said DSCR is becoming equally important once again.
Pattison cited the reason for the original post-GFC change was because interest rates became so low that DSCRs looked too positive or too strong for many lenders, leading them to feel as if they needed another risk measure to help differentiate between high- and low-risk loans.
The biggest surprise across the 50-year-plus data set was that safer or higher debt yields had higher loss rates throughout history. “And that is because debt yield, when taken alone, is probably not as meaningful as looking at a debt yield spread to the cap rate, or at least considering the debt yield relative to the current interest rate environment,” Pattinson said.
As an example, before the GFC, a lender may have wanted a 1.5 or higher DSCR and then as rates declined, everything being screened was closer to a 2.0 or higher DSCR, according to Pattison. In turn, DSCR almost became a less-believable measure at the time and now for the exact inverse reason with rates being higher now, DSCR is being perceived as a more useful indicator of risk.
“Cap rates have become somewhat less relevant during the pandemic, and especially the last year,” Pattison said. “This has been especially true in the industrial and apartment sectors where market rents have moved up by 20 or 30 percent in some markets, and we know that the year one income will be lower than what the year two income will be, and therefore the cap rate has less value. So instead of that, we’ve been focusing a little more on discount rates and also focusing on downside scenarios when underwriting commercial mortgages.”
As a perceived result of guidance offered by the Federal Reserve, there has been a pullback from some of the largest banks when it comes to lending frequency and volume. Pattison said this kind of shift has been noticeable to MIM because the firm is now seeing more opportunities for mortgage lending or at least less competition from other mortgage lenders in the space in the near term.
Persistent inflation and interest rate increases have also changed the valuation equation when it comes to assessing any new debt deals, though prices have retained some stability among the major asset classes, excluding office.
“Overall, we think discount rates have gone up about 50 basis points since May,” Pattison said, noting the rates are definitionally the unlevered return an equity investor receives. “That would suggest something like a 10 percent decline in property values, but because inflation has been so high, rents and net operating income has also been high in the apartment, industrial and retail sectors and as a result of that, prices have not really declined.”
The office sector, notably, is different. MIM sees the sector as one where prices are declining even though such an estimation is challenging to confirm with transaction volume being so slow. MIM found the current cycle has boded well for apartments with their near or lowest vacancy levels ever alongside neighborhood retail and shopping centers, though the latter has some concerning aspects when anchored by a grocery business.
“We’re actually a little bit negative on grocery-anchored retail – not because we think the fundamentals are poor – but because we think investors are getting too aggressive in the pricing,” Pattison said. “And e-grocery is real and growing and we don’t think it’s getting priced in today.”
While enclosed malls have struggled a little bit from a pandemic-induced decline in foot traffic and subsequently business sustainability for tenants, Pattison noted leasing demand there has been significantly stronger than MIM expected at the beginning of the year.
The September 20 report comes as commercial mortgages have become an increasingly large part of institutional portfolios over the past three decades, with MIM’s report noting an 11 percent average annual increase in fundraising for these strategies over the past decade. The report’s focus on loss metrics could also offer portfolio managers greater guidance when structuring investments and portfolios.
At the same time, the National Council of Real Estate Investment Fiduciaries and Commercial Real Estate Finance Council are working to roll out their own commercial real estate debt fund index to help bring a new layer of institutional viability to the sub-sector.
The pair are still drawing closer to a full launch as further testing is conducted on the benchmarking tool with sights set on attracting more debt fund participants in the interim. The index would provide more transparency for investors looking closely at return generation, potential risks and rewards.
According to CREFC, very preliminary data showed CRE-focused debt fund returns were only slightly below their equity fund counterparts from 2014 to 2020, a performance which should prove attractive to those without a current CRE debt allocation looking for less return volatility and risk in the fund marketplace.