US commercial mortgage-backed securities to start slow, finish strong

Lenders and borrowers active in the US commercial mortgage-backed securities market are taking a wait-and-see approach to the coming year, with market participants broadly expecting to see diminished issuance as a result of higher interest rates and widespread volatility. 

KBRA, a New York-based rating agency, is projecting a volume of private-label conduit, single-asset/single-borrower and commercial real estate CLO of about $71 billion – a 29 percent drop from 2022. Trepp, a New York-based data and analytics provider, is estimating a similar drop in issuance next year. 

“You could take it as a modest win that the market is still issuing and lending, but certainly the pace has been slower,” says Manus Clancy, senior managing director and the leader of applied data at Trepp. “The biggest percentage of drop-off will be probably coming from the CRE CLO space, where loans on transitional properties are based off floating rates.”

Analysts think the lending market will not fully unlock until there’s more clarity over pricing. When property prices fell considerably in 2022 owing to higher interest rates, sellers lacked the full recognition of the impact of this change. While on the buyers’ side, they are still waiting for the discounts to appear, Clancy explains. 

“There’s a pretty big bid-ask spread right now, and nobody wants to step into the breach at this point,” says Indraneel Karlekar, global head of research and strategy at Principal Real Estate Investors. “Whether you’re a lender or an equity owner, you just need to be patient and wait for greater price discovery to play out.” 

Refinancing pressure

While borrowers and lenders are both waiting for a more benign interest rate environment, CMBS loans that are approaching their maturity dates will have to navigate hurdles in refinancing. 

A November Fitch report forecast about $6.2 billion of CMBS and agency loans maturing through the end of 2023 will see refinancing distress, which accounts for 23 percent of the estimated $26.5 billion of maturing conduit loans.

The New York-based rating agency also projects the US CMBS loan delinquency rate will increase significantly to between 4 percent and 4.5 percent by 2023 from 1.89 percent as of October 2022 due to higher interest rates, persistent inflation and weak economic growth. While maturity defaults will be the main driver behind this rise, some defaults might be temporary as special servicers explore the possibilities for extensions, the rating agency notes. 

Roy Chun, senior managing director at KBRA, says that as loan-to-values rise, borrowers would have to put up some equity to reduce new loan balances, which raised the possibility of extensions for maturing loans. “We will definitely see the trend of loans going to special servicing [as they] can’t get a refinance but borrowers may be willing to put up capital to extend,” Chun says, adding extensions won’t come without some costs. “For some [they will] not be able to get favorable financing at the market currently, and they will just end up defaulting.”

However, it’s believed that 2023 won’t witness a significant scale of loan delinquencies as was seen during the global financial crisis. “I don’t think we’re going to see any of the numbers that we saw in 2008, but the word [around delinquencies] we keep using is episodic,” Clancy says. 

Fluid performances  

Based on the uncertain market environment, analysts give an equally complicated and fluid outlook on CMBS of different property types. The office sector, noticeably, will be facing outstanding headwinds from higher interest rates, shorter duration of the rent roll, and opaque demands caused by the hybrid work model. Other property types such as multifamily, industrial, hotel and retail will also navigate fluctuations respectively.

“We need to be cautious,” says Anuj Gupta, CEO of Boise-based A10 Capital. Investors need to take a cautious approach when examining the potential performances of various property types in 2023. “The risk is going to be localized. I don’t think it’s just about one property type being solid [or not] anymore. I think it’s about how that property is going to do in the market.” 

Keith Kockenmeister, senior managing director at KBRA, sees significant complexity in the office sector.

“The class A spaces that have high quality finish and amenities and are very ESG friendly are the ones that are able to attract tenants and bring employees back to the office,” says Kockenmeister. “[In contrast] Class B and C offices have really suffered and lost tenants to the class A buildings. Because rents are starting to contract in most sectors, it’s not as expensive to go from a class B/C office up to an A.”

However, people have been citing the performance of the retail sector for the past five to seven years as an analogy to the office sector now, saying that while the market is currently challenging, it might not end up as bad as feared.

“There will be properties that are going to be deemed redundant or obsolete, and they’re going to be converted into something else. But there are many properties particularly like in New York City, where you’re in a good location, and someone’s going to come in and redevelop the property,” says Alan Todd, head of US CMBS research at Bank of America. 

Todd cites the recent deal achieved between Vornado Realty Trust and Rudin Management with Citadel that allows the developers to construct a 1.7 million-square-foot Midtown East office tower. Citadel will execute a master lease on the property, 350 Park Avenue, for 10 years with an initial annual rent of $36 million. 

Although 2023 will start off as a light year for CMBS, the changes in the economic environment may lead to turning points through which the market presents new opportunities. 

“In the best-case scenario where rate increases start to ease up during the first half of 2023, we think most of the volume is going to be backloaded in the second half once people start getting clarity on pricing and credit spreads,” says Kockenmeister.

There is an expectation that 2023 will bring opportunity as well as dislocation. 

“Real estate is cyclical. We’ve enjoyed a really great run of real estate performance and seen a new cycle emerge,” says Karlekar. 

“[But] when we see the dominant moments of dislocation and volatility, it’s also the moments when we see opportunities arise.”