As deteriorating economic conditions continue to weigh heavily on the U.S., no sector of the real estate market remains intact, including the formerly healthy commercial mortgage-backed market.
With short-term CMBS loans approaching their maturities, and an illiquid market for refinancing, market participants are fearful of mounting term defaults.
Defaults and delinquencies in the market are already trending upward, market participants agree. "Default rates are rising at a historically fast pace," said Richard Parkus, head of CMBS research at Deutsche Bank Securities.
Delinquencies are now approaching their peak levels seen in the early 2000s of 1.9%. Delinquencies are already at 1.65% and are expected to be at or above 3.5% by year-end and in the 5% to 6% range by the end of 2010, Parkus said.
Market participants blame the gloomy U.S. economic outlook. "The key driver of the commercial mortgage market is the economy," said Jamie Woodwell, senior director in commercial/multifamily research at the Mortgage Bankers Association (MBA).
With unemployment rates continuing to rise, consumer spending down and a pull back in manufacturing, macroeconomic conditions have begun to filter through to commercial multifamily properties with increases in vacancy rates and declines in the rents that landlords are asking, Woodwell said.
Although all vintages are experiencing deterioration, delinquencies and defaults are widely expected to be most concentrated in the 2006 and 2007 vintages. Term losses from these recent vintages could ultimately approach levels of the early 1990s, of about 10%, Parkus said.
These pools also consist of many larger assets, according to a recent report from Fitch Ratings. Given the lack of liquidity in the capital markets, there is little to refinance even performing loans.
However, some loans are better positioned to weather the storm. Fixed-rate well-seasoned loans that remain performing will likely receive an extension, market players predicted.
"Special servicers will likely negotiate a maturity forbearance or extension as long as the property has cash flowing sufficiently to cover debt service," said Lisa Pendergast, managing director of CMBS strategy at RBS Greenwich Capital.
In 2009, $18 billion in CMBS loans are coming due, with the majority of this total being fixed-rate, Pendergast said. Many of these loans were made in 1999 when the average coupon was 8% and the average capitalization rate was closer to 9%.
The outlook for floating-rate loans, especially in the 2006 and 2007 vintages, is more problematic, as there is a very real possibility of soaring term defaults, Pendergast said. These loans are secured by transitional assets that may never see the promised cash flow assumed at underwriting in the time frame anticipated, if at all, she said. Such cash-flow shortfalls will lead to term defaults on these floating-rate loans.
"If the reserves to pay debt service are depleted, borrowers will have to pay out of pocket. But, they will not be inclined to do so if they perceive that their equity investment in the asset is wiped out," she said.
While some of the more well-seasoned loans are still able to find refinancing, the number of loans paying off dropped from 400 to 500 loans per month in early-to-mid 2008 to less than 100 per month currently, Parkus said.
"Even loans that are performing well are now encountering problems refinancing. During the 2010 to 2012 period there are about $150 billion of short-term CMBS loans from the 2005 to 2007 vintages maturing, and a large proportion of these will not qualify due to much tighter underwriting standards, commercial real estate prices that will have declined by 40% or more and cash flows that will be significantly lower. This makes for potentially enormous refinancing problems," Parkus said. "These loans are coming due at the trough of the market, and they were originated under lax conditions. We need to be cognizant of that and put effort into addressing this problematic situation as soon as possible," he said.
Spreads Wider Still
Spreads have also been factoring in default fears. Triple-As are trading historically wide relative to historic levels.
One CMBS investor noted that relative to the risk, super senior triple-As are cheap, with yields over 15% because of the lack of investor demand.
Indeed, the lack of liquidity in the market continues to push out spreads. "It is a combination of technicals and fundamentals weighing on the assets and bond prices as well as the financial stress on the banks and conduit lenders," Pendergast said. Larger loans are having the toughest time attracting bidders. "Any loan over 25 million is finding fewer and fewer sources of capital," she said
Although the performance of commercial mortgages has been impacted, with signs of rising delinquencies among investors' commercial multifamily holdings, they still remain moderate, Woodwell pointed out. Furthermore, bank-held multifamily mortgages presently remain their best performing loans compared with other sectors of the economy, he said.
Consumers Still Suffering
But with further economic deterioration, a weakening in the sector is inevitable.
"It is no secret that the consumer is under a degree of stress not seen in decades," Parkus said. "Demand for office space is declining sharply as office employment contracts. Financial institutions are shedding jobs by the tens of thousands; the FIRE - financial, insurance and real estate - sector has been terribly hard hit," he said.
One mitigating factor in the office space sector is long-term leases, which provide insulation against rent declines, Parkus said.
Office loans in these states have a default rate of 0.65%, more than 40% higher than the national average. Furthermore, tenants are trying to renegotiate rental rates with commercial borrowers to help reduce their own costs and maintain profitability, Fitch said. As market rents decline, many tenants will likely be able to reduce rental payments on long-term leases in markets where the ability to lease vacant space is significantly constrained, Fitch said.
Recent delinquencies, according to Fitch, include a $225 million loan secured by the Riverton Apartments, a $175 million Resorts Atlantic City loan and a $130.5 million B2 multifamily portfolio loan. The larger two loans defaulted because of economic deterioration in each borrower's plan to reposition the property to earn a higher budgeted cash flow, Fitch said.
Meanwhile, the smaller loan was stabilized at issuance but suffered because of tenants falling behind on rental payments.
U.S. CMBS loans backed by multifamily, retail and office properties are defaulting almost 30% more frequently in states most impacted by these economic factors, Fitch said.
Properties in Florida, Michigan, Arizona, Nevada and California, which represent approximately 25% of all retail, office and multifamily loans in Fitch-rated U.S. CMBS transactions, appear the most vulnerable, the rating agency said.
Multifamily loans in these states have a default rate of 4.1%, the highest of any property type and more than 20% above the national average. Speculative multifamily construction in these states outpaced nationwide levels, and supply has not been absorbed as expected, Fitch said.
Last month, affiliates of the Bethany Group, a multifamily apartment investor, filed for bankruptcy. The Bethany Group has properties around the country, including in Arizona, Texas, Maryland, Georgia and Florida.
Although the industrial sector has not deteriorated to the same extent yet in terms of loan performance, it is expected to come under stress as production and international trade flows are down significantly, Parkus said. With effectively one-day leases in the hotel sector, lodging, which also has yet to experience dramatic deterioration, will also be negatively impacted, Parkus said.
Indeed, the refinance process should begin early in order to get a package together and work through potential issues, said Jan Sternin, senior vice president of the commercial/multifamily division at the MBA. She noted, however, that servicers remain optimistic about refinancing options.
Servicer Consolidation Likely
Servicers will also face stress as CMBS loans approach their maturity. Although servicing capacity is expected to remain adequate, market participants agreed.
"Servicers have reaffirmed their feeling that they are well positioned in terms of capacity," Sternin said. Most of these asset managers are well seasoned and have an origination and servicing background, so they are able to move resources around as need be, supplementing servicing support with outsourced or contract support, she said.
Special servicers are in a much better structural position than master servicers, Pendergast said. The master servicing business is highly competitive, which led to declining fees, and is predicated on continued growth and volume.
However, currently, there is no new volume, and servicing fees still remain low. At the same time, the pool of loans being serviced requires greater attention and deeper skill sets given the complexity of some of the loans and the stressed commercial real estate environment.
By contrast, special servicing fees can be quite lucrative, both in terms of fees paid by the CMBS trusts and those paid by borrowers. Many special servicers with B-piece portfolios issued re-REMICs using their B-pieces as collateral in an effort to monetize their holdings and lay off credit risk.
"These special servicers are probably best positioned to not only weather the current storm, but potentially excel in it," Pendergast said.
While there are many master and special servicers in CMBS loans, the market is heavily concentrated among the biggest servicers, according to recent research from Merrill Lynch/Bank of America Securities. The top five master servicers are currently holding an 87% market share and the top five special servicers an 80% market share, the analysts said.
The top five largest special servicers include LNR Property Corp., Midland Loan Services, Centerline Capital Group, CWCapital Asset Management and Capmark Financial Group.
Some special servicers are more at risk than others. Recently, Capmark saw its special servicer rating cut to 'CSS2-' from 'CSS1' by Fitch. With the possibility of further ratings reductions, there could be movement to replace the servicer with another stronger special servicer, market players predicted.
It is possible that trustees or servicers could lose their minimum required rating, which could result in a transfer of rights and obligations, while also complicating the reporting process for the investors, Merrill/BofA analysts said.
As the market continues to deteriorate, consolidation among these participants is likely. "As some of these servicers come under further financial pressure, it is our view that servicing rights could flow into the hands of just a few players," the bank analysts said. "As such, these servicers could, arguably, have greater negotiating power in making decisions with respect to the resolution of defaulted assets."
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