CMBS pricing saw some unprecedented trading margins over the last several weeks, but market players said that the sentiment does not carry through to fundamentals.
The speed at which spreads tighten, though, is still a noteworthy improvement. At one point the movement in a single day was in a 10-basis-point range - unusual given the reticent appetite for these legacy assets at the start of the year.
According to Barclays Capital, recent vintage last cash-flow triple-A bonds tightened in mid April for the seventh time in a row, by an approximate 25 basis points, trading firmly below the 300 basis point mark. The subordinate triple-As - AMs and AJs - rallied similarly, up four to six points on the week in price terms.
The higher beta CMBX outperformed its cash counterpart with certain tranches rallying as much as 12 points. The largest movements occurred in the more cuspy tranches, which had seen a migration down the capital structure from AM/AJ to the AJ/AA tranches and even down to the A tranche for CMBX.
The tightening is of course encouraging but may be ahead of improvements in the state of commercial real estate (CRE). The psychology in markets has improved in that losses aren't expected to be as severe as they were at the height of the crisis, but CRE fundamentals still have to catch up with the overall improving sentiment of the economy in general.
"The overall market tone is becoming more positive, and that has been a big driver in improving technicals," said Malay Bansal, head of portfolio management and advisory for CRE and CMBS at NewOak Capital. "The Moody's Investors Service CPPI had bottomed and had been going up for a few months, raising hopes for some but it declined again last month. It will be a while longer before fundamentals in CRE reach the bottom.
He added that the commercial real estate space is not done in terms of problems, and this could lead to further volatility in the future. Industry players are focusing on the positives now, but if the focus shifts to fundamentals and refinancing issues with conduit origination closed, spreads could widen.
Richard Parkus, head of CRE debt research at Deutsche Bank Securities, said that the spread tightening in the CMBS space was part of an extraordinary rally across all asset classes seen over the past weeks.
"Investors are reaching for yield in low-interest rate environment, and it's also forced investors to begin looking down the credit spectrum in search of yield," he said. "High yields have been on fire over the past months, as have CLOs, non-agency RMBS and subprime bonds, although tightening has slowed a bit in the last couple of weeks."
Parkus added that the exceptional tightening within the CMBS space probably reflected the fact that many of these bonds have been beaten down more than corporates, coupled with a tremendous increase in risk appetite driven by this search for yield - the combination of factors has led to the improved pricing in legacy securities.
"This hasn't been the case only for triple-As at the super duper level, where you expect minimal risk, but investors are moving down and finding tremendous amounts of opportunity when they go down the credit spectrum," he said.
The improved sentiment could be sending out the signal that the environment for commercial real estate is improving. But given the story for CRE fundamentals, this point of view is overly optimistic.
"Last week, dramatic tightening in CMBS spreads coincided with the first time an AJ tranche, originally rated 'AAA', faced interest shortfall," Bansal said. "Also, CMBS delinquencies became higher than they have ever been in the history of the CMBS industry. Rapid spread tightening from increased optimism combined with still worsening fundamentals points to more volatility ahead, which will be positive for traders. However, volatility may not be encouraging to those looking to originate and warehouse loans for securitization."
The AJ tranche that Bansal referred to is from a 2007 vintage deal. Interest shortfalls occur when fees and expenses associated with troubled loans reduce the amount of interest available to be paid on CMBS bonds. When the interest shortfall takes place, interest is then deferred, with subordinate CMBS classes usually the first to be affected.
It's the first time interest shortfalls have reached as high as the AJ tranche but the forecast is for more of these tranches to begin experiencing shortfalls as rents decline and vacancies increase resulting in lower cashflows from malls, offices and other properties."I think that people were expecting even worse performance from CMBS so the event was not a surprise and so didn't have a strong impact," Bansal said.
Parkus said that there is always some lag time between improvement in the economy and improvement in CRE fundamentals, and he believes it will take some time to see any significant improvement of operating costs within the CRE space."When we begin to see some uptick in job growth then we can start to look forward to improvement in CRE fundamentals but that is likely another six to 12 months away," he said.
The hotel sector is likely to turn the corner earlier and could see improvements in the next 12 to 18 months as consumer sentiment improves and leads to an improvement in cash-flow performance, which would therefore lead to an improvement on defaults in the hotel sector.
However, office retail space still faces a number of years of deterioration in declining rents and growing vacancies before any stabilization begins.
"Overall, when we talk about improvement, we mean no deterioration, so we aren't looking at a quick turnaround in cash flow; that stress won't go away even as the market stabilizes," Parkussaid. "There are a large number of commercial mortgages outstanding that are significantly over-levered and have seen values drop by 35% to 50%. We think values have hit bottom but we won't see property prices increase by 30%."
The question of financing is still the missing link in the equation. For CMBS, prices began to collapse before the economy went into a tailspin because the issue had to do with financing as the allowable leverage decline and prices began falling. Parkus estimated it will be another six years before cash flows peak again, but the terms of financing are likely to remain constrained. " Financing will loosen some over time but the allowable leverage is very low and will probably stay that way," he said. " So even as cash flows increase prices will remain much lower as a result of problems with financing."
Lisa Pendergast, managing director of CMBS strategy and risk at investment banking group Jefferies and president-elect of the CRE Finance Council, said losses are still projected in the market as "in many cases the borrower will have to fill the equity gap, and with $100 million properties now worth $60 million, they may realize that the market is not going to greatly shift in the next two years and just exit out." According to Fitch Ratings, loan defaults will continue to escalate for U.S. CMBS, with an additional 4.4% likely in 2010 and the overall rate to exceed 11% among Fitch-rated deals by the end of the year.
New CMBS loan defaults increased more than five fold last year (1,464 conduit loans totaling $17.75 billion), with 34% taking place in the fourth quarter alone.
Another area of concern is large loan defaults, which increased dramatically last year. In 2009, 56 loans over $50 million in size defaulted compared to just five in 2008. Not surprisingly, most of the defaulted loans came from 2006-2008 vintages.
Delving deeper into specific vintages, 2007 deals led in defaults last year, accounting for 35.6% by principal balance. "The aggressive underwriting and higher leverage in the 2007 vintage is leading to substantially higher default rates," said Mary MacNeill, a managing director at Fitch. She predicted 10-year cumulative default rates on 2007 Fitch-rated CMBS to reach 27%.
This volatility will likely not be helpful for restarting conduit origination and new issue CMBS deals. "So far the market has seen four new deals, and in all of them the bank did not take the risk of holding the loans before securitization because they couldn't be sure of spreads at which they will be able to sell bonds from the deal," Bansal said.