Commercial real estate markets should continue to improve in 2017, though it remains to be seen how big of a role mortgage bonds will play in financing going forward.
A slow economic expansion and consistent job growth continue to boost demand for space in apartments, office buildings, industrial property and hotels. This, coupled with limited new construction, is driving occupancy rates and rental rates up, resulting in higher property-level cash flows. Real estate prices are also rising, albeit at a slower pace than over the past few years.
However participants remain concerned about the impact of new rules requiring issuers to keep “skin in the game” of commercial mortgage bonds, even if the threat has been significantly downgraded since the beginning of 2016. The risk retention requirement, which took effect Dec. 24, is no longer expected to cause a major market disruption. Analysts at J.P. Morgan recently described it as "relatively surmountable."
The CMBS industry gained unusual concession allowing deal sponsors to offload the first of first loss to third-party investors, rather than keep it on their own books. Yet there have been few takers. The traditional buyers of this risk balked at the requirement to hold so much of it, unhedged, for as long as 10 years.
Instead, the first few deals designed to comply with the rules rely on banks themselves to retain the risk.
There's still a risk that originators may not want to price loans, particularly riskier loans, until issuers of mortgage bonds and so-called B-piece buyers come to an agreement about holding riskier tranches in a way that complies with risk retention.
The good news is that compliance will generally lead to better underwriting. The first deals are expected to conservative in terms of both collateral and structure. And this, in turn, could attract greater interest from buy-and-hold investors.
Most notably, J.P. Morgan expects to see less of a practice known as “credit barbelling” whereby a few loans with very strong metrics are added to a pool that includes dodgier, loans, resulting in higher average scores.
Compliance with risk retention could also boost demand for U.S. mortgage bonds from European investors, since, under most approaches, deals could relatively easily be brought into compliance with E.U. risk retention rules as well.
Estimates for issuance in 2017 range from $55 billion to $80 billion. Even at the high end, that would be down from 2016, which finished at over $90 billion. And the market is likely to get off to a slow start, given the acceleration of activity in the fourth quarter.
Delinquencies have been rising in recent months, but this is largely driven by loans taken out before the financial crisis. Kroll Bond Rating Agency expects that three quarters of the loans maturing in 2017 should be able to find refinancing. However, the rating agency expects to see more airing of grievances from borrowers about CMBS servicer practices; these run the gamut from poor customer service to complaints of excessive fees for routine post securitization requests.