CMBS have enjoyed a steady recovery in spreads and dramatic improvement in credit performance this year, setting the stage for a pickup in issuance in 2013.
It is a measure of how attractive the market has become to yield-starved investors that a significant portion of next year's issuance is expected to come from deals backed by a loan on a single property; single borrower deals are considered riskier because of the lack of diversification and greater exposure into the event of default.
Barring a macro-economic shock, such as a worsening of Europe's sovereign debt crisis or an economic slowdown in the United States as the result of expiring tax cuts or pending reductions in government spending, it is more than likely there will be enough new CMBS issuance to accommodate the wave of commercial loans that must be refinanced by 2015 or 2016.
"We are talking about a market that is being somewhat well received because it offers a stable supply for higher quality bonds that are fixed rate and longer duration and given the general consensus that rates are expected to remain low, for longer, that is appealing to many investors," said Richard Hill, director of CMBS strategy at the Royal Bank of Scotland (RBS).
RBS has one of the most conservative forecasts for next year's volume: It is calling for issuance of conduit deals between $30 billion and $35 billion, with another $10 billion coming from large loan, single borrower deals. That would be about even with the $45 billion tally expected for all of 2012.
Ratings agencies forecasts are higher. Fitch Ratings expects a slight increase in total non-agency CMBS issuance to $50 billion in 2013. Standard & Poor's expects conduit CMBS issuance to reach $45 billion; and the rating agency expects another $20 billion of issuance in large loan, single-borrower structures, bringing the total for 2013 to $65 billion.
Moody's Investors Service has the most optimistic forecast: it is calling for $70 billion, including both non-agency and agency CMBS paper. "This year saw a real burst of CMBS issuance activity largely due to spreads tightening so markedly," said Nick Levidy, a managing director at the ratings agency.
In July, spreads on the benchmark, triple-A long dated super senior, triple-A hovered around 150 basis points to 160 basis points over swaps. But by the end of November, they had compressed to 80 basis points to 90 basis points, which Levidy said has made the entire market much more of a competitive alternative financing source.
"It's one of the reasons why the single-borrower deals have started to come back," he said. "These deals would normally be financed by the life insurance companies." Levidy said that if spreads stay where they are, volumes should easily reach Moodys' $70 billion forecast. On the other hand, if things fall apart in Europe or if the United States falls off the proverbial fiscal cliff, those spreads are going to blow out, making the entire CMBS sector less competitive.
Growth Supports Refinancings
Hill of RBS believes that the market is in a good place. He estimates that the bull markets of 2006 and 2007 saw nearly $150 billion of issuance each year; by that measure, the volume expected in 2013 would be really just a drop in the bucket. But at this pace, the market is stabilizing. It must continue to stabilize if the wave of loans coming due over the next few years, is to be refinanced, he said.
Keith Banhazl, vice president in Moody's CMBS surveillance group, said that if there is any contraction in banks' lending, then the refinancing issues for deals increase as there are a lot of loans coming due in the next five to 10 years.
Another cause for concern: "There is a growing disconnect between the way Moody's analyzes the value of properties, which is their long term sustainable value for support and getting debt refinance vs. current values," said Tad Philipp, director of commercial real estate research at the rating agency. "We have been seeing refinance risk grow during CMBS 2.0, which is second generation deals starting from 2010."
What has kept refinancing woes at bay so far is that, in the commercial real estate space, unlike other sectors, servicers have a fair amount of flexibility. They can grant extensions on loans and negotiate with the borrower; they are not forced to sell assets in the bottom of the market. "When loans don't perform at maturity, servicers don't necessarily have to foreclose, they might grant an extension to the loans that will help get through a liquidity crisis," said Philipp. "That is a pretty significant mitigant."
Banhazl said that many loans that have come due in the last couple of years have been extended or modified. "The theory of 'kicking the can down the road', despite its negative connotation, has actually worked for the CMBS market as much of the collateral supporting the extended loans has started to recover."
The best-known example is the 2009 bankruptcy of General Growth Properties, which had a lot of malls with mortgage debt coming due that was extended, without substantial loss. In the 19 months following its bankruptcy, General Growth sorted through $15 billion worth of complex commercial mortgages, negotiating new terms and extensions of their due dates.
But there is still some repricing that needs to be done. Philipp calculated that there is around $60 billion of specially serviced loans that face the challenge of having a loss over the years. So some of these loans are backing properties that have lost value, and that means that when these properties change hands the loan may need to be resized. Philipp believes that the market still has another couple of years of resizing debt to go.
Credit Quality Deterioration
Existing deals performed well in 2012. The delinquency rate for commercial real estate (CRE) loans in CMBS dropped 30 basis points to 9.69% in October, according to Trepp data. That was the largest drop in 14 months.
However, the credit quality of new deals has been deteriorating, and it is likely to deteriorate further into next year as a result of continued competition among conduit loan originators. For example, Moody's has observed an uptick in loan to value ratios in new issues over the past several quarters, though Phillip said "investors are sensitized to this and we are hoping it will be moderated."
In fact, credit deterioration is one reason Fitch isn't looking at single-asset deals, according to Huxley Somerville, group managing director of CMBS at the rating agency. He said Fitch believes that the credit is too aggressive in some instances. "There is too much triple-A being asked for and the debt amount is higher than we would prefer at the triple-B level," he said. "They aren't bad transactions, we just can't get comfortable and the amount of debt is too much at the triple-B level; it's more than what we are prepared to rate."
Some Sectors Better than Others
The multifamily and hotel sectors have bounced back very well. Somerville said that over 2013, Fitch will monitor these properties on the income side to ensure that revenues don't become unsustainable over the longer term.
"There has been a lack of new construction in the multifamily sector and there is some demand created from the demise of single family homes. The question is, will it be sustained over the longer term?" Somerville said. "We are not completely comfortable that, in certain places, income that is currently generated will be able to be maintained over the longer term."
The retail sector got a boost from the bounce back in consumer spending in 2012, but certain issuers within retail still need to be watched, such as anchor stores at malls, like JCPenney and Sears. Here, Somerville said, the continued competition between brick-and-mortar retail and the Internet and, more recently, shifts in demand for retail usage have led to some eye-opening declines in value in certain areas.
Moody's is also cautious on retail properties; its CRE team recently met with its retail team and learned many retailers are looking at upcoming lease expirations as opportunities to either take smaller space, reduce rent, or negotiate for refurbishment. The agency analyzes malls based on their sales per square foot to determine if they are productive places for retailers to locate. "We believe that malls with sales of less than $300 a foot have a high risk of closure," Philipp said.
Even if the rating agency thinks a particular mall will succeed, it must determine whether tenants are going to continue to pay the same rent because, said Philipp, tenants are only willing to pay a certain percentage of their sales as rent and, in some malls, high ratios indicate a potential decline in rents.
The office sector was the biggest contributor to defaults in 2012 and Fitch said that delinquency rates in the sector continue to rise, even as the rates in other sectors fall. Philipp at Moody's shares this concern. "In the office space there is still the problem of excess supply, more so in the suburban area," he said.