High interest rates, liquidity tightening, and weaker commercial real estate fundamentals will drive up CMBS defaults and special servicing, according to Fitch Ratings. Delinquencies will remain volatile into 2024, particularly for office and retail loans, the rating agency said in a report.
The raising of interest rates by the Federal Reserve has two significant impacts, said Jonathan Mizrachi, co-head of commercial real estate at Varadero Capital.
"First, it makes it more difficult to borrow money or refinance existing loans; second, it depresses property values by causing investors to seek higher returns, driving up cap rates," Mizrachi said. "These problems are further exacerbated by a pullback from regional banks who are currently unwilling to issue new loans."
The CMBS market continues to face a range of liquidity issues, including office vacancies, valuations for retail, hotel and malls, higher interest rates and the ability to refinance," said Rob Scott, a portfolio manager for structured products at Ameritas Investment Partners.
Office properties with lease rollover or near-term maturities, or both, have been hit worst, said James Manzi, senior director, structured finance research at S&P Global Ratings.
"The office delinquency rate rose for the ninth consecutive monthly period in September to 5.6%, up some 400 basis points since the end of 2022," he said. "During the same period, the overall U.S. CMBS delinquency rate rose about 120 basis points to 3.8%."
According to Fitch, in September 2023 new 60+ day delinquency volumes for CMBS increased to $1.24 billion from $780 million in August. Office loans accounted for 66% of the September delinquencies.
Along with growing delinquencies, special servicing has been rising, says commercial real estate and CMBS data provider Trepp. Its CMBS Special Servicing rate has increased every month this year, to reach 6.87% in September, when the office special servicing rate surpassed 8.0% for the first time since May 2017. A total of $2.41 billion in loans were transferred to special servicers in September; 54.0% of the balance was for office properties, 19.2%, for lodging properties, and 12.9% for retail properties, Trepp said.
Current conditions are making it much more difficult to originate loans than several years ago, said Roy Chun, senior managing director and head of CMBS surveillance at Kroll Bond Rating Agency.
"Borrowers are unsure whether investing to keep and attract tenants will provide the returns they desire, and lenders are unsure about future cash flows and values."
Lenders are also constrained by regulatory concerns.
"Global regulators have made it clear they are paying close attention to the sector," said Som-lok Leung, executive director of the International Association of Credit Portfolio Managers.
In October,
"While many banks are well-positioned to work with their borrowers to restructure loans or to mitigate risk of related losses, some banks with large undiversified and geographically concentrated CRE portfolios may be at greater risk," according to a transcript of Bowman's speech.
Bowman said she is monitoring the potential financial implications of non-performing CRE loans that are packaged as part of CMBS. "It is much more difficult to restructure a non-performing loan that is part of a CMBS pool when compared to non-performing loans held directly by the lender," Bowman said.
"Pooled CMBS portfolios are often held in significant volumes or in concentrated shares by large insurance companies and pension plans. Should we see significant losses in their CMBS holdings, there could be broader effects on the securitization pipeline for CMBS and on the CRE market."
Next year will be tough, predicted Christian Gore, founder of G1 Capital Partners, which enables private capital to access institutional-quality real estate investments. While new construction best-in-class office space will be fine in strong markets, the Class B/C office space will take years to work out those loans, he said.
"In our view, investors are largely avoiding CMBS backed by retail and office sectors," said Mizrachi. "However, even in this uncertain environment, there are diamonds in the rough. In certain circumstances, we believe that astute credit pickers can find attractive investments with margins of safety, specifically in cases where the risks are adequately reflected through the discount in price."
Gore said that investors can find value for well-located products that might have the appropriate structure for a conversion to multifamily. "However, that will typically work in a few of the most population-dense markets," he said. "Additionally, where we expect to find value in both the office and hotel/lodging spaces is through G1's special servicing relationships. There's going to be a lot of pain for the lenders on those office loans, and we're willing to buy them off their books at anywhere from 20%-40% of their original valuation."
