US commercial real estate (CRE) was visibly hit by the rise in interest rates. CRE debt issuance plunged 54% in the first half of this year and CRE prices dropped up to 19% from the peaks in 2022.1 Now, hopes are rising that the worst is over as the Fed tightening cycle is approaching an end and prospects of an economic soft-landing are improving.
We are not expecting a wide-spread CRE crisis but we think that higher interest rates and tougher underwriting standards will lead to more refinancing problems and loan defaults, especially in the office sector. Moreover, we do not expect the Fed to cut interest rates soon or significantly, and while we agree that chances of a soft-landing have improved, we think recession over the next 12 to 18 months remains a significant risk.
In this report, we focus on CMBS, which we view as a visible proxy for overall CRE debt. We are gradually increasing our CMBS exposure from underweight but we believe that bargain-hunting down the capital stack for high-spread opportunities in seasoned CMBS continues to be risky. Instead, we prefer new CMBS issues with more conservative underwriting standards in the middle of the capital stack that offer what we view as attractive spreads.
US CRE has a long history of boom-bust cycles (see Chart 1). CRE was not at the center stage of the Great Financial Crisis (GFC) but lending and construction activity were over-extended and collapsed when the crisis erupted. CRE activity has recovered since the GFC but is not overextended as it used to be in prior cycles (see Chart 1 again). This is good news and the main reason why we do not expect a deep crisis.
Source: Board of Governors of the Federal Reserve System, U.S. Bureau of Economic Analysis and ZAIS estimates
2
On the other hand, the interest rate cycle is changing as well. Over the last 40 years, interest rates moved lower with every cycle,3 which helped CRE to recover after each downturn. We believe the Fed will finish the tightening cycle by the end of this year and possibly start cutting interest rates later next year. However, we are convinced that the days of sub-2% inflation are over and Fed policy will have to be structurally firmer to keep inflation under control. In addition, we expect more upward pressure on long-term interest rates from the government’s inability to contain the soaring budget deficit.4
Thus, while a bubble crisis looks unlikely to us, we think CRE faces challenging times adjusting to a permanently higher interest rate environment. The adjustment will play out differently among property types, including severe stress situations in some market segments, especially office.
Roughly 20% of CRE loans in CMBS will mature over the next two years.5 Borrowers’ ability to refinance maturing loans depends primarily on three variables: First, the change in interest rates; Second, the loan-to-value (LTV) ratio of the new loan; Third, the growth of net operating income (NOI) since the issuance of the maturing loan as well as NOI growth prospects.
In our base scenario, we expect that 10-year Treasury yields will stay at or above 4%, which is on average 200bps higher than during the 10-year period before the start of Fed tightening in 2022.6 We also anticipate that mortgage rates for new loans will be about 50bps wider relative to Treasuries, implying a total interest rate increase of at least 250bps for new CRE loans.
Furthermore, we see a tightening in underwriting standards. LTV ratios have dropped by 10% from ten years ago.7 Consequently, borrowers need sufficient NOI growth to offset the higher interest rates and tightened underwriting standards. How much NOI growth is needed also depends on the term of the loan (typically 10 years but more recently also five years) and the amortization schedule (fully or partially amortizing or interest-only).
Table 1 shows model calculations of implied property value changes and equity gains / losses at the point of loan refinancing based on different amortization schedules and NOI growth rates for maturing 10-year loans. Underlying the calculations are our base-line assumptions of continued 250bps higher mortgage rates and 10% points lower LTV ratios.
Implied property and equity value changes at the point of loan refinancing based on different amortization schedules and NOI growth rates of the maturing loans with 10-year terms and our base-line assumptions of 250bps higher mortgage rates and 10% points lower LTV ratios at the point of refinancing assuming internal rates of return (IRR) remain unchanged.
* The term of the loan is 10 years but the amortization schedule is calculated assuming a full amortization period of 30 years.
** in % of the initial equity (– = recapitalization need).
Source: ZAIS Group8
Our model calculations show that a 250bp rise in mortgage rates will lead to value losses for most of the displayed NOI growth configurations. Only properties with NOI growth of 4% or higher are likely to avoid significant value losses.
However, property value losses do not automatically result in equity losses (recapitalization need). This depends largely on the residual size of the maturing loans. For loans with an amortization schedule over 30 years, our model calculations show that those with NOI growth of less than 4% are at risk to suffer significant equity losses (i.e., require recapitalization).
The picture is worse for interest-only loans. In that case, only loans with NOI growth of more than 5% stand a chance to avoid equity losses (i.e., do not have to recapitalize). For loans with NOI growth of less than 3%, the risk is that the recapitalization need exceeds the initial equity stake.
The challenges facing interest-only loans is concerning for the overall CMBS market because their share increased from less than 20% in 2013 to 50% in 2018 and over 80% most recently.9 Interest-only borrowers with large recapitalization needs are at high risk of defaulting unless they accumulated sufficient reserves over the life of the maturing loan or have access to other capital sources. Our concern is that many borrowers have used their cash flows to fund investments in other properties and failed to build up sufficient reserves.
We believe that many borrowers have achieved sufficient NOI growth over the 10 years, but we also see a significant tail of borrowers with much weaker NOI performance that are likely to face serious refinancing stress. Moreover, we expect a more mixed NOI growth performance going forward, putting pressure on loans that were issued at peak valuations.
Refinancing conditions will change for the better or worse depending on the direction of monetary policy, underwriting standards and the performance of the economy. The impact of changing refinancing conditions varies by property type. We believe that industrial followed by multi-family loans are best positioned, while those secured by office properties are likely to face significant stress, and prospects for retail and lodging depend more on the performance of the economy.
NOI growth for industrial (logistics) properties has been consistently close to double digit over the past 10 years as well as most recently (see Table 2). The online shopping boom of the Covid period is over, but we expect structural demand for industrial properties to remain solid.
* Lodging publishes no NOI growth data. Instead, we use the revenue per available room (RevPAR) growth rate data, which we believe is a good proxy for NOI growth.
Source: CoStar10
Idiosyncratic problems facing individual properties aside, we believe only a very severe squeeze in refinancing conditions and/or a deep recession would create serious challenges for industrial properties.
NOI growth for multi-family is more middle of the road but sufficiently strong to offset tighter refinancing conditions (see table 2 again). At our base scenario, we expect few multi-family loans to face serious refinancing problems. Vacancy rates dropped sharply during the Covid period and increased recently to more sustainable levels as new apartment supply increased (see Chart 2).
CoStar11
In our view, multi-family properties are least sensitive to cyclical downturns – people still need a place to live. Structurally, we see the main support for multi-family in the overall shortage of housing (see Chart 3). Indeed, we expect demand for rental housing to increase, as higher interest rates make buying a home less affordable.
Source: US Census and NAR12
NOI growth for office properties has been solid going back 10 years, but started to slip five years ago and most recently turned negative (see Table 2 again). We believe that the time people spend working in offices will rise again but will not return to the pre-Covid levels, significantly reducing overall office demand. Moreover, we expect tenants to gravitate to class A buildings at more suitable locations and with better amenities.
As a result, we see vacancy rates rising further from already high levels (see Chart 2 again) as leases mature, resulting in negative NOI growth over the next few years. We also expect NOI growth to come under pressure from rising costs for refurbishments and upgrades as well as higher operating expenses (e.g., increased insurance premium). Furthermore, given the problems facing the office sector, we think borrowers of lower-quality properties will face tougher refinancing conditions (i.e., lower LTV ratios and higher required debt yields). Not surprisingly, CMBS office delinquency rates have been rising 3.5% points so far this year (see Chart 4). and we believe this trend will continue for the next year or more.
Source: TREPP13
Retail and lodging properties have been hit hard by the pandemic but managed a solid recovery (see Chart 3 again). NOI and revenue growth rates for retail and lodging properties are also holding up well (see Table 2 again). Thus, we expect that the majority of borrowers should be able to refinance maturing loans without major difficulties.
Retail fundamentals have improved with vacancy rates at historical lows (see Chart 2 again), which we attribute to falling new supply as well as significant tenant and building rationalizations. Lodging still benefits from pent-up demand following the pandemic, with room rates well above the pre-Covid levels.14
The main downside risk for retail and lodging is the economy. We view both sectors as more sensitive to the economy than industrial and multi-family. We agree that chances for a soft-landing have clearly improved, but believe recession remains a risk for 2024. We do not think a potential recession in 2024 is likely to be deep and expect in that scenario weaker NOI/revenue growth for retail and lodging and a modest rise in defaults, but not a crisis.
Overall, we think CRE is not in bad shape: no leverage and construction excesses, strong demand for multi-family and industrial and solid recoveries in retail and lodging, but lower-quality office properties face structural and refinancing problems that are likely to lead to more stress situations.
As a result, we have recently added to our CMBS exposure. It is tempting to pick up spreads between 850 and 1000 bps for BBB/BBB- tranches of seasoned CBMS issues (see Table 3 on next page). However, we think the refinancing risk is still too high especially if economic and financial conditions deteriorate. New conduit CMBS should be safer, in our view, as they have been issued under current (tighter) financial and underwriting conditions and the share of office loans has declined to a ten-year low so far in 2023 (see Table 4). New conduit CMBS trade 20 to 120 bps tighter than seasoned CMBS depending on the credit tranche (see Table 3 again), but we believe that the premium is worth paying.
*Source: JPMorgan15
*Trough August 2023.
Source: JPMorgan and TREPP16
We prefer new conduit tranches in the middle of the capital stack (A/AA), which we believe have limited credit risk yet offer attractive spreads relative to the pre-Covid period (see Table 3 again) as well as relative to comparable corporate bonds. New conduit CMBS still trade about six times wider relative to equal-rated corporates than in normal times (see Chart 5). Given the rate convexity, we think this segment is likely to outperform should interest rates and spreads decline in the future.
Source: JPMorgan17
As always, we are available to discuss our views with you. Please contact your Client Relations representative at +1 732 978 9722 or zais.clientrelations@zaisgroup.com
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