Investment Insights

CMBS in the Eye of the Storm

Tracy Chen, CFA, CAIA
July 2020

The COVID-19 pandemic dealt a heavy blow to the commercial real estate (CRE) market. Social distancing accelerated the secular decline of brick-and-mortar retail and reduced foot traffic for lodging and indoor dining properties. Work-from-home introduced uncertainties for office space, disrupting rent payments and threatening the validity of business models and long-term survival. Will the feared “rent apocalypse” materialise, creating the biggest CRE bust since the global financial crisis (GFC)? To determine the potential impact on commercial mortgage-backed securities (CMBS), we assess CRE fundamentals, valuations, and policy mitigations.

Some Positive Forces at Work

The CRE market is not all doom and gloom. Entering the pandemic, the CRE market was in better shape relative to pre-GFC, with mostly retail stores and lower-quality malls facing secular decline. CRE price appreciation has been strong with no obvious excesses of supply except for some localised sector supply imbalances. Cap rates have been on a consistent trend of compression, yields have remained attractive, and demand for the sector has continued, particularly among pension funds and insurers needing to generate returns in the low interest rate environment.

There are some positive crosscurrents that have helped spreads on most CMBS senior tranches to retrace and the new issue market to reopen, albeit with limited volumes. These factors can mitigate the crisis and drive the future of the CRE market:

No Oversupply: The current CRE challenge is not a supply-driven crisis due to oversupply as construction is slightly below the historical average (see Figure 1).

Favorable Timing: CMBS market maturities are extremely light for the next two years due to the low issuance after the GFC.

Improved Underwriting, Lower Projected Losses: Post-GFC, average loan-to-value (LTV) ratios are lower, and average debt service coverage ratios (DSCR) are higher (see Figures 2 and 3). As a result, lower leverage means projected losses should be less. In addition, credit enhancements for post-GFC deals are also higher than pre-GFC deals, especially from the AA to BBB tranches, providing more loss protections.

Embedded Cushions: The CRE super-cycle, which is nearing an end, generated net cashflow growth and property price appreciation for seasoned loans, providing some embedded cushions for bonds.

Policy Support: With its liquidity injection and massive stimulus, the Federal Reserve (Fed) has signaled its support of the CMBS market and provided a backstop for AAA-rated bonds through its Term Asset-Backed Securities Loan Facility, or TALF program. Furthermore, more help may be on the way for borrowers and servicers in the form of payment forbearance or preferred equity injections into commercial properties.

Signs of Bottoming in Fundamentals: Late-payment volume is trending lower—Conduit CMBS posted a record delinquency rate for the hospitality sector in June (see Figure 5). However, a significant drop in the volume of late-pay status loans from April to June indicates the sharpest default rate increases may be behind us.

Renters are making payments—As of June 20, 2020, the National Multifamily Housing Council reports that 92.2% of renters made a full or partial rent payment (see Figure 6). Multifamily rent collections have been remarkably high throughout the pandemic despite elevated unemployment rates. However, the expiration of the CARES Act federal unemployment benefit at the end of July could put lower income rentals at risk.

Positive Offsets for Office Space: While the work-from-home trend may lower demand for office space, social distancing requirements may provide an offset by reversing office densification and increasing demand. Long leases also provide some protection.

Limited New Issue: New issue supply is very limited, providing a favorable technical (see Figure 7).

Risks Remain, but Disparities May Create Opportunities

The effects of COVID-19 vary by sector and geographic location. Some sectors, like hotels and retail, bore the full brunt of the shock, whereas multifamily is a relatively bright spot, and the industrial sector actually benefited from booming e-commerce. Geographic location matters because of supply and demand technical and secular trends, like de-urbanisation and de-globalisation.

Potential Delayed Decline in Property Prices: The heightened uncertainty has made it difficult to value future cashflows for CRE properties, which has created a mismatch between bid and ask prices and dampened transaction volume. The year-over-year price appreciation rate also decelerated across all major property types. Until we see forced distressed sales, CRE prices may continue to stall, but the impact from COVID-19 could show up once activity recovers.

Impact on Operating Income: Net operating income growth has slowed, particularly in sectors like retail, and may continue to face challenges as vacancy and delinquency rates tick higher.

Uncertainty Around Losses: A prolonged pandemic will create high uncertainty around losses. Problem loans include loans that were already having issues with net cash flow declines and sectors facing near- and long-term challenges, including retail, hotels, and offices.

Valuation and Spread Risks: Valuations and further spread compression face two risks: a second COVID wave and steep rating downgrades. However, spread movement in the lower part of the capital structure has lagged the higher part, providing an opportunity. Furthermore, BBB and Single-A CMBS appear to be cheaper than high yield BB and investment grade BBB corporate bonds (see Figures 8 and 9).

Conclusion

The coronavirus pandemic brought an abrupt end to the super-cycle in the CRE market, accelerated the secular declines faced by brick-and-mortar retail, and created new challenges for other sectors. However, the fallout has not been consistent across sectors and geographies, with some areas even seeing some benefits. Given that the CRE market was in better shape entering this crisis and government stimulus has been extraordinarily supportive, we do not anticipate a massive implosion of the market.

Instead, we see a slow burn with pockets of attractive opportunities, particularly in the following CMBS sectors:

  • We think last cash flow (LCF) AAA and AAA still offer good value for investors who are more risk averse and want to hedge against volatility since TALF acts like a ceiling for these securities with a backstop on spreads.
  • CMBS interest only (IO) tranches can benefit from slower prepayment and loan extension as maturing loans may get extensions. IOs can be paired with principal and interest (P&I) amortising bonds as a hedge against extensions.
  • Top-tier CMBS Single-A and BBB- offer attractive value relative to corporate bonds.
  • Given the relative strength of the industrial sector through the pandemic, SASB bonds with industrial property as collateral present opportunities.
  • Freddie K multifamily mezzanine tranches also offer good value due to solid underwriting and favorable performance

Certainly, the COVID-19 pandemic continues to present risks to the CMBS market, which we will monitor closely. However, as countries reopen and learn new ways to manage the virus, green shoots are emerging. While the shock has been severe, the policy responses have been equally expansive, setting the stage for recovery. The Fed has signaled its commitment to maintaining the unprecedented amount of stimulus for some time, which may include further protections for commercial real estate and more support for renters, lenders, and servicers.

Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.

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