With growth in the broader real estate market decelerating and memories of 2008 still lingering, investors are increasingly focused on the health of the commercial real estate (CRE) debt market. They’re wondering if lenders are keeping real estate borrowers in check this time around. Bottom line, can investors feel comfortable allocating to this asset class?
One way to assess the health of the overall real estate debt market is to look to the market for commercial mortgage-backed securities (CMBS). Trepp, a leading provider of CRE market data, recently released a report indicating the CMBS delinquency rate continues to fall, setting a post-crisis low of 2.34% (recorded in both November and December 2019). Sounds like a good thing, but what does this really mean for investors?
Why does the CMBS market matter?
CMBS represents a significant portion of the overall CRE loan market. CMBS transactions securitize primarily long-term fixed rate financing on all types of commercial real estate. CMBS financing is a significant source of capital for the U.S. commercial real estate industry and is typically the third-largest capital source for real estate buyers behind banks and government-sponsored enterprises (Fannie and Freddie). About $500B in CMBS securities was outstanding as of June 30, 2019.1 Issuance (i.e., lending) through December 2019 totaled $98B in the United States – 27% higher than 2018 levels. This is no surprise given strong real estate transaction volume driving the need for debt financing.
CMBS prices can reflect investor confidence. At the same time, spreads have tightened on highly rated CMBS, showing healthy investor demand for investments backed by CRE debt. After spiking at the end of 2018 when the Fed hiked interest rates, new issue CMBS spreads have fallen significantly – this compression reflects investor confidence in real estate debt markets.
Pricing has remained tight despite a 20% pickup in issuance in 2019 compared to a year earlier.2
How is delinquency measured?
CMBS delinquency is measured as any loan that is more than 30 days delinquent. Note this does not necessarily mean that investors suffer losses. It is just an indicator of potential trouble on the horizon. In terms of a trend, the current delinquency rate of 2.34% is nearly 1% lower than just 12 months ago.
The dip in delinquencies can be partially attributed to transformational changes made in the market since the financial crisis, which brings us to another point. The CMBS market is not homogeneous.
Are all CMBS created equal?
In response to the financial crisis, CMBS issuers tightened their structures and lending standards to create what is referred to as “CMBS 2.0.” Some key features include:
- Enhanced underwriting: There is generally stricter underwriting with less credit for future/pro forma cash flows, lower overall loan-to-value ratios (60% to 80%) compared to pre-crisis transactions (70% to 90%), and less additional debt beyond the senior level.
- Enhanced cash management: Lenders have enhanced structures in place to manage the cash flows generated by the underlying properties. For example, many deals require borrowers or even the underlying tenants to deposit cash flows directly into lender-controlled cash management accounts. This provides lenders additional protection in times of trouble.
- Additional reserves: Borrowers are typically required to post reserves for tenant improvements, leasing commissions and capital expenditures to ensure the costs do not place additional strain on the operations of the property or the borrower.
- Limited interest-only loans: Some CMBS 1.0 deals featured over 70% interest-only loans. Most loans in CMBS 2.0 feature a built-in amortization component in which the borrower is required to pay down a portion of principal over time.3
The result of these changes is that real estate lending has remained conservative despite the run-up in the overall market and heavy transaction volume. Further evidence of the benefits of CMBS 2.0’s conservative underwriting standards can be found in the vastly different delinquency figures between CMBS 1.0 and 2.0. At a time when overall delinquency is falling, legacy CMBS 1.0 delinquency remains high – 43%(!) – in December. This is offset by a rate of 0.97% in the CMBS 2.0 market.
How’s the rest of the market?
Lest you worry we are cherry picking, the increased discipline in the CMBS space is indicative of a broader shift in the CRE debt markets post-financial crisis. Leverage has fallen across the board, debt service coverage ratios are higher and additional lender protections have become more commonplace. The data beyond the CMBS market supports this notion of a healthy lending environment. Although the metrics are calculated differently for different lender types, delinquency rates across the board are at or near their lows looking all the way back to 1996.
While delinquency rates at record lows may signal a cycle peak to some, we believe it is more of an indicator of the positive changes in the marketplace. The reforms made in the CMBS market post-crisis appear to have had a positive impact on the performance of real estate debt, resulting in lower delinquencies and a healthier market overall. Given this backdrop, the real estate debt market is a good option for investors looking for income and principal protection.
1 Mortgage Bankers Association.
2 Bloomberg, as of December 31, 2019.
3 Practical Law Real Estate, “Expert Q&A on Developments in CMBS Lending,” Thomson Reuters, 2015.
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