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If you thought 2023 was challenging for CRE capital markets, 2024 might not be much better.
A new investor report from Moody’s concluded that property values underlying commercial mortgage-backed securities (CMBS) will remain strained under the pressure of high interest rates.
“In the U.S. and Europe, high rates will continue weighing on property values across CMBS sectors, with certain segments, such as office, at elevated risk,” the report concluded. “However, economic growth will somewhat offset rate-related risk and aid property [net operating income], especially in the U.S.”
Amid volatile market conditions, the CMBS market has been less than efficient or reliable as a financing source, however the Moody’s team described a constant flow of CMBS conduit deals and a functioning ecosystem among special servicers, originators, and investors in the report.
“2024 might not be the most exciting year for commercial real estate or CMBS, but it’s continuing to provide its function,” said Darrel Wheeler, vice president and senior credit officer of research at Moodys. “The special servicers are doing their roles, the originators are doing theirs, and investors are still very involved in private production.”
Higher interest rates have created a transaction stalemate as values remain dislocated from market expectations. The stalemate is aggravated further by an ongoing, wide bid-ask spread, with buyers convinced that property values have further to fall, and sellers holding off in hopes of incipient recovery— especially with a rate pause currently in place.
As a result, transactions have slowed down to 2013 levels, the Moody’s report states.
“[The bid-ask spread] will either break higher or lower, but the borrowers who own the properties still think their properties are worth X amount, and a tremendous amount of capital on the sidelines is only prepared to pay X-minus 20 percent,” explained Wheeler.
More than anything, elevated yields on CMBS bonds have further increased property value risks for basically every asset class besides industrial.
“Yield movements have translated into drops for property values, which have mostly returned to 2021 levels,” said the report. “Industrial is the only sector reporting appreciation since second quarter 2022, with a value increase of 2 percent.”
Higher interest rates are also pressuring leverage and credit enhancement on loan packages.
Moody’s concluded that loan-to-value [LTV] ratios for transactions will remain low next year in order for borrowers to meet their debt payments and generate positive debt-service-coverage-ratios [DSCR]. The average underwritten LTV ratio fell 60 percent in first quarter 2022 to 55 percent in third quarter 2023, according to Moody’s.
“The increase in mortgage coupons to a recent average of 7.21 percent, about double the 2020 rate of 3.62 percent, has strained many borrowers’ ability to show an initial 1.2 times DSCR,” said the report. “These higher interest rates have also caused the percentage of interest-only (IO) loans to increase to help borrowers show positive initial DSCR ratios.”
Wheeler said these changing numbers have left some borrowers with a wholly unappetizing set of options of how to make their financing work.
“To get to that [1.2 DSCR] a borrower has to pay down their mortgage because interest rates have moved so much,” he said. “It’s more than doubled, so that’s a pretty big surprise to some of these borrowers.”
Under these difficult credit conditions, investor appetite for conduit and single-asset, single-buyer [SASB] CMBS has predictably slowed down, but not stopped.
Overall U.S. conduit issuance reached $19.2 billion year-to-date in 2023; compare that to annual conduit issuance of $23.3 billion in 2022 and $31.4 billion in 2021.
“The conduit market is doing about $2 billion a month which is two or three deals priced [per month],” said Wheeler. “There are pretty constant numbers, but the pool size has gotten smaller as there’s less loans to work with.”
But amid those declines, there is optimism that investors will flock back to the market.
“In 2024, CMBS issuance volume will likely rise further as banks’ portfolio borrowers face more restrictive lending standards and consider CMBS loans,” the report concluded. “In 2023 SASB transaction volumes decreased as borrowers used existing loan extension options to put off refinancing and as sale transaction volumes declined.”
Finally, the new, higher-for-longer interest rate paradigm will likely lead to increased maturity default risks for the next 12-to-24 months.
At the center of the distress are office buildings. Moody’s found that office refinancing rates for conduit loans dropped from 72 percent in 2022 to 47 percent in 2023, with that refinancing rate falling even further in the third quarter of the year to 25 percent, suggesting a wave of impending office conduit loan maturity defaults. That said, the rebounding performance of hospitality and retail has helped offset some investor concerns when it comes to conduit CMBS.
“During 2023, office maturity defaults drove the conduit office delinquency rate up 255 basis points to 5.28 percent from 2.73 percent in 2022,” said the report. “Over the same time frame, the continued return to normalcy for hotels and non-mall retail delinquency offset the office increase.”
Investors should expect some pain. Moody’s estimates that of the $42.3 billion of performing CMBS conduit loans scheduled to mature through 2024, nearly 20 percent of these loans “have characteristics that put them at elevated default risk,” analysts wrote.
While a majority of these loans “should be able to refinance,” according to Moody’s, roughly $12 billion of those same loans are already delinquent or in special servicing.
Additionally, $4.4 billion of performing conduit office loans maturing through 2024 face now refinance risk; together with $1.5 billion of retail and $700 million of hospitality loans also facing refinance risk, this pool of performing loans supported by office, retail, and hospitality properties poses an $8.1 billion default risk to the U.S. CMBS market, according to Moody’s.
“The additional $8.1 billion of defaulted loans could increase the overall conduit delinquency rate by 2.2 percentage points to 7.05 percent in 2024 from 4.85 percent in November 2023,” the report concluded. “However, we expect servicer resolution strategies and payoffs of certain loans will limit the overall increase in delinquency.”
Brian Pascus can be reached at bpascus@commercialobserver.com
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