The U.S. commercial real estate (CRE) sector is regaining strength in the post-crisis environment. CRE prices increased in 2013, with the Moody’s Commercial Property Price Indices (CPPI) national all-property composite index rising 16.3% in the 12 months ending in December (most recent data). At this point, PIMCO believes the CRE market has reached the middle to late innings of a recovery, with prices just 8% below their November 2007 peak. Importantly, the recovery remains notably bifurcated, with select multifamily and office property prices well above their late 2007 and early 2008 peaks, while many industrial, office and retail properties outside of major cities remain 20%–40% below their pre-crisis highs.
Several factors have contributed to the recovery in CRE prices, including historically low interest rates, limited new construction and improving economic conditions. Perhaps the most significant factor in the CRE recovery has been credit availability – which stands in stark contrast to the residential real estate market, where credit remains generally tight. The commercial mortgage-backed securities (CMBS) market has been a primary source of CRE credit expansion, and its growth in 2014 and the years ahead will be imperative for a continued improvement in CRE fundamentals.
CMBS market rebound continues
CMBS are mortgage-backed securities that are secured by loans on a commercial property. Unlike the private label residential MBS market, CMBS issuance has rebounded after essentially freezing in 2008–2010 (see Figure 1) and is once again being used as a primary source of liquidity for real estate investors and commercial lenders. It should be noted that CMBS are subject to liquidity risk. At $625 billion outstanding, the CMBS market represents an important source of debt capital (filling the gap that traditional lenders such as banks and insurance companies can’t, or won’t, provide) and totals more than 20% of all commercial-mortgage-related debt outstanding in the U.S. (as of 31 December 2013, according to SIFMA and the Federal Reserve). Issuance has grown substantially in each of the last four years, with 2013 issuance totaling $76.5 billion, an 82% increase over 2012.
In addition to origination volumes increasing, lending standards have loosened, allowing credit to flow more freely to properties outside of top tier cities (e.g., New York, San Francisco). While the increase in interest rates in the latter half of 2013 put a brief pause on commercial lending volumes, the expansion in CMBS credit availability largely offset interest rate volatility. Several developments in the CMBS lending environment in 2013 reflected continued growth in origination activity:
- Increasing competition among lenders. The number of commercial mortgage lenders originating loans for CMBS has practically doubled over the last two years, resulting in greater competition and increased capacity, and also setting the stage for continued growth over the near term.
- Robust investor demand for CMBS debt. As activist Federal Reserve monetary policies have pushed investors further out on the risk spectrum in search of yield, demand for commercial mortgage debt remains quite strong. And demand is strong across the capital structure, as many hedge funds and real estate investment trusts (REITs) with high-single-digit return targets have been investing in mezzanine CRE debt.
- Continued expansion of the “credit box.” The combination of greater competition among lenders and robust demand for CRE debt income is contributing to a continued easing of credit standards (i.e., expanding the so-called credit box) in commercial mortgage lending.
Against this backdrop, the stage has been set for a strong 2014 in the CMBS market, despite the abundance of upcoming maturities on legacy CRE loans that will need to be refinanced. Several years ago, many market participants were concerned that this “wall of upcoming maturities” would pose material risks to CMBS investors, but robust issuance and credit expansion in recent years have resulted in a CMBS market much better positioned to provide capital: PIMCO expects 2014 CMBS issuance in the range of $60 billion – $80 billion, which should provide ample financing for the $56 billion in maturing loans this year.
Stay alert to trends in lending standards
While the above trends support growth in the CMBS sector, they also pose risks. As the credit box continues to expand, CMBS investors may be exposed to more complex, and potentially more risky, loan and security structures. For example, some recent new issue CMBS deals have included weak retail loan exposure and loans to borrowers with poor credit histories. Increasingly aggressive loan underwriting is perhaps the most concerning trend; today we see increasing use of mark-to-market rents and buy-up leases, and lack of required reserves. While we don’t consider these procedures to be anything like the kind of bubble-era (circa 2006–2007) lending activity that included underwriting on “pro forma,” or made-up, property financials, we do find the recent behavior comparable to what was exhibited circa 2005. We base this assessment on comparisons of loan-to-value ratios (LTVs) of CMBS since 2005: We’ve seen a gradual increase in LTVs for CMBS issued in 2013 and early 2014 (see Figure 2).
While newly issued CMBS LTVs remain below the pre-crisis peaks of ~120%, recent trends clearly point to gradual increases in LTV, as well as other disturbing developments that are emerging from below the surface – including the ratios of interest-only loans and additional debt. Rating agencies that analyze CMBS debt attempt to “normalize” for these trends using their own LTV assessments based on internal adjustments, models and forecasts. These rating agency views can vary greatly from an underwriter’s typically optimistic outlook, and even among each other.
Because rating agencies set credit enhancement requirements for new CMBS transactions, investors typically view them as one of the first lines of defense against credit deterioration. Importantly, rating agencies have been proactive in improving post-crisis CMBS underwriting, not just relying on model-driven analytics, but also analyzing large loan exposures qualitatively and performing additional diligence and underwriting checks. However, as the number of nationally recognized statistical rating organizations (NRSROs) has increased in recent years, so have the number of diverging views on credit and the different types of ratings scales (an “Aa1,” “AA+,” “AAH” and AAsf” can all mean different things). As a result, Wall Street firms have an increasing number of options to choose from in getting new issue CMBS bonds rated, which contributes to greater competition and the potential for miscategorization – or, even worse, misunderstanding – of credit risks for investors relying on those ratings.
This is not to say that any one opinion or evaluation is wrong, but the trend toward a weakening common denominator is one that CMBS investors should continue to monitor as the expansion in credit availability continues. While a near-term positive for CRE valuations, riskier lending could also result in greater downside risk in CMBS bonds down the road. CMBS investors need to speak with their wallets and push back on either valuations or underwriting standards if recent trends continue.