CMBS Declined in 2018 and Expected to Decline 5 to 10% in 2019

Understanding the Current State of Commercial Mortgage-Backed Securities

At one time, commercial mortgage-backed securities were very popular. In recent months, however, lenders offering this option are having a hard time retaining market share in this area. The market is just so competitive right now, and it also doesn’t help that conduit lending is suffering as a whole.

Trepp, an analytical securities and investment management company, is forecasting that CMBS issuance will decline in 2019 by about 5 to 10 percent. This declining trajectory is following the same path in 2018 when CMBS issuance totaled $77 billion in the United States as compared to the $87.8 billion in the same time frame of 2017.

What is Causing this Rapid Decline?

As unfortunate as these facts may be for lenders, the truth is that CMBS lending is down. The important thing is to determine why. After all, that is the only thing that’s going to bring about any kind of change.

One cause industry experts propose is fewer maturities being readily available. In the future, the volume of maturities is likely to increase. Hopefully, that will help the state of CMBS, but as of now, the market is really suffering.

Increasing competition is also a problem affecting the CMBS scene. While CMBS was once the most popular type of higher leverage loans, capital is more commonly moving into higher yielding options these days. These include options like private equity debt funds or mezzanine loans. Not only are such loans typically higher-yielding, but they are also more flexible, which makes them appealing to more and more diverse investors.

Due to that competitive landscape, CMBS lost traction in 2018. Shorter duration loans were more interesting to borrowers last year, perhaps because of late stage business plans. Per Joe DeRoy, a senior vice president and CMBS program leader for KeyBank Real Estate Capital says, “We saw a lot of five to seven-year requests in 2018, more than we had seen in years prior.” Borrowers were able to obtain more leverage through the CLO market than the CMBS market by going with the three-year/plus one/plus one route on non-recourse floating rate debt.

Reference: https://www.nreionline.com/cmbs/cmbs-issuance-might-decline-5-10-percent-2019

Credit Quality is Deteriorating

Moody’s Investors Service is expecting that debt service coverage ratios of loans that are newly originated will continue to decline in 2019 coupled with rising interest rates. They also expect CMBS exposures to interest-only loans, single-tenant loans, and loans with subordinate debt will remain high. Because of the moderately rising interest rate environment and refi valuation, interest-only loans are viewed as riskier. According to Moody’s research, more than half of the 2.0 CMBS loans are interest-only which reminds everyone of 2007 levels.

Can Anything Be Done to Improve the CMBS Scene?

In 2019, the fate of CMBS will be linked to performance in other markets such as residential, high yield, and corporate credit markets. While things are not looking great for CMBS lenders at the current moment, there are things that could help change that in the future.

Already, many in the CMBS market are making the smart move of sourcing low leverage loans to help balance out the losses they are experiencing and to make this type of lending more accessible for more people.

Offering interest-only loans is an other strategy that is proving very helpful for CMBS lenders. Furthermore, CMBS lenders that differentiate themselves by offering new products or services also stand a good chance of “staying afloat” and riding out this tough time for CMBS loans.

There are key issues to watch for in 2019 such as major corporations like GE being downgraded, large ETF outflows, and how the leveraged loan market will function. These factors may cause CMBS spreads to widen and at some point, the other asset classes become very competitive with CMBS, which usually prompts investors to recalibrate.

The important thing to remember in the financial sector is that fluctuations are common and always will be. The key is to predict these fluctuations as well as possible and then to work hard to combat and protect against those that may have a temporarily negative effect.

More Capital but What Caused the Shift?

Over the last 10 years, the floodgates of capital have opened dramatically in the real estate market, and continue to remain open, providing borrowers and investors with more options and opportunities.

How We Got Here

In the immediate years following the Great Recession of 2008, capital was severely limited. Institutional lenders had practically frozen new lending activity, and the investments of most legacy private sources of capital had crashed as a result of the rapid loss of value in real estate assets, poor credit decisions and highly-leveraged investments.

New private lenders that entered in the market during this time lent on assets whose values had readjusted to the existing market conditions, and as a result, increased their equity positions with a lower cost basis. Meanwhile, federal regulation, spurred by the 2010 Dodd-Frank law, weighed heavily on banks and other traditional lenders, further limiting the availability of capital

Then market started to adjust. It didn’t take long for conditions and subsequent actions resulting from the recession—historically low interest rates and low construction costs, combined with new monetary and fiscal initiatives—to stimulate the economy. Even before the institutional world took notice, and as they reeled from the recession, private investors had started buying and developing again, especially in emerging submarkets like Brooklyn on the East Coast, and in the West, the Arts District of downtown Los Angeles.

Institutional capital soon followed, as did private lending. The lower cost of capital in the market allowed newly-formed debt funds backed by private equity, hedge funds and life insurance companies, to deploy capital on commercial and residential lending opportunities, while arbitraging the increasing spreads. The combination of more available capital, low borrowing costs, depressed valuations and attractive pricing on raw materials, started heating up the real estate market again.

Fast Forward to Today

The tax cut passed earlier this year also has been a boon for financial institutions. The larger banks and institutions are only now selectively returning to construction lending, due to the HVCRE rules that impose higher loss reserves and increased direct equity contributions from sponsors of development projects. Consequently, banks and institutions are providing less financing of the total construction budget for these projects, and developers have had no choice but to seek private money to bridge the gap.

Interestingly, many institutional owners and developers have created debt funds to invest in subordinated tranches of construction loan debt to cover the shortfall on bank construction loans. While it is challenging to find development sites that make sense at today’s cost of entry, banks are providing mezzanine debt to 75% or 80% of the capital stack—a viable basis should they have to step in and take over the asset.

Debt Fund Market is Too Hot

The debt fund market is as hot and active as ever.

Debt funds have had no trouble raising capital from both domestic and foreign investors, as they are finding cheaper sources of capital which often can be very competitive, especially for financing transitional properties. The bridge loan space, in particular, is very competitive, with debt funds competing head-to-head with commercial banks. Quality sponsors in this space are seeing multiple bids on financing requests, with a race to the pricing bottom. Many insiders with whom we spoke also are starting to see pressure on covenants, as more lenders try to find ways to win business.

As debt funds overheat in this highly competitive market and are forced to deploy capital to avoid depressing yields, investors are taking on more risk by capitalizing lesser-quality collateral in blind pools of highly-leveraged loans that are cross-collateralized by bank debt with onerous covenants. This hapless by-product of an overheated capital market environment is resulting in a growing deterioration of investors’ equity positions that in previous, cooler economic years, helped protect their downside risk.

Private lending opportunities have increased due to the changes in institutional lending. As the number of loans issued by private lenders increases, there was a decline in loans issued by traditional banks. During 2011, there were three banks that issued 50% of the loans. Currently, private lenders are the ones issuing the majority of loans.

A Better Dwelling report recently revealed that private lenders originated more than $2 billion nationally last year and currently have about 7.87% of the national mortgage market. Another source said that private capital has grown steadily over the past few years and accounted for 51% of all real estate purchases in 2017

So, Is Private Lending the New Normal?

There are several salient, key competitive advantages to consider when looking at private lending.

Private lenders are nimble, much more so than larger institutions, and can move quickly to fund…in days, instead of weeks or even months, especially through new digital platforms that streamline the process.

Private lenders have the ability to fill voids and meet needs that are caused by short time horizons, impaired credit, limited liquidity, and transitional property scenarios or business plans that are more complex than regulated lenders can undertake.

And, given the monumental shift in the availability of capital, the private lending industry is looking more like the institutional world in terms of pricing. How long this will last in view of the current economic outlook over the next few years is anyone’s guess.

Where Do We Come In?

Investors who seek private debt funds can benefit from using the services provided by Wheeler Capital Partners. We can assist investors or borrowers with the development of strategic financing plans for banks, insurance companies, CMBS placement and private lenders or debt funds. We as intermediaries work for you work in an independent manner presenting your project to multiple funding sources which will provide multiple solutions to achieve your goals.

The team at Wheeler Capital Partners has considerable experience in the lending industry to assist clients with achieving the funding they desire. With over three decades of banking experience and an awareness of the requirements of various lenders to expedite the process for clients, a private lender could be the right choice.

Is Commercial Real Estate on the Decline?

After enjoying two consecutive quarters of growth, the United States commercial real estate (CRE) market declined sharply in the first quarter of 2017. This decline was significant, dragging CRE investments below $100 billion for the first time since the beginning of 2014. Total CRE market investments remained strong at $90.9 billion for the quarter, but this number represents a 32% decrease from the final quarter of 2016. First quarter 2017 numbers were 18% below the first quarter of 2016 and 43% below the market’s peak in 2015.

(PRNewsfoto/Ten-X)

Naturally, the need for CRE continues to shift as more businesses attempt to shift their business activities to the virtual world. Political factors, however, are having a profound effect on the current CRE market.

In an industry where uncertainty plays such a large role, the reasons for this decline seem clear. Peter Muoio, chief economist at the Ten-X real estate marketplace, blames several contributing factors for the decline. One is the lack of clarity from the current administration on several issues that will affect the commercial real estate market. Worldwide political upheaval may also be to blame. Another significant political factor affecting CRE is the new accounting standards being applied to real estate investment trusts. These new rules greatly increase the administrative costs of certain real estate investments.

Ironically, another reason for the CRE investment decline may be the current strength of the stock market. As investors are well aware, bull markets don’t last forever. At eight years old, the current bull market is one of the longest in history. Savvy investors know, however, that all good things must end, and many feel that a bear is surely looming.

The news isn’t all bad, however. In spite of the CRE market decline, the prices of commercial properties are increasing by approximately 10% per year. The value of office space increased by 22.3% from 2016 to 2017 while apartment values have gone up 15.2% during the same time. While price corrections could be coming, investors still have reason to expect positive outcomes in spite of the market’s recent decline.

Will Cap rates rise in 2017?

Interest rates have begun to rise and according to the Federal Reserve are expected to continue throughout 2017. How will this change forecasted domestic and foreign CRE investment and will cap rates increase in response to interest rates.

According to Spencer Levy head of research at CBRE, China’s weaker capital investment is expected however German and Japanese investors will be increasingly seeking higher yields with near zero rates domestically. In 2016 most domestic and foreign investors sought property in secondary markets for extra yield and this is expected to continue in 2017 but there is concern if this market is “liquid” enough and if it has enough products to fill demand.

Continued uncertainty of government policy with the Federal Reserve increasing short term rates could move buyers and sellers apart. Throughout 2016 the cap risk premium has narrowed according to Ryan Severino chief economist with CRE services firm JLL. This resulted in little movement in Cap Rates but risk premium margins suffered. If there is clear direction in policy a sense of urgency with buyers and sellers will continue and cap rates could remain flat.

Remember we have not had cap rates this low. When short term rates rise from 50 basis points to 1.5% versus historically when they rose from say 5% to 6%, the percentage increase in the first instance is 200% while in the second instance is only 20%. Leverage transactions will reflect LIBOR changes and spreads will move as extended terms are requested. Once rates rise, these leverage investors may experience sale or refinancing shock.

It is important to remember many items can determine Cap Rates (most notably NOI) but a pure mathematical table is below:

As shown in the table, if Cap Rates increase by 2% from 4% at acquisition to 6% at sale, the value of the property will decline by 33% (excluding any NOI increases for presentation purposes). If the increase in Cap Rates is more severe, going from 4% to 8%, then values decline by 50%. Approximately 70% of the IRR on a CRE investment derives from the sale or terminal value and the Cap Rate expansion shown above may negatively affect internal rates of return.

REIT activity supports the concern of Cap Rates. Much of REITS total return is based on sale of the asset to continue to distribute their IIR. According to Commercial Property Executive REIT acquisitions were down 35% and dispositions were up 31% and the highest annual figure in industry history. It appears the REIT industry are “taking advantage of high prices (low Cap Rates expected to go higher) to shed non-core assets in primary markets”.

Even if NOI increases 3% to 4% per year from robust rent growth the investor has tremendous terminal value Cap Rate risk. According to the Mortgage Bankers Association 2017 CRE loan originations are expected to increase 3% over 2016 and be a record year at $515 billion. Expect banks to tighten underwriting at the direction of the regulators, CMBS volume to down again this year and GSE to have another record year of originations. All lenders will increase focus on repayment cash flows with initial increasing interest rates.

Be cautious. We may live off “spread” but pushed by rising short term interest rates and demand for higher current yield from all investors Cap Rates may move upward and prices downward.

Rushing to a wall of uncertainty in 2016

We find 2016 is upon us beginning with a historic decline in the stock market, crude oil at record lows, the dollar strengthening with domestic employment growing in an election year certain to change US leadership. Globally most industrialized countries’ growth has slowed most notably China and currency valuations have been used to improve export growth to the US. Concurrently we have had multiple year growth in CRE market with most segments growing and exceeding 2007 activity levels with abundant debt and capital available. The wealth of this country has been confidently spending and investing during this recovery and the global wealth increasingly finds the US CRE market as a safe and an appreciating market. What could be of concern?

Demographics

Demographics – Aging “Boomers” have either accumulated wealth and security which they are investing or spending but more than anticipated where permanently negatively affected and will need social service support for the remainder of their life. The all be it smaller in number the “Xers” are busy attempting to save and provide for later retirement but have not had the previous generations wage growth and now realize as the first generation that will not do as well financially as their parents did. The newest Millennial generation is quickly growing into purchasers and now exceeds in number the “Boomers”. Every type of real estate product is now becoming influenced by them.

Interest Rates

Interest Rates – The Federal Reserve has increased interest rates the 1st time since 2007. So far this has not affected CRE but flattened the cure leaving long term rates with little change but the fed and others forecast up to 3 more increases during the year. Will the interest rate continue to flatten? What effect will this have on cap rates, values and available financing?

Regulation

Regulation – Federal Bank and SEC Regulators with examination, new regulation, and enforcement are implementing constraints to CRE growth affecting the two largest providers of CRE debt, Banks and CMBS. Without going into detail all the following are announced and in some form of implementation:

BASAL III (Banks and CMBS)
Fed CRE Concentration guidance (Banks)
SEC Regulation AB (CMBS)
FASB / CECL (Banks)
FASB / Investments 825-10 (Banks)
FASB Multi-year lease treatment ( All companies)
Money Market Rules (Banks)

In spite of the concerns above the underlying demand drivers of job growth, consistent retail sales growth and strong demographic trends are encouraging commercial real estate investments. Vacancies have tightened for all property types and in most markets demand has outstripped new supply. Resulting increasing rent growth will remain a positive driver as investors consider future yields. This will result in increasing transaction activity supported by increasing debt throughout 2016.

CRE to the rescue!

Yes there is so much uncertainty with almost everything. Global economies, political strife, global environmental practices now affect our domestic investment decisions. Many of these and other factors seem to be beyond our control. Slowly commercial real estate has been building a solid story of predictability. But consider the following concurrent issues creating uncertainty:

The stock market volatility index (VIX) continues to forecast investor’s lack of confidence even after the market (DJI) lost 1300 points in two weeks.
China’s growth has slowed; their currency devalued causing disruption in commercial trade.
Oil and commodity prices are down lead by $45 / barrel oil.
The Federal Reserve is hesitant to increase short term rates as promised.
CRE has outpaced S&P returns to date with lending, investing and selling real estate increasing year over year.

As we begin September 2015 institutional-quality real estate pricing continues to rise with cap rates remaining historically low. Recently however lower quality smaller properties have been selling in increased numbers and averaging 14% annual increased price appreciation according to CoStar Commercial Repeat Sales Indices. In fact net absorption across all asset classes totaled 575.5 million square feet over the past 12 months and was the highest on record since 2008.

This good news for investors hasn’t been unnoticed. Watching for another real estate “bubble” the Federal Reserve Bank’s Semiannual Monetary Report to Congress reported concern for commercial property’s rapidly increasing prices and the deterioration of CMBS activity reported by Moody’s investment services. Mitigating concern by the regulatory agencies is the increased capital required by banks for construction and development loans. Current bank construction loans outstanding are down from 2008 levels of $630 billion to $236 billion and growing slowly. Private lenders some referred to as “Shadow Banks” firms act like lenders ( but don’t have depositors, federal regulators or access to the Federal Reserve bank discount window) have expanded their market share and now account for $150 billion of $500 billion of total 2014 commercial mortgage activity with considerable growth in construction activity. The Fed seems pleased risk has been reduced in the banking system but they have been seeking greater regulatory oversight of this activity by the SEC. The Federal Reserve expects to dampen this increased real estate activity by increasing short term rates at future Fed meetings.

Mortgage Bankers Association has reported commercial mortgage activity increased 29% year over year for the first 6 months of this year. Borrowing increases were broad based across most types of CRE except health care. (-50%) (Multifamily (+58%), industrial property (+32%), office (+22%), retail (+17%) and hotel (+16%)

All commercial mortgage originators increased activity year over year. Leading all originators were agencies Fannie Mae and Freddie Mac with 113% increased originations. Banks increased volume by 64% taking greater interest rate risk and insurance companies continued their growth trend now increasing volume by 14%. Banks had the highest quarterly volume in the last 5 years while they try to offset margin decline with volume. 2015 CMBS activity totaled more than $49.6 billion in six months which supports the $100 billion forecasted this year but swap spreads continue to widen and liquidity moderated in August with economic uncertainty. Individually institution volume was led by Deutsch Bank and Wells Fargo but collectively 56% of CMBS volume was originated by conduits. The lodging sector has seen the largest increase of issuance ($13B) now exceeding any time in the last 3 years and loan to values are increasing to now 70.19% depending on property type.

Commercial mortgage real estate investment trusts (mREITs ) are playing an increasing role in the commercial real estate lending market. mREITs predominately originate commercial mortgages to hold on their balance sheet but they also originate conduit loans securitizing for sale and they invest in commercial mortgage-backed securities. Collectively 13 Mortgage REITS hold $32.2 billion in assets and are up 52% since 2010. Since mREITs are less regulated than banks they have become a significant competitor for banks and are expected to take an increasing share of the $350 billion maturing CMBS loans maturing in the next 2 years.

In summary investors have found commercial real estate investment returns to be rewarding and perhaps a more certain return than other asset alternatives. Most assuredly if absorption is finally dramatically increasing you can be sure rental rates and increased construction will follow. Existing and new private lenders are aggressively providing low cost financing and if rental rates increase with absorption even increased rates won’t necessarily slow down the momentum. With current uncertainty in other investible assets CRE is here offering what can’t be found elsewhere.