Issuance volume in US CMBS has been dismal so far in 2023, with the $14.1bn priced in the first three months of the year the lowest of any quarter since the second quarter of 2012, according to data from Finsight.
Yet the first six months of 2023 have been nothing if not eventful, with defaults from giants of the asset class — such as Blackstone and Brookfield — increasing the scrutiny on the quality of commercial estate.
Some in the market say “office” has become a dirty word. With portfolio managers unwilling to have to justify themselves to their end investors, many accounts have been doing want they can to rid themselves of any office exposure.
“The 800 pound gorilla is obviously what happens to the office market and all of the non-class A buildings that have been financed via CMBS conduit and SASB [single asset, single borrower] transactions,” says Jason Brooks, global securitized product analyst at Janus Henderson, an asset management group. “Right now, spreads are too wide relative to where borrower loan demand is to justify significant loan creation via the securitization channel.”
There is therefore huge pressure on coming maturities. Some $7.8bn of CMBS office loans will mature in 2023, according to Moody’s, and about 84% of them are likely to have challenges refinancing.
“Where borrowers have the optionality to extend their loans, they will exercise those options,” says Brooks. “In instances where they have well-performing assets in good locations, they will look to refinance, even at a higher interest rate.”
Bifurcation based on quality
The fundamental risk facing the office sector is the secular change towards hybrid work, which has drastically reduced demand for office space. But investors are realising that not all office CMBS is built the same.
As overall demand for offices weakens, there will be a clear bifurcation between newly furnished offices and older buildings, says Brooks, and many cities will find themselves with an old downtown area that can attract neither enough tenants nor investment.
“Many downtowns are full of 30 to 50 year old office buildings that need massive capital investment to bring them to a level that would attract tenants, and unfortunately the rents that would be achieved in many cases simply won’t justify the investment,” says Brooks.
Parking lots and cubicles in the suburban office park are becoming emptier, too, as the model of companies having one centrally located downtown office and then suburban satellites appears to be dying out.
“I think we end up more with a hub-and-home model, where the central office where everyone can congregate and collaborate makes sense, but the spokes are not leased suburban office spaces,” says Brooks. “They are simply people working from home.”
Some have shown concern about the implications of a downward spiral from the office sector to the rest of the economy. In this theory, old, obsolete buildings are not recapitalised and city governments create no incentives for redevelopment. Asset values would decline and property owners would default, leaving lenders with assets that have very little residual value — and taking losses on their loans.
Reality would be more nuanced.
“It can go that way [in a downward spiral]; I see signs that cities like San Francisco could potentially be on that path,” says Lea Overby, head of CMBS and ABS research at Barclays. “But I don’t think that phenomenon is going to be particularly widespread.”
Many tricky outcomes could be avoided if existing lenders are willing to work with property owners and borrowers to modify or extend loans in exchange for further investment by the owners, or if there are municipal incentives that create a win-win for the areas these properties sit in as well as for the new capital required.
Overby says her “base case” is for a period of extremely weak demand for offices for the next five years.
“Slowly but surely, we [would] figure out how to backfill the existing supply,” she says. “Some of that backfill can be done through demolition, repurposing, [or] multi-conversion. Some of that will also come from just growth in the overall economy.”
Entry point
With hopes of a more stable interest rate environment in the second half of the year, and an expectation that the US recession could be mild, office demand could eventually increase. In this case, some have expectations that CMBS will not be dealing with much trouble beyond a simple rise in office delinquencies.
This creates an interesting entry point for investors, especially those with distressed mandates, says Edward Shugrue of RiverPark Floating Rate CMBS Fund, a mutual fund focused on floating rate CMBS. Where there are large-scale office defaults, the widening spreads in office loans mean investors can take good quality bonds at historically cheap prices.
From around 340bp over US Treasuries in January 2022, the average spread on BBB-rated CMBS stood at 925bp as of May 18. This is the highest level since the global financial crisis, with the exception of the brief market dislocation that occurred with the onset of Covid-19 in March 2020.
“People are wondering if the office is going away, [but] it is not going away, so it’s a good opportunity to find good quality assets at an attractive price,” says Shugrue, “There are also plenty of reasons why landlords want to defend their properties.
“If you’re concerned about losing a tenant, you might be willing to go back and make a deal at a very favourable rent to retain them, because it’s so costly to get a new tenant.”
More pain ahead
Still, elevated interest rates will continue to weigh on asset quality and market conditions. Continued high interest rates will not only lead to possible defaults and higher than usual transfers to special servicing in floating rate notes, but could also lead to potential changes of ownership if borrowers cannot raise sufficient equity, says Shugrue.
“High rates will still be a huge impact on the marketplace,” he says. “It’s going to serve to slow down origination, and we’re going to see some cracks in the credit market after having good credit for a long time.”
The more defaults that occur, the more downgrades are likely to follow. These will ultimately reduce the buyer pool and add to secondary supply if ratings requirements force some investors to sell.
“If we end up seeing a good number of downgrades, we’ll also see a pretty significant amount of spread dislocation, as we’ll have more forced sellers,” says Barclays’ Overby.
She believes the CMBS market has held up surprisingly well amid the challenges this year, and part of that is because downgrades have been limited, meaning there hasn’t been too much forced selling. That could yet change.
“Given the scale of the downgrades, we’re somewhat concerned about how that might end up looking for this year as well,” says Overby.
Glimmers of issuance hope
Of course, CMBS buyers have plenty of options beyond office. Industrial real estate and multifamily, for example, have seen strong growth in demand over the past decade, and there are still significant secular tailwinds within those two sectors that are attracting investors in times of stress.
“In industrial real estate, for example, the rise of e-commerce and subsequent need for logistics real estate to accommodate it is not going away any time soon,” says Brooks at Janus Henderson.
Fundamentals also look strong for multifamily, because the US continues to suffer from a structural lack of housing supply.
And while market participants expect CMBS issuance to remain light for the remainder of 2023, with some predicting an 80% year-on-year drop, it’s not all bad news. Lighter supply might result in spread tightening in the second half of the year, says Shugrue.
“High interest rates will continue to [cause] lacklustre supply,” he says. “But investors are still waiting to put their money to work, [and] this will inevitably create tighter [spreads].”
Still, CMBS may be over the worst of the primary market slowdown. As borrowers gradually come to grips with the new reality of rates and cost of funds, issuance will pick up later this year, believes Brooks, although it will still be a lot lower year-over-year.
The deals that do come to the market are often looking different to those of the past few years, when most issuers preferred 10 year loans — or even longer.
“Although people who need financing will have to accept the new interest rate environment, nobody wants to be locked into a high rate for 10 years,” says Edward Dittmer, head of North American CMBS at DBRS. “While a lot of borrowers understand that rates will stay high, they still believe that there’s potential for rates to come down sometime during that term, so we are already seeing a wave of five year deals, and it will continue.”
In the first quarter of 2023, two out of the four conduit CMBS deals that were priced were backed entirely by loans with five year terms. In February, a consortium of banks led by Deutsche Bank and Citigroup launched the FIVE 2023-V1 conduit deal backed entirely by five year loans, for instance.
Moreover, the recent US banking sector turmoil may in the long run drive more lenders to the CMBS market.
“There are certainly borrowers that have not considered CMBS in the past and will go into the CMBS market now, because commercial banks, especially the small regional banks and community banks, are now less able to lend given the stress on the market,” says Dittmer.
