Among many sectors of the financial markets grimacing at the prospect of interest rates rising, Europe's CMBS market is one of the most uncomfortable.
The US-Israeli attack on Iran has caused an immediate surge in energy prices, which feeds through very quickly to fertiliser and food costs. Inflationary pressure is widely expected to force central banks into raising interest rates. And higher interest rates threaten to stifle the longed-for revival of commercial mortgage-backed securities.
The market was just recovering from the 2008 financial crisis when it got hit by the triple whammy of Covid — which upended social habits for working and shopping — and then Russia's invasion of Ukraine and the interest rate rises of 2022-23.
Some CMBS got into difficulties as property owners struggled to refinance loans. The asset class's particular vulnerability is that deals are not structured to be fully repaid from cashflow. Meeting the expected maturity relies on the underlying borrowers refinancing their loans.
When interest rates are high, the contractual rent yield on the property looks low, so property values tend to fall to compensate. That can make it impossible to raise enough new debt on the property to repay all the old debt without loss to the owner.
There were a few high profile casualties. In 2024, even the senior investors in Elizabeth Finance 2018, a small UK CMBS parcelling two loans originated by Goldman Sachs, were hit with a small principal loss on notes originally rated AAA/AAA by S&P and Morningstar DBRS, when the special servicer liquidated the second of the loans.
Working it out
But in the main, borrowers and investors found a way to muddle through, and bondholders resisted snatching the keys.
On many deals, the owner had good enough tenants and could service the debt. Restructurings were thrashed out in which the investors accepted higher coupons in return for giving the borrower more time to repay, until it could eventually refinance.
Morgan Stanley's Viridis (European Loan Conduit No 38) deal, for example, on Brookfield and China Life's Aldgate Tower office building in London, was rescued with an equity injection and new £117m securitization placed by Citigroup in April last year.
A couple of weeks later Brookfield clinched a restructuring of another London tower, Citypoint, securitized in Morgan Stanley's Salus (Eloc 33). Brookfield had been unable to sell the building for a satisfactory price, but instead gained three extra years from noteholders, until April 2028.
Despite all the stresses, there was no wave of CMBS defaults.
Last year, confidence flooded back. Refinancing activity picked up, property owners put in more equity to help deals out of tricky spots, and appetite to transact was recovering.
Both a healthier property market and a healthier CMBS market were emerging. Patience was being vindicated.
CMBS investors were even able to provide crucial marginal demand to help some of the biggest real estate deals of the year get done, like Blackstone’s £1.5bn private CMBS as part of a £2.9bn UK holiday park refinancing.
Hope dashed
But all this revival was based on the expectation — universal throughout financial markets in 2024 and 2025 — that interest rates were going to come down.
That hope had already been deferred last year by President Trump's tariff-happy — and hence inflationary — economic policies.
But the Iran war has thrown the rate-cutting script out of the window. First, market participants expected just a temporary spike in rates, then ‘higher for longer’, then fewer cuts overall and now perhaps actual rate hikes.
Central banks, some think, will be eager to avoid allowing inflation to take hold again, as it did after Covid. The most likely path back down for prices is a recession, which would also be bad news.
For the commercial real estate market, and CMBS in particular, the question now is whether they can use the extend-and-pretend playbook another time.
Expectations of rising rates will put more pressure on valuations, provoking more struggles to refinance, more protracted restructurings and perhaps some fed up bondholders eager to get out.
If there is no end in sight to the workouts and wrangles, regular CMBS buyers who have little appetite for the effort and fees involved in a restructuring battle may just decide it is time to sell up and move out.
That could put deals in the hands of distressed funds, who just love a fight.