CMBS market looks to life after Covid

Although commercial mortgage backed securities remain a small portion of the overall European asset backed securities market, the asset class is responsible for one of European securitization’s biggest headaches. 

The properties backing many CMBS transactions are not fully open and many have not been valued since the start of the pandemic.

Should the re-opening of society not prove the panacea that many of these businesses require, many properties could be revalued far below their pre‑pandemic levels and CMBS deals re-rated, meaning investors are stuck with paper.

“Property valuations are a potential issue and our biggest fear as an investor is on valuations and revaluations,” says Rob Ford, co-founder and portfolio manager, TwentyFour Asset Management, adding that his concern is not for new issues so much but for the effect on deals in the secondary market.

Ford says that most CMBS properties tend to have annual revaluations, but lots of the properties backing the sector got waivers last year, which he said was “quite right” because valuers couldn’t even be sent out to a property during lockdown.

Also, because many properties had to be shuttered for an indefinite period, and even when they were given a re-opening timeline the amount of people they might be able to serve was still uncertain, valuations were nigh on impossible. But many of these properties will begin to be valued again. 

“It is right that they got waivers, but the question is: what will valuations look like this year and how much information will there be for a valuer to look at, given that we are still only just emerging from the latest lockdown?” says Ford. “For investors, the effect of revaluation depends where they are invested in the capital structure, but also it depends on what the rating agencies decide to do. 

“Should there be a whole raft of downgrades, possibly by whole categories, then what will the relative value of that paper be in the secondary market?”

 

Winners and losers

One of the winners to emerge from the pandemic in the commercial real-estate sector has been the logistics industry, spurred on by the increase in online shopping.

In its outlook for European commercial real estate for 2021, CBRE said that strong occupier demand for logistics assets across Europe during the pandemic continued to underpin strong performance in the sector, despite the challenging macro-economic environment. 

The uptick in demand for more commercial logistics sites has led to a proliferation in new distribution centres across Europe, to meet the increased demands for speedy home deliveries. Of the five CMBS deals that were priced in the first quarter of 2021, several were heavily weighted towards the sector.

Last Mile PE 2021 and Taurus 2021‑1, two deals backed by portfolios of logistics sites, were particularly popular. They also achieved tighter pricing than other recent CMBS deals backed by non-logistics industrial properties.

“The logistics sector broadly has performed well through the pan-demic,” says Steven Dyer, EMEA head of commercial real estate lending at Morgan Stanley. “There have been high collection rates and the sector in general has been very strong. We have seen a lot of activity on the equity side with new players looking to get into the sector with a strategy of aggregation and large platforms and I think that will continue. 

“The performance of logistics in particular, in my view, is going to remain a strong theme, helped by the structures we see in CMBS and the flexibility the sector can offer.”

In contrast to logistics, the retail sector has been battered by the pandemic. 

Its problems pre-date the arrival of Covid-19, however, with the steady growth in online shopping eating away at traditional bricks and mortar retail’s profit margins and income streams.

“Retail has certainly been the sector, for us at least, where we have had to be most active in our surveillance of what’s going on. We have seen very dramatic plunges in value in the last couple of years, certainly accelerated by the pandemic,” says Euan Gatfield, head of EMEA CMBS at Fitch Ratings. 

“We started to see it of course before the pandemic — it wasn’t, in the UK at least, a sector that was in particularly rude health. The pandemic has just accelerated all of those negative trends for retail property in a very profound way.” 

Because of these sectoral pressures, and pandemic enforced lockdowns, some retail properties have begun to be downgraded by rating agencies.

“We have made a range of downgrades in some cases in more than one category — Metrocentre, for example, is now at CCC and that is a significant downgrade from BBB with a negative outlook immediately before the pandemic hit,” adds Gatfield. 

“Over the last two to three years it has lost over 50% in value. So that’s a startling fall from grace for what is one of the largest shopping malls by square footage in the UK.”

While retail is in a difficult spot, that doesn’t mean no retail CMBS deals will come to market.

Sponsor reputation remains important, as does having several large retail assets. If a sponsor has a history of injecting cash into its CMBS deals and supporting them, or a transaction is backing a more popular retail asset — say, Westfield Stratford — then issuers are still likely to find investors willing to play in the deal, even if it is further up the cap stack than they would invest in a logistics-backed transaction.

“There is demand for assets in sectors that were more challenged during the heights of the pandemic, highlighting that investors are willing to analyse opportunities on a case by case basis,” says Dimitri Kavour, head of securitized products group syndicate EMEA at Morgan Stanley. “For example, in retail the quality of assets varies widely, as does the price differentiation between, for example, units that are anchored by super-markets and other retailers which are more high street focused. 

“Depending on their ability to analyse the opportunity, and their risk appetite, some investors may choose to wait for better clarity as to how things play out.”

In the new issue market at least, the contrast between winners and losers looks clear cut, but there are still some secondary market concerns for some investors who might have heavily backed the logistics sector.

The reason? Simple bond maths.

“Logistics is that bright spark in the sector, coming at the cost of retail property, and that’s the area that almost everyone is flooding into,” adds Gatfield. “But that poses its own sort of challenges from a credit perspective. Yield is being pushed down way below long-term averages. 

“Logistics functionally is in a good spot. But when you see yields down well below 4%, and some close to 3%, in a sector which previously carried a 6%-7% yield, it is a 50% drop.” 

 

Liquidity concerns

The growth in the market is encouraging but because new issuance lags so far behind other asset classes, investors have to be careful about building up too much exposure, for fear of being stuck with paper should the fortunes of one particular asset class change. 

“A big concern I have about CMBS is the size of the market and liquidity, particularly secondary market liquidity,” says Ford. 

“In a highly homogenous asset class like RMBS or traditional ABS, we regularly trade with something like 25 different counterparties from the top global investment banks to a whole host of smaller players from Europe and beyond. 

“But that universe of dealers gets much smaller when you get to CMBS. You have the big guys like Morgan Stanley, Deutsche Bank, Goldman Sachs and Bank of America, but there are not nearly as many players as in other sectors. For secondary liquidity, CMBS is one of the worst sectors out there.”

With CMBS far behind issuance of other securitization such as residential mortgage backed securities or collateralised loan obligations, the asset class often does not play a large part in the portfolios of many fixed income investors.

“In our headline flagship investment grade fund, CMBS represents about 3.5%, and in our non-investment grade fund it is about 4%, neither of which are very big allocations but are actually pretty relative to CMBS issuance as a percentage of the securitized market,” says Ford. 

“Then when you take into account that investing in CMBS is very sector specific, with whole areas to potentially be avoided where it’s more difficult to get comfortable about valuations or a particular sponsor, then the available universe narrows even further. 

“We would invest throughout the stack in several sectors, such as logistics, which we generally favour, but each sector makes up a smaller percentage of CMBS, and therefore a tiny percentage overall.”