After increasing every year since 2010, issuance of CMBS in 2015 was essentially flat compared to 2014, defying early predictions of $120bn of new deals. And yet, despite the drop in supply, spreads on benchmark triple-A CMBS ended the year at around 130bp over swaps, well above the post-crisis tights of 72bp over swaps just one year before.
“[Super-senior] CMBS is at a level not seen since 2012, and I think that certainly has flown in the face of expectations,” says Edward Shugrue, chief executive of New York-based Talmage LLC, which specialises in commercial real estate debt investments.
CMBS followed the rest of the market wider over the summer, as anxiety around the state of the global economy spread. Spreads gapped out in sympathy with losses in equities. Then, just as a brutal summer came to a close, issuers decided to turn on the spigot and flood the market with new deals, likely to get ahead of Regulation AB II, which went into effect on November 23.
Issuance in September and October was $9.4bn and $10.4bn, respectively. Investors buckled under the weight of issuance and spreads blew out further, settling into their present 130bps over swaps area.
“After five years of really steady improvement, there are a lot of new factors coming into the market in 2016, and along with the overall market concerns, there is going to be a lot of pressure on CMBS,” Shugrue says.
Tightening ahead?
A catalyst for any tightening trend is uncertain. Renewed appetite for CMBS in the first quarter could drive spreads in. Similarly, with CMBS looking cheap relative to corporate bonds, more investors may decide now is the time to jump in.
“Reinvestment demand will provide an important source of technical support for the new issue market [in 2016],” JP Morgan analysts wrote in a November 20 note, adding that a majority of investors surveyed were looking to reinvest proceeds into longer duration assets.
As with securitized products broadly, the elephant in the room is regulation, specifically the implementation of risk retention. But unlike other sectors, such as CLOs, managers of which have gotten ahead of the rule by issuing compliant deals since the middle of 2015, CMBS players are still wondering exactly how the rule is going to impact them.
Though the impact will not be truly felt until the end of the year, there are several themes tied to risk retention that could take shape in the run up to the Christmas Eve implementation date. First, issuers will likely look to get ahead of risk retention and ramp up issuance going into December, once again putting pressure on supply and demand technicals.
In the market for the lowest rated CMBS, the B-pieces, market players should expect to see a smaller field of buyers and more arranged deals between issuers and the B-piece investors, as opposed to an open auction of the bonds.
“It isn’t going to be a matter of people getting out of B-pieces, as much as it will be a matter of that market getting away from some investors,” says Richard Jones, partner and chair of the real estate finance group at Dechert. “Regulatory forces are going to create a dynamic that makes the street much pickier about whose cooking they eat.”
New entrants to the B-piece market could find themselves out in the cold as the well capitalised and established buyers get first crack at new deals.
Bubble fears
In commercial real estate fundamentals, expect valuations to continue to rise, adding to bubble fears voiced throughout 2015. Commercial property prices have surged past pre-crisis levels in major markets, according to Moody’s commercial property price index.
Kroll Bond Ratings Agency has tracked an increase in “credit barbelling” in 2015. The practice allows issuers to mask highly levered loans in a CMBS pool by sprinkling a few investment grade, low leverage loans throughout. This lowers the overall leverage but exposes investors to riskier loans. The practice has become more common in the past two years and is expected to continue.
Despite these headwinds, a new year inevitably brings hope for improvement. This year is the first of two very big years for CMBS loan refinancing, with around $100bn in legacy loans expected to mature. This should keep dealflow steady. Additionally, the US economy continues to make small, but steady improvement, as unemployment continues to fall and GDP increases.
“Going into it, I think the strategy we’re all pursuing is one of hope, at least hope that it will be better this year than it was in the last quarter of 2015,” says Jones.