The US CMBS market, shrouded in the years since the pandemic as office and retail properties faced unprecedented challenges, would appear to be in fine fettle if you look at primary markets.
Market conditions remain strong, and the recent slight softening in spreads is largely down to impressive supply. Private label year-to-date issuance stands at $47.7bn already, according to Finsight, more than 2023’s total of $43.2bn.
Yet, below that surface, the picture is murkier.
For one thing, let's take a look at the drivers of the pick-up in issuance volumes. A key factor has been the fact that capital markets are filling the financing void from banks curtailing their commercial lending. Most previous funding channels for commercial real estate have dried up.
As market conditions thawed earlier this year, CMBS has been one of the few reliable avenues for sponsors to get the funding they need to refinance.
The CMBS resurgence is therefore not down to CRE flourishing. Rather, as one analyst puts it, for this battle-worn sector CMBS is "the only game in town".
That's perhaps not surprising, as delinquencies and loans entering special servicing — both signs of distress — continue to tick up across the board in both conduit and SASB deals. This highlights the pressures that loom.
Growing distress
Morgan Stanley’s latest CMBS research pegs the delinquency rate for conduit CMBS at 5.27%, up 139bp year-on-year. And SASB is at 4.06% respectively, up 96bp year over year.
This increase may not even tell the full story.
For one thing, current delinquencies probably understate the true extent of stress in CRE. As S&P pointed out in its CMBS quarterly last week, delinquency rates are reduced by reperforming loans, with the rating agency describing "a certain segment of loans that were previously delinquent but subsequently resolved and reclassified, including loans that failed to pay off at maturity and were extended by the servicer".
In reality, these could be borrowers that were able to negotiate more relaxed terms with their lenders, and those lenders were happy to kick the can down the road rather than deal with the problem immediately. It is likely that many of these loans could become distressed again.
Indeed, S&P has therefore decided to begin tracking loans going into special servicing — a sort of purgatory from which most loans end up delinquent rather than reperforming. Again they point to more pain.
Morgan Stanley puts special servicing rates for conduits at 7.49% in June — up 195bp year over year. Of this 7.49%, only 2.7% of them are performing — with the remaining considered specially serviced and delinquent. On the SASB side, the current rate is 128bp higher than at the start of the year, having reached 7.62%.
Breaking down headline volumes shows how investors remain extremely cautious to fundamental concerns. Office properties, the most troubled sector, can — with a few notable exceptions — only find financing in conduit deals, where risks are mitigated by the less concerning sectors like hotels, retail and industrials. Idiosyncratic risk is still too high for for most office building to appear as single asset, single borrower deals.
Rates risk — underrated?
Finally, for CMBS and CRE more generally, a huge amount of the future hinges on the uncertain rates outlook. Even in a best case, with a 25bp rate cut in September, affordability will remain a challenge with much refinancing to do. Many previous vintages of deals, as recently as 2021, were underwritten in a near-zero rate environment.
S&P's latest update is telling. Of the 50 SASB CMBS deals that came to market in the first half of 2024, the agency refused to give feedback on 18. The issue was not leverage, as used to be the case in these situations, but because — remarkably — projected cashflows suggested the borrowers would be unable to cover debt service from day one, with Sofr so high.
As broader markets appear confident of a soft landing and bet on rate cuts, there is an underappreciation of the fact that “higher“ might still mean “longer” — and that this brings an increased risk of an economic downturn.
Such is the Fed's focus on inflation, given how overoptimistic its previous forecasts were, that some are worried it could be excessively stubborn in resisting cuts. Many borrowers do not have too long to wait.
We should celebrate the return to form of the CMBS market and the fact that it's been able to shrug off the negative headlines and remain open to borrowers that need funding — many of which are perfectly strong credits. But capital markets momentum should not distract from the fact that there are many reasons to remain very cautious on the outlook for the asset class.