- Fixed Income Credit Analyst
Spain, Institutional
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Tough times have gotten even tougher for the commercial real estate (CRE) sector over the past month or so, starting with the well-publicized failure of Silicon Valley Bank (SVB) on March 10, 2023 — but not all areas of CRE are equally vulnerable to today’s stresses, so finding potential investment opportunities is all about knowing where to look.
A challenging environment for CRE
As of this writing, we have become more negative on the broad outlook for commercial mortgage-backed securities (CMBS) based on tightening credit conditions at regional US banks. Going into March, CRE was already facing stiff headwinds from substantially increased borrowing costs, declining asset values, and a generally slowing economy. The recent turmoil in the banking sector has only exacerbated these challenges, especially for weaker commercial properties.
Regional banks have historically been among the largest providers of CRE financing, accounting for as much as 70% of such lending by all banks, which equates to nearly 30% of total CRE debt financing. Shrinking credit availability from these regional banks will of course further restrict borrowers’ access to needed capital, making it more difficult to refinance a CRE loan and likely adding to downward momentum in property prices.
At this juncture, we are most negative on office buildings and regional malls — two commercial property groups that were already under tremendous secular pressures and are among the main components of a diversified CMBS pool. We still expect the grim story in the office segment to play out over several years due to the many long-term leases that are currently in place, although we are closely monitoring lease rolls given that vacancy levels are now higher than they were during the global financial crisis (GFC), including for subleased office space.
Possible CRE scenarios going forward
Similar to previous downturns in the CRE sector (notably, during the GFC and amid COVID-19), we expect loan special servicers to grant loan modifications and extensions to troubled borrowers as long as the latter can demonstrate a willingness to work with the servicers. Still, deal sponsors will likely need to contribute their own capital to help support underperforming assets, which may cause many of them to walk away from the properties (as we have seen with a few high-profile office loan defaults recently).
The special servicer “playbook” was successful during the GFC and COVID-19 because the CRE sector downturns were temporary. The risk case this time around is that the slump could prove deeper and more lasting for the office segment (similar to what we saw in retail), leaving many borrowers reticent to pony up fresh capital. On the positive side, loan maturities have typically been a catalyst for an uptick in defaults, and there is fortunately not a large number of loans scheduled to mature this year.
We believe borrowers who locked in cheap fixed-rate financing at low interest rates will be incentivized to extend their loans in order to buy time for borrowing costs to come down and lending conditions to improve. Borrowers who took out floating-rate loans, however, are already grappling with “payment shock” from higher rates and may thus be hard-pressed to meet the performance hurdles required to extend their loans (e.g., debt-service coverage ratios). Additionally, these borrowers would have to purchase new interest-rate caps for an extended loan period, which have become quite expensive following the sharp rise in rates over the past year or so. These factors could explain why some floating-rate borrowers are opting to walk away from their properties.
CMBS performance likely to vary by segment
Overall, we expect CMBS performance to vary considerably by property type and submarket in the period ahead:
- Within office, we believe higher-quality, newly constructed or renovated office buildings look poised to outperform older, lower-quality ones, as many borrowers may seek to take advantage of the recent weakness in this property segment to upgrade their office space.
- On the other hand, we are more positive on the industrial and multifamily property segments at this time. Despite softening fundamentals and higher financing costs, both segments benefit from stable net operating income and are starting from a position of relative strength.
- Given the dispersion we are seeing across and even within CRE property types, we believe skilled security selection will be critical going forward, as the bifurcation in performance between the weakest properties and the strongest ones will likely become more pronounced.
- CMBS performance is also likely to vary quite a bit from a geographic standpoint, with some global regions and countries apt to perform well in the coming months, while others may be prone to struggle.
- We think most AAA rated bonds should be well insulated from today’s hostile environment, but that more subordinate CMBS (e.g., BBB rated bonds) now face much greater risk of credit rating downgrades and potential loss of investors’ principal.
- While credit spreads for AAA CMBS have generally tracked those of investment-grade corporate bonds, they have widened of late, which may present an opportunity given their top credit ratings and robust structures (Figure 1).
- By contrast, spreads for BBB CMBS, where credit risk has grown, have decoupled from high-yield corporates (Figure 1). We are closely watching this fluid situation to evaluate whether or not it reflects appropriate pricing of current risks.
Figure 1
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