DEBT MARKETS: CMBS Large losses for legacy CMBS deals will level off as secondary property values stabilise. Andrea Daniels offers the outlook for securitised lending
After a sustained period of turbulence in economic and financial markets, the global economy now looks set for a period of somewhat greater stability over the next two years. Moody’s economic outlook for the UK and Germany remains one of positive growth. This improved economic outlook is supporting commercial real estate capital values and is boosting confidence as money continues to pour into the market. Tenant demand and the availability of financing are improving on the back of the enhanced economic outlook and rising confidence.
Robust fundamentals will support real estate values and stabilise weak commercial mortgage backed security (CMBS) performance in 2014.
Moody’s outlook for capital growth drivers is positive. The prospects for the two key drivers of capital growth (yield impact and rental value growth) look robust, with some market participants projecting UK all-property rental growth of 1% and capital growth of 2% in 2014.
Improved market sentiment will sustain capital inflows. Approximately $120bn of newly available capital is targeting European real estate in 2014, an increase of 6% on the previous year. An upswing in property market sentiment and the relative attractiveness of property in a low-yield macro environment will sustain capital flows into European real estate, at least for the next year and a half.
Investment volumes could top €30bn in Germany and £36bn in the UK, where real estate investment volumes are on track to finish 2013 with around £36bn transacted, a 20% increase on the previous year. Investment volumes in third-quarter 2013 were the highest since 2007. Investment in German commercial property totalled just over €19bn in the first three quarters of 2013, which is nearly 27% more than in the same period in 2012. Full-year investment volumes for 2013 could potentially reach €30bn.
The strong capital inflows are lifting prime property capital values. Robust capital inflows are driving capital value increases for prime properties across Europe. For example, the IPD UK Monthly index, which is heavily skewed towards prime properties, showed the sixth consecutive month-on-month capital growth of 0.6% in October 2013.
Uptake of commercial property space in Europe is generally up across all geographies and asset classes. The lack of speculative commercial property development during the downturn has led to a shortage of good quality space, which is exerting further upward pressure on rents.
More funding is available compared with last year, with lenders now less reluctant to finance investors higher up the risk curve. The now well-established upward trend for prime property capital values has spread to good quality secondary properties, with the yield differential between the two property types starting to narrow. Driven by a lack of available prime stock in the major metropolitan areas, investors are moving to regional cities in the UK and Germany in their efforts to find higher-yielding investment properties.
In their search for more attractive returns, investors are also taking on greater risk through exposure to higher-yielding secondary properties and alternative asset classes, such as student housing and care homes. There is also a greater appetite among investors for taking on redevelopment and leasing risk and even some speculative developments.
Underwriting standards remain relatively robust. Real estate lending margins are starting to narrow and loan-to-value ratios are rising as more non-bank lenders enter the market. While there has been a gradual slip in underwriting standards as competition among lenders intensifies, the standards are still conservative compared with the property market peak in 2007.
Significant losses are expected from legacy commercial mortgage-backed securities (CMBS) deals of roughly €9bn in the next five years. Although progress has been made in terms of working through the refinancing wall – with the net debt funding gap in European real estate dropping by 14% in the six months to November 2013 – the region still has a significant funding shortfall estimated at $74bn. The European CMBS refinancing wall peaked in 2013 and is expected to be less challenging, in comparison, over the next few years. Nonetheless, European CMBS financing needs in 2014 is expected to be a multiple of real estate lending available and that the funding gap for European CRE will persist, with a gradual improvement over the coming few years.
In a recent Moody’s study of European CMBS loan maturities, €7.3bn of EMEA CMBS loans were scheduled to refinance in 2014 with 55 loans representing €5.5bn of the current securitised balance having original maturity dates in 2014; another 22 previously extended loans (€1.8bn current securitised balance) will again mature in 2014 (figure 1).
Most of the properties securing legacy CMBS loans are highly leveraged, having been underwritten at or near the property market peak in 2007. Despite the continuing improvement in real estate fundamentals, which is now spreading from prime to secondary properties, around 60% of the €5.5bn loans maturing in 2014 will not repay. These loans will add to the 27% or €17.8bn of CMBS loans in special servicing as of December 2013.
On a positive note, weak performance is anticipated to begin to bottom out as values for secondary properties begin to find a floor. In 2014, the weighted average loss for a loan in workout is expected to plateau at around its current 44% level. The loss rate is likely to be on the decline in the coming five years, with CMBS loan level losses estimated to fall to around €9bn over this period.
Andrea Daniels is associate managing director at Moody’s Investors Service
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