A three-year spike in maturing US CMBS is fast approaching and will require a record level of refinancing. But the latest signs suggest that this glut will be eagerly digested by investors.
In several recent reports, Fitch Ratings describes a CMBS market experiencing strong investor interest, ample new capital, and improving fundamental and technical conditions. While weak spots remain, those tend to be in well-known troubled vintages, and specific projects primarily in the retail sector. And much of the remedial work on loans in CMBS issues that will start maturing next year has already been done.
Fitch notes a slight decline in underwriting standards led to a modest uptick in credit enhancement required for new issues to be rated AAA during the first quarter of 2014, while the percentage of loans with debt service coverage ratios below 1.0x (signaling a net operating loss) rose in the first quarter and year-over-year. But overall, Fitch reports, delinquencies are falling, and the dollar volume of loans in special servicing is declining as workouts of troubled deals sold in 2005-07 proceed.
“We expect to see more loans that will default at maturity”
The number of classes Fitch upgraded in the first quarter rose sharply to 87 in the first quarter of 2014, compared with just eight in the prior quarter and only 58 for all of 2013. Downgrades dropped to just 119 classes compared with 333 for Q1 2013 and 864 classes in 2013. The annual default rate for securitised commercial mortgages also fell – to 0.9% in 2013, the lowest level since 2008. The 2013 default rate was 26% lower than in 2012 and down 75% from the 2010 peak.
Those conditions show the broader commercial real estate markets are stabilising and healthy new CMBS issuance volume is providing ample liquidity, says Mary MacNeill, a managing director in Fitch’s US CMBS Group.
Delinquencies are likely to continue to recede and special servicer resolutions of distressed assets are likely to continue, supporting the market’s stabilisation, Fitch Ratings says, with rating upgrades to exceeding downgrades for the near term.
Fitch says special servicers resolved approximately 28.5% fewer loans in 2013 compared with 2012, though the resolution of some large loans kept dollar volume flat at $16.4bn (€11.9bn). Outcomes improved as well: of the 872 loans resolved, 506 were disposed for losses in 2013, a decline from 742 loss disposals in 2012 and 951 in 2011. The agency expects resolutions to continue to fall as property values stabilise for all property types and as resolutions outpace new transfers into special servicing status.
The stabilisation means the market is well positioned to process the historic amount of CMBS debt that will come due between next year and 2017. Fitch alone rates CMBS totaling more than $180bn due to mature during that time and estimates of the total maturity wave top $350bn.
“For us it’s not necessarily a big credit risk,” MacNeill says of the upcoming maturity spike. As the decline in resolutions indicates, “you’ve had a lot of loans that have already defaulted, so some of those have already extended, some of those have paid down early because they’ve liquidated, and some have gone into default”.
Since many of the loans that survived the crisis and remain in CMBS issues are interest-only loans, says MacNeill, “we expect to see more loans that will default at maturity”. That could trigger renewed transfers of loans to special servicers, she says. But as long as a project has reasonable tenancy and interest rates remain low there could be an opportunity to refinance, or to inject more equity or debt to restructure a property from a new source, “such as a B-piece or a mezzanine loan,” she says.
As buyers of the most subordinate tranche of mortgage bonds, B-piece investors are in “first loss” position. They are also first in line when it comes to structuring CMBS and monitoring loans. B-piece investors can kick out loans tied to potentially problematic properties, and CMBS pooling and service agreements typically give B-piece holders a key role in monitoring the performance of each loan, decisions about issues at underlying assets, and appointing special servicers to carry out those functions.
The rewards for effective gatekeeping present a compelling investment case in today’s yield-starved markets; investors are reportedly earning loss-adjusted returns between 13% and 18% from securities backed by real property collateral monitored by the investors’ agent.
It is attracting new investors. In 2013, 11 participants completed 45 B-piece transactions with a value of $53.1bn, according to Commercial Real Estate Direct, which compiles issuance data and allocates deal credit on the sector. That was up from 27 transactions completed by eight participants with a value of $32.2bn in 2012. This year, activity looks set to surpass 2013 levels – by the end of the first quarter, six participants had bought 13 deals totaling $14.8bn in deal value.
The leading B-piece investors are Rialto Capital Management, LNR Partners, Raith Capital Management and Eightfold Real Estate Capital. The top firms, which have been consistently involved since 2012, are hedge funds or specialists in mortgage finance, securitisation, and servicing. Rialto, for example, is an affiliate of US homebuilder Lennar Corporation. Several new names joined the B-piece league table in 2013, including Cerberus Capital Management, Saba Capital Management and Perella Weinberg.
While market conditions are stabilising and investors are stepping in to buy the riskiest tranches of CMBS issues, one outlier remains. A sharp increase in interest rates could derail efforts to refinance the loans underlying maturing CMBS bonds.
“I don’t think anyone’s really predicting a fast interest rate movement over the next year or two,” says MacNeill. However, she adds, “if that were to occur, that would be problematic”.