By the Numbers

Relative value opportunity as CMBS spread stabilize

Mary Beth Fisher, PhD | April 1, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Rising interest rates and a seasonal slowdown in transactions has stalled commercial real estate price appreciation after exceptional gains during the pandemic. The stabilization in property prices has coincided with signs of stabilization in CMBS spreads. After widening from late 2021 through mid-March 2022, spreads across much of the structured product universe appear to have found a footing. Spreads of conduit CMBS ‘AAA’ classes have stabilized close to pre-pandemic averages, but AS classes are lingering a bit wide of last cash flows, creating a relative value opportunity for investors to pick up additional spread.

Like most of the structured product universe, conduit CMBS spreads hit multi-year tights during the pandemic. Spreads began to widen in late 2021 and into 2022 as the Fed signaled it was preparing to initiate a hiking cycle to subdue inflation. Fed liftoff on March 16 this year was followed by hawkish commentary from FOMC members that led the market to price in a more aggressive path of rate hikes. Despite a 25 bp sell-off in the long end since mid-March, conduit CMBS new issue spreads of ‘AAA’ last cash flow (LCF) and AS classes appear to have stabilized in-line to just barely wide of pre-pandemic levels (Exhibit 1).

Exhibit 1: Conduit CMBS new issue spreads

Note: Conduit CMBS new issue spreads were historically quoted versus the LIBOR swaps curve. Beginning in 2022 new deal spreads are being quoted versus the SOFR swaps curve (P-spread). Average pricing spreads for deals issued since January 2022 have been converted from SOFR to LIBOR based on the 10-year SOFR-LIBOR swap basis on the day of pricing.
Source: Bloomberg, Amherst Pierpont Securities

The average spread between the AS and LCF class at pricing was as tight as 12 bp to 13 bp in new deals during the pandemic. During 2019 the AS class priced 26 bp back of the LCF class on average. In February of 2022 as spreads were widening, the AS class often priced 30 to 40 bp back of the LCF. Spreads across structured products—with the exception of agency MBS—have shown signs of stabilization, and conduit CMBS deals have been tightening across the stack.

Benefits of the AS

The AS class typically has the same weighted average life as the LCF tranche at issue. The front LCF and LCF tranches absorb any prepay risk, resulting in a more stable weighted average life for the AS.
Although the credit enhancement is lower in the AS versus the LCFs, causing it to price wide of the LCF, it is still rated ‘AAA’ to ‘AA+’ due to the exceptionally low probability of losses.
The AS has room to tighten a few bp to the LCF, and the LCF could tighten from above 100 bp to the mid- to low-90s, which would be consistent with pre-pandemic spreads at similar rate levels.

CRE price appreciation takes a breather

Commercial real estate (CRE) prices are also showing signs of stabilization (Exhibit 2). CoStar’s repeat sales price indices both fell slightly in February from new historic peaks in January. The value-weighted index, which heavily weights investment grade properties in top tier markets, fell 0.4% in February – notching the first decline in 12 months. The equal-weighted repeat sales index, which reflects the much more numerous sales of lower-priced properties in secondary and tertiary markets, fell by 1.3% in February – also notching its first decline in a year and erasing a 1.3% gain in January 2022.

Exhibit 2: Commercial real estate composite price indices

Source: CoStar

The stalling of price appreciation is both expected and welcome, hopefully leading to a normalization of market prices after two years of historically rapid appreciation. The value-weighted index was up 19.6% year-over-year in February, and up 28.2% since February 2020, just prior to the pandemic. CRE price appreciation wasn’t confined to the high end of the market, as the equal-weighted index rose 16.4% year-over-year, and was up 23.2% since February 2020.

Exhibit 3: CRE repeat sales transactions

Note: Number of transaction pairs, monthly.
Source: CoStar

Healthy markets contributed to robust price appreciation. The number of monthly repeat sales was elevated beginning in early-2021 through year-end, spiking much higher in December of 2021. December is typically the peak as investors seek to close out transactions for the year, followed by a winter lull. This year should see a lower level of price appreciation as interest rates rise and transaction volume normalizes (Exhibit 3).

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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