By the Numbers

Better value in non-agency CMBS

Mary Beth Fisher, PhD | July 15, 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.

The increased costs of financing commercial real estate in volatile markets has slowed loan originations, widened spreads and stalled CMBS securitization. Conduit CMBS spreads have widened in-line with other securitized products while agency CMBS has remained anomalously tight. Investors can migrate from agency to ‘AAA’ non-agency CMBS to pick up an additional 100 bp to 140 bp of income across the curve.

Conduit CMBS spreads, like most securitized products, are currently at the widest levels of the year (Exhibit 1). The ‘AAA’ classes have widened across the curve:

The average A1 class (2.7 WAL, 30% CE) has widened from 50 bp to 135 bp
The last cash flow A5 class (9.8 WAL, 30% CE) has widened from 105 bp to 178 bp
The AS class (9.9 WAL, 20% CE) has widened from 125 bp to 225 bp.

Exhibit 1: Conduit spreads at wides of the year

Note: New issue spreads at pricing.
Source: Bloomberg, Amherst Pierpont

These ‘AAA’ classes offer up to 100 bp spread pick-up compared to standard Freddie Ks. The most recent standard Freddie K deals priced the A1 class (6.9 WAL, 20% CE, agency guaranteed) at a spread of 77 bp, with the most recent WI A2 (10.3 WAL) coming at 83 bp. Investors who do not need the lower risk weights or better liquidity of agency paper should move to private-label CMBS and pick up the additional 100 bp to 142 bp of spread.

The real estate slowdown has already started

Commercial real estate prices have begun to roll over, with CoStar and Green Street commercial property price indices stagnant to declining month-over-month this year. Year-over-year price growth has decelerated sharply across most property types from about 20% in 3Q 2021 to roughly 12% in the first quarter of 2022 (Exhibit 1). Yearly CRE price growth remains positive thanks to the rapid price appreciation during the first half of 2021, but year-over-year growth will likely continue to decline rapidly towards the 5% range by the end of this year and could be flat to slightly negative by the first half of 2023.

Exhibit 2: Trends in CRE property price indices and year-over-year price growth

Note: Data is quarterly through Q1 2022. Index values are all equal to 100 in December 2000.
Source: CoStar, Amherst Pierpont

Inversion in the front end will likely drive down CRE transaction volume

Current market expectations are that the Fed will hike interest rates to 2.50% in July, to 3.25% in September then to 3.75% by November before potentially pausing (Exhibit 2). The 3-year Treasury currently has the highest yield on the curve from bills through the 10-year Treasury at about 3.12%. A Fed hike to 3.25% in September would fully invert the front end of the curve at current rate levels.

Exhibit 3: Market expectations for Fed Funds target rate

Note: *Upper bound of FOMC target range. Probability of rate level after FOMC meetings derived from fed funds futures.
Source: Bloomberg, Amherst Pierpont

The market is anticipating that the rate hikes to tame inflation will quickly push the economy into recession. Rate cuts of 25 bp to 50 bp are being priced in for the latter half of 2023 (Exhibit 3).

Exhibit 4: Fed funds futures implied longer term rate path

Note: The implied rate is equal to the fed funds contract rate + 17 bp, to account for the current spread between the fed funds effective rate (FEDL01 Index on Bloomberg) and the upper bound of the target range (FDTR Index).
Source: Bloomberg, Amherst Pierpont

The combination of higher interest rates and pandemic-accelerated price growth have already tightened financial conditions and slowed commercial real estate transaction activity in 2022, though it remains about 10% above activity in the years prior to the pandemic (Exhibit 4).

Exhibit 5: Commercial real estate transactions

Note: Data is monthly through May 2022.
Source: CoStar

CMBS issuance in the private markets has tapered dramatically since May (Exhibit 5), suggesting that when the transaction data is update for June and July it will likely show a significant decline. Non-agency CMBS issuance had been averaging about $12 billion per month from January through May of this year, then declined to $6 billion in June and the new issue pipeline has all but shut down in the first half of July , with only a single SASB deal printing.

Exhibit 6: CMBS issuance has slowed dramatically over the summer

Note: Data through July 15, 2022. Privately placed and retained classes of deals are not included in issuance numbers.
Source: Bloomberg, Amherst Pierpont

Another 175 bp to 200 bp of rate hikes through year-end 2022 will likely slow transaction activity further and put additional downward pressure on commercial property price growth. This would not necessarily be unwelcome and could lead to a soft landing in the commercial real estate market after the torrid price appreciation of the past two years.

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

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