By the Numbers

Out-of-consensus calls on the 2023 CMBS market

Mary Beth Fisher, PhD | November 18, 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.

Consider the possibility of commercial real estate prices dropping 10% to 15% and the market actually improving in 2023. Capitalization rates rise by at least 1%, delinquencies continue to trend down and the securitization market comes back to life as origination volumes rebound from the late-2022 doldrums. This scenario is likely to play out in multifamily, industrial, retail and hospitality. Office, on the other hand, may only be in the early stages of its correction, where tech heavy corridors could produce a mini-wave of defaults.

This likely path leads to four out-of-consensus calls for the 2023 commercial real estate market:

Begin going down in credit now, and continue to overweight ‘AA’ through ‘BBB’ exposures as property prices tumble through the first half of 2023.
Stay concentrated in floaters through year-end 2022, and begin extending duration during the first quarter of 2023 before the market decides the Fed is finished hiking. The snap back in rates and spreads will be sharp and fast.
As transaction volume begins to pick up, this benefits pre-pandemic borrowers. Agency multifamily loans from 2016-2019 vintages will likely have prepayment speeds in the mid to high single digits despite being deeply out-of-the-money to refinance. This should lift returns for interest-only tranches that receive prepayment penalties, like those in Ginnie Mae project loan deals.
Conduit CMBS with heavy office exposure in vulnerable areas could experience downgrades and eventual losses in the lowest-rated tranches. However, at an appropriate discount some A rated tranches offer attractive double digit yields and remain well insulated from potential losses.

A rate-driven price correction alongside solid fundamentals

Short term interest rates have not been in the vicinity of 5% since before the financial crisis, when the Fed held the target rate at 5.25% from mid-2006 to mid-2007. This was neither unusual or notable. From 1994 through 2001, the Fed kept the target rate in a channel between 4.75% and 6.50%. The path back to higher rates has been particularly bumpy, in part due to the speed with which it has occurred. But a deep or prolonged recession triggered by the Fed’s rate hikes seems increasingly unlikely. The unemployment rate will almost certainly tick higher in 2023, but nowhere near the levels required to dramatically increase vacancy rates in most commercial real estate categories. Large declines in rent and downward pressure on net operating income, which would indicate weakening of fundamentals, are at odds with a resilient consumer and relatively low unemployment.

Much of the price appreciation in commercial real estate during the pandemic was driven by ultra-low interest rates. The price correction is primarily due to the rise in interest rates, as the fundamental outlook for most sectors remains solid as long as the economy avoids a deep or prolonged recession. There are a variety of commercial property price indices, with the two most popular being the Green Street and CoStar commercial property price indices. Their methodologies and the scope of transactions and properties that they cover differ significantly, but both show that investment grade CRE prices have declined in 2022.

Green Street’s model-based index focuses on properties owned by US REITs, and incorporates prices where CRE transactions are being negotiated and contracted. Their index shows CRE prices broadly down 8% for the year, and off 13% from the 2021 peak (Exhibit 1).

Exhibit 1: Green Street Commercial Property Prices, sector-level indices

Note: Prices as of October 2022.
Source: Green Street

CoStar indices a much broader set of commercial real estate property prices – its equal weighted index tracks most of the universe of U.S. CRE transactions. CoStar’s sector indices in prime metro areas (Exhibit 2) are the closest comparison to the Green Street indices, but these are still considerably broader than the portfolios tracked by Green Street.

Exhibit 2: CoStar Commercial Property Price Indices in prime metro areas

Note: Data through third quarter 2022. Prime metros vary across sectors and are defined here.
Source: CoStar

CoStar indices indicate that CRE prices across multifamily, office and industrial sectors declined quarter-over-quarter in the third quarter of 2022. This was the third linked quarter decline for prime multifamily prices over the past 5 quarters, resulting in a cumulative year-over-year decline of 1.3%. CoStar’s methodology is based on repeat sales transactions that have closed. While robust, its indices can be lagging indicators of current market prices.

The drop in CoStar indices is unlikely to mirror the decline in Green Street’s indices because the CRE portfolio being tracked is so much broader. However, as transactions close throughout the coming 4 to 6 quarters the CoStar indices will likely show steady price declines across most sectors.

A focus on multifamily

Whether investors believe property prices have already tumbled or are just beginning to turn over, the outlook for 2023 is that higher interest rates will continue to push prices down. Trends in multifamily property prices across the broader market, as tracked by CoStar, show that price growth peaked in the fourth quarter of 2021 and has been steadily decelerating through 2022 (Exhibit 3).

Exhibit 3: Multifamily property sale price growth (12-month)

Note: Data through third quarter 2022. Slices correspond to property star ratings assigned by CoStar.
Source: CoStar, Amherst Pierpont

Across the broad market the pandemic-driven price growth was less than half that seen in the aftermath of the financial crisis. Though the 29% rise in the first quarter of 2011 was preceded by a nearly 22% decline in the first quarter of 2009. The economic-wide fallout from the financial crisis was severe, which contributed to the dramatic deterioration in multifamily fundamentals. Rent growth fell 4.0% year-over-year in the fourth quarter of 2009, and was negative for nearly three years (Exhibit 4). Rent growth also deteriorated and fell by nearly 2.0% in the aftermath of the dot-com bubble, as job losses piled up and the unemployment rate peaked at 6.1% in September of 2003. Despite the negative rent growth, multifamily property price growth actually accelerated from 8% to 14%, driven by the Fed lowering interest rates from 6.5% in late 2000 to 1.0% by late 2003.

Exhibit 4: Multifamily rent growth (12-month)

Note: Data through third quarter 2022. Slices correspond to property star ratings assigned by CoStar.
Source: CoStar, Amherst Pierpont

The price declines in 2023 are primarily expected to be driven by rising rates, not a weakening of fundamentals. Rent growth should stagnate to fall modestly as prices decline and the unemployment rate ticks a bit higher. Declines in rent growth will be much smaller than property price depreciation, which will lift cap rates.

Projected trends in multifamily for 2023

Property prices declines of 12% to 15% will push capitalization rates into the 6.00% – 6.50% range.
Rent growth will turn modestly negative before stabilizing around 0%.
Transaction volumes will be moderately low, but new issue spreads should tighten on stronger investor demand.
The modest backlog of Covid-related defaults should complete workout, with little impact on the market. Overall delinquency rates will continue trending down as most loans remaining in forbearance cure.

Multifamily a template for other sectors, ex-office

The pricing trends exhibited in multifamily will likely be seen in industrial and self-storage as well. Cap rates need to rise along with all interest rates, and the higher cost of financing will drive prices lower while net operating income mostly remains steady. Retail is improving after several years of mostly terrible performance, and hospitality is the most economically sensitive of all CRE sectors. As long as unemployment remains low and the consumer strong, downward price pressure due to higher financing costs should be modest.

The office sector is on its own trajectory, which is outside the scope of this outlook. Suffice it to say the ratings agencies have all warned that a small percentage of conduit CMBS ratings, primarily on lower-rated classes, may be downgraded due to high office exposure. These scenarios are evolving but investors should limit exposure or do deep dive analysis of deals with high office exposure to make sure prices reflect potential downgrades and incorporate projected credit losses. There are terrific opportunities in some deep discount tranches that are well insulated from potential losses but have spooked investors.

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

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.