By the Numbers
Lessons learned in CMBS in 2022
Mary Beth Fisher, PhD | December 16, 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.
The first lesson learned is a follow-on from 2021: forbearance continued to work, supporting the commercial real estate market throughout 2022 with fundamental improvement as delinquencies trended down and defaults remained low. The second lesson is that changes in financing costs can overwhelm fundamentals. The commercial real estate market peaked at the end of 2021 as low financing costs drove a historic surge in transactions, pushing property prices to record highs and capitalization rates to record lows. The Fed’s torrid pace of rate increases has driven financing costs sharply higher, transaction volume down and property prices in some sectors have started to roll over.
#1 Forbearance continued to work
Throughout 2022, commercial real estate (CRE) loan performance steadily improved. The percent of delinquent CMBS loans in conduit or single-asset, single borrower deals continued to decline from a pandemic peak of over 10% in June 2020 to below 3% by September 2022 (Exhibit 1). Forbearance policies allowed most delinquent borrowers to eventually cure missed payments and reperform. The inventory of real estate owned (REO) properties remained relatively stable around $5 billion throughout the pandemic, interrupting the relatively steady, years-long decline in REO inventory since its peak of $20 billion in late 2012.
Exhibit 1: CMBS delinquency and special servicing rates show steady improvement
The majority of remaining delinquencies continue to be concentrated in the hotel and retail sectors, both of which suffered the worst impact from the pandemic (Exhibit 2). In December 2019, just prior to the pandemic, the lodging sector had the second lowest delinquency rate at 1.42% among the major property types. By June 2020 that rate jumped to over 24%, the highest delinquency rate of any property type, as hotel borrowers entered into forbearance agreements to manage through the shutdowns. Retail properties had a similar delinquency path, but both sectors have steadily improved with most borrowers curing forbearance. Delinquency rates in the multifamily, industrial and office sectors were lower than their pre-pandemic levels by September 2022.
Exhibit 2: Lodging and retail account for largest share of CMBS delinquencies
#2 Changes in financing costs can disguise fundamentals
Loan delinquency and REO rates are inherently backward-looking metrics of performance, and their ability to diagnose or reflect changes in fundamentals varies immensely across sectors.
- Hotel and retail revenues react nearly instantaneously to changes in economic conditions and consumer spending
- Multifamily revenues respond with a lag, as leases are typically for 1-year periods
- Office properties can benefit or suffer from average lease periods of 10 years; delinquency rates for office properties remain relatively benign for now, but the outlook for the sector is quite grim
However, changes in financing costs impact all CRE sectors somewhat uniformly. Financing costs influence property prices, capitalization rates and sales volume. The structural decline in long-term Treasury rates over the past 20 years has contributed to a drop in capitalization rates (Exhibit 3). Cap rates across major property sectors touched a new low during the second quarter of 2022. The time required to close a CRE sale varies from six weeks to three months, so most of the transactions closed during the quarter entered into negotiations at the end of 2021.
Exhibit 3: Capitalization rates declined as long-term Treasury rates fell
The 10-year Treasury rate hit a historic low, remaining below 1.00% throughout post-pandemic 2020, and below 1.75% throughout 2021. Similar to residential real estate, historically low financing costs contributed to surging commercial real estate prices (Exhibit 4). Prices across most sectors peaked in early 2022, following record CRE transaction volume in the fourth quarter of 2021 (Exhibit 5).
Exhibit 4: Property prices surged as financing costs fell
CRE sales volume retreated as the Fed raised interest rates. Sales volume during the third quarter of 2022 is in-line with sales in 2019. The number of sales so far in the fourth quarter has fallen levels last seen in 2012 when the CRE market was still recovering from the financial crisis.
Exhibit 5: CRE sales volume surged as financing costs declined, but has cratered recently
The CRE markets have struggled to adjust to the Fed’s torrid pace of rate increases even though the long-term fundamental outlook for most sectors, ex-office, remains quite constructive. The CMBS new issue market stalled in October and has basically shut down for the remainder of 2022. The lack of supply has left spreads in the primary market at their wides of the year, but spreads in the secondary market have tightened modestly. The Fed isn’t done tightening, though they have reduced the pace. The hope going into 2023 is that the CRE market can gradually and constructively return to being driven by fundamentals without being whipsawed by interest rates.