The Big Idea
A midterm exam in CMBS
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.
A lot of people saw the deterioration in commercial real estate coming. Price appreciation in commercial real estate has slowed for several quarters, with office and multifamily properties now notching outright year-over-year declines. The correction likely has a bit further to go in multifamily, and a lot further to go in office. The longer and higher rate hiking cycle was unexpected, however, and has kept investors and borrowers on their back foot. One consequence has been that CRE sales volume has withered to anemic levels, pulling CMBS origination down with it. Transaction volume should slowly rebound as the Fed finishes hiking and downshifts their rhetoric, which suggests improvement could come by early fall. CMBS spreads of lower-rated tranches have likely hit their cycle wides, outside of office-heavy deals, and should pull tighter as the environment becomes more constructive through year-end.
Calling the top in ‘BBB’ spreads
Across CMBS and CRE CLOs, the credit curve has been steadily widening since the Fed began raising rates in March 2022. Spreads for lower-rated classes have gotten so wide that new deals are either not pricing those classes or are pricing them at spreads that push them into double digit yields of 11% to 14% (Exhibit 1). New issue conduit spreads across B to E classes illustrate the steepening, with the ‘AA’ and ‘A’ B and C class spreads off their recent wides, while the ‘BBB’ and ‘BBB-‘ D and E classes continue to touch new wides or are not issued at all.
Exhibit 1: AA to BBB-rated new issue conduit spreads at pricing
Note: Conduit classes B through E are typically rated AA to BBB- at origination. Spreads are either to the Treasury (J spread) or SOFR swap (P spread) curve. Source: Bloomberg, Santander Capital Markets US
Investment implications
- Assuming the Fed ends its hiking cycle at 5.50%–a big assumption—lower-rated CRE credit spreads should have hit their wides for this cycle. There is a lot of bad news priced in, and the market should begin to stabilize and recover through the second half of 2023.
- Rates in the long end have already rallied 25 bp over the past week on the chance that the Fed will be done at 5.50%.
- Investors should go down-in-credit and extend in duration in CMBS. Target a holding period of at least 18 months, just in case the Fed does hike to 5.75% before year-end.
- In CRE CLOs it is better to target lower-rated classes of seasoned deals in the secondary market, where full extension is two years or less. A lot of loans in these deals are struggling due to the rise in floating rates and the exceptional increase in the cost of interest rate caps, but are not fundamentally distressed. The 2019 through 2021 vintages, particularly those with heavy multifamily exposure, also have a buffer of property price appreciation that should allow them to find new financing options.
Caveat office: Possibly not at the wides are any classes already on rating agency lists for potential downgrades due to high office exposure. Tread carefully there.
Property prices ex-office should stabilize by year-end
Property prices will take the longest to show stabilization, primarily because they tend to be a lagging indicator of the CRE market. Price indices based on closed transactions peaked in June of 2022 (Exhibit 2), months after the market began to soften and the Fed was already raising interest rates. Multifamily and office properties are in negative territory: down by 3.2% and 1.7%, respectively, on a year-over-year basis as of the end of the first quarter of 2023, the last quarter for which complete data is available. From the June 2022 peak, multifamily prices have fallen by 9.1% and office properties are down 5.3%. Data available so far for the second quarter indicates these price declines have deepened, despite very low transaction volume and exceptionally few distressed sales.
Exhibit 2: CRE price growth has been decelerating
Note: Year-over-year changes in CoStar repeat sales indices by property type. Indices are equal weighted, data is quarterly through March 2023. Source: CoStar, Santander Capital Markets US
Projected trends for multifamily for the second half of 2023
- Multifamily property prices will likely continue to decline through the third quarter of 2023. The original projection for 2023 was for prices to fall 12% to 15% from their peak. That remains the base case, with more weight towards a 15% decline given the higher than expected terminal funds rate.
- Multifamily cap rates were projected to rise to the range of 6.0% to 6.5%, which has so far been dead on (and also a no-brainer, so there are no presumptuous bows over here). Average cap rates for the most recent multifamily transactions have now touched 6.2% according to CoStar data, and 6.5% remains the target. For a complete overview, see Cap rates rise as commercial real estate sales crater.
- If the Fed makes the July rate hike to 5.50% their last, and backs down on the saber rattling that contributes to market volatility and investor anxiety, property prices broadly should begin to stabilize before year-end, and could begin notching modest gains by the first quarter of 2024.
The workout in office will take much longer. Prices could fall through 2024 and into 2025 as problematic or delinquent loans progress through special servicing and bank workouts, and distressed properties finally clear the market.
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