The Big Idea
Out-of-consensus calls on CMBS in 2024
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 outlook for commercial real estate and performance of securitized CRE next year is unusually tied to volatility and the path of interest rates. The fundamental trajectory remains a bit grim: one of ongoing deterioration in commercial real estate. Property prices should decline further, delinquency and default rates rise, borrower equity and credit support in deals erode. But economic resilience, lower volatility and easing interest rates should eventually tip CRE performance from a rout to a correction.
CRE investors should have a few ways to add to performance next year:
- Defense wins championships
- Position for faster prepayments
- Take selected CRE CLO credit exposure
A bit of background
The specter of sticky, high levels of inflation has diminished, and fears that the Fed will raise rates again have virtually been priced out of the futures market. Market consensus on the path of short-term rates evolves with every data release, but current expectations are that the Fed will cut rates by 100 bp in 2024, beginning at the May meeting. Long rates have also come down. The 10-year Treasury rate briefly touched 5% in mid-October but has since retraced to around 4.50%.
It is worth noting that some of my colleagues take a different view of both the Fed path and longer rates. Stephen Stanley, our US chief economist, argues in this issue that the Fed still has some chance of a hike in the first half of 2024, and will not cut until the fourth quarter. Steven Abrahams, head of investment strategy, makes a case for rising term premiums next year and argues that 10-year rates will end up above their implied forward path. Both of these outcomes would put more pressure on CRE than implied by current market pricing.
Market consensus around CRE is mostly grim, with some analysts suggesting 2024 is already a write-off, and investors should plan to come back in 2025. My outlook is cautious but considerably more constructive:
- Lower long-term rates and lower volatility should undoubtably take some pressure off CRE
- Lower mortgage rates should encourage refinancing, particularly out of floating-rate loans
- Lower volatility and forward rates consistent with future rate cuts also reduce the cost of the interest rate caps that are required on most floating-rate loans
- These influences will not likely change the trajectory of rising CRE delinquencies through at least the first half of 2024, but it could lower the peak for all property types except office
- Rate stability could also lift CRE transaction volume, which could put a floor under declining prices earlier and higher than previously expected
Defense wins championships
Delinquency and default rates began rising in mid-2022 and are likely to continue rising at least through the first half of 2024. Some loan losses will inevitably accrue to issuers and sponsors, B-piece holders, and investors in subordinated tranches. The market should materially improve in the latter half of 2024 even if delinquencies continue to tick a bit higher.
The bulk of CRE exposure that could potentially destabilize markets is actually held by banks and specialty finance companies. Headline risk is real, and CRE securitized product spreads may have not peaked if a handful of community or smaller regional banks implode due to losses in their loan portfolios. But those risks are isolated and should be easily contained. Securitized investors across the risk spectrum can avoid most of the pitfalls by playing good defense.
Investors who want to mitigate credit risk can find better relative value in a few pockets:
- In agency CMBS from Ginnie Mae and in the fully guaranteed classes, DUS pools or participation certificates from Fannie Mae and Freddie Mac
- In ‘AAA’ tranches with short weighted average lives off CMBS or CRE CLOs—although minimize exposure to office, which will likely be on its own downward path for another two to three years
- Adjust duration as appropriate, but shorter weighted average life positions should benefit most when the Fed begins to cut interest rates and the yield curve steepens; these include the front sequential classes of new issue Ginnie Mae project loans and the A1 classes of Freddie K-deals
Position for faster prepayments
Prepayments in some corners of CMBS should pick up. In particular, pressure from interest rate cap replacements should augment traditionally fast floating-rate loan prepayment speeds. Investors can capitalize in a few areas:
- In CRE CLO floaters trading at a discount
- In seasoned floating-rate deals and SARMs from Freddie Mac and Fannie Mae, particularly those from mid-2020 through mid-2022; these were issued at discount margins from 18 bp to 50 bp. Current discount margins range from 75 bp to 80 bp, which has resulted in a lot of seasoned deals and pools trading at up to a 2-point discount
Exhibit 1: Performance across all CRE CLO collateral has been deteriorating
Note: Data thru 10/1/2023.
Source: Intex, Santander US Capital Markets
Take selected CRE credit exposure
Investors willing to strategically take on credit risk for additional yield should find good value investing at the lower end of the capital structure alongside CRE CLO sponsors who already have such a track record of performance.
- Invest in sponsors with better-than-average credit records. Argentic, for example, an affiliate of Elliott Management Corporation, has been a consistent sponsor of CRE CLO deals since its first issue in 2018 (AREIT) with $3.7 billion of collateral across six deals currently outstanding. Despite having some payment defaults at the onset of the pandemic, the troubled loans were relatively swiftly worked out, the loans were paid off, and the deals have incurred no losses (Exhibit 1). Overall, Argentic’s deal performance is considerably stronger than that of CRE CLO collateral in general with minimal delinquencies outside of the period affected by pandemic. Invest down the stack in Argentic ‘BBB’ or below, or from other sponsors with better-than-average performance and a substantial track record.
Exhibit 2: Argentic performance has been mostly stronger than average CRE CLOs
Note: Data thru 10/1/2023.
Source: Intex, Santander US Capital Markets
The flip side of going down the credit spectrum with outperforming sponsors is staying at the top of the stack in deals and with sponsors who have hit a few bumps. Their ‘AAA’ classes still have plenty of subordination, but they trade wide of other sponsors with cleaner collateral.
- ReadyCap (RCMT) is a CRE CLO sponsor with a consistent history of issuance, 11 deals with $5.5 billion currently outstanding, and a long track record of performance. Performance has been a bit worse than the average across all CRE CLO collateral, including ReadyCap taking a modest loss in a 2019 deal (Exhibit 3).
- Delinquencies have been ticking higher across all CRE CLO collateral to about 2% of UPB outstanding, while ReadyCap’s delinquency rate has recently been running at about twice that at 4%. During the peak of the pandemic, ReadyCap’s delinquency rate briefly rose above 10%, compared to 2.25% across all collateral.
Exhibit 3: ReadyCap deal performance has been a bit worse than average
Note: Data thru 10/1/2023.
Source: Intex, Santander US Capital Markets
The commercial real estate market is in for a bumpy ride in 2024, but it’s also full of opportunities. Moderating inflation and a Fed that turns the corner from tightening to easing could provide much needed stability to a market that’s been struggling for over a year.
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