The Big Idea

Lessons Learned in CMBS in 2023

Mary Beth Fisher, PhD | December 15, 2023

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.

One of the reasons that commercial real estate proved surprisingly sensitive to short-term interest rates this year is the huge migration in recent years to floating-rate loans. CRE CLOs, floating-rate SASB, floating-rate agency CMBS in K-deals and SARMs all had record years for issuance in 2021 and 2022. The build-up of floating-rate loans during the pandemic not only hurt property pricing and credit quality as the Fed raced to raise interest rates, but it still stands to shape eventual CRE stabilization and recovery.

The past shapes the future

Commercial real estate fundamentals historically have reflected both inflation and the economic cycle, with only loose ties to changes in short-term interest rates. That obviously changed during the pandemic, when ultra-low short- and long-term interest rates combined with a booming economy to touch off an investment spree across residential and commercial real estate. Real estate transactions hit record highs, as did property prices and CMBS origination volumes.

The party lasted until the Fed began raising interest rates in March 2022. The CRE sales and origination cycle is comparatively long, so the peak in property prices was around mid-2022 for multifamily, industrial and retail properties and in December 2021 for office (Exhibit 1). CRE prices overall are down 12.3% from their peak, though there is significant disparity across sectors:

Multifamily is down 16.2% year-over-year
Industrial is down 6.6%
Retail property prices have declined a modest 2.1% year-over-year
And Office is down 10.6% with the steepest declines likely yet to come.

Property price declines show some signs of deceleration, but given that the peak in long-term rates was in October, prices will likely fall at least through year-end 2023.

Exhibit 1: Property prices across sectors have declined from their pandemic-driven peaks

Note: Value-weighted, quarterly indices. Most recent data point is September 2023. Data through October 2023.
Source: CoStar

The return of liquidity is essential to recovery in CRE. December has seen a mini-burst of CMBS origination but CRE sales volume remains close to multi-decade lows (Exhibit 2). Property prices should stabilize once the market finds a clearing level and investors are confident buying. This will take longer for office, which has seen a terrific decline in sales volume due to bigger headwinds, but liquidity could begin to rebound in other sectors in the first quarter of 2024.

Exhibit 2: CRE transactions spent all of 2023 near multi-decade lows

Note: Data is quarterly through November 2023.
Source: CoStar, Santander US Capital Markets

The road forward

The Fed all but said it had finished raising rates at the December meeting. Moreover, the dot plot shows 75 bp of expected cuts in 2024. The market celebration included a strong rally in equities, and a move towards a 4.00% yield on 10-year Treasuries. That’s all wonderful for putting a floor underneath CRE prices, and likely lowering the peak in delinquencies and defaults expected in 2024. But borrowers with floating-rate loans are still stuck with an index in the neighborhood of 5.40% until the Fed actually cuts rates, and that will likely happen slowly.

The fixed mortgage rate at which borrowers will be able to refinance has already come down appreciably from the October highs. If property prices stabilize early in 2024—a big if—it could provide a reasonably large exit window for strong borrowers. But delinquency and default rates are likely to continue rising through the first half of 2024, in part due to an underlying deterioration in credit quality, particularly in some multifamily properties. Agency multifamily loans, which arguably meet the most stringent underwriting standards, have seen climbing delinquency rates and a build up of loans on the watchlist (Exhibits 3 and 4).

Exhibit 3: Delinquency rates are rising for Freddie K-deals

Note: Data through October 2023.
Source: Freddie Mac, Santander US Capital Markets

Exhibit 4: A shadow build of loans on the watchlist in Freddie K deals

Note: Percentage of outstanding UPB of loans on the watchlist in Freddie K-deals. Data through October 2023.
Source: Freddie Mac, Santander US Capital Markets

The rising rates of non-performing loans is also happening at Fannie Mae and Ginnie Mae, and in non-agency CMBS and CRE CLOs as well.

The end of Fed rate hikes and relief rally in long rates will surely help buffer the CRE market next year, but it’s still going to be bumpy. Maybe the best lesson to take from 2023 is that new opportunities also may introduce new vulnerabilities.

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

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