CMBS resilience: investors steer around slow-moving train wreck

LSEG’s Damon Caputo and Unmesh Bhide explore the new dynamics shaping the CMBS market and the strategic responses to the evolving landscape

Navigating the formidable terrain of the US commercial real estate and commercial mortgage-backed securities (CMBS) markets demands a keen understanding of the myriad challenges and opportunities that lie ahead. From the disruptive forces of e-commerce to the lingering effects of the Covid-19 pandemic, stakeholders must embrace unprecedented uncertainty.

Colliding trends

Unmesh Bhide, LSEG

The US commercial real estate market faces significant turbulence, especially in the CMBS sector, with office vacancy rates soaring to approximately 20%. While coastal cities such as San Francisco and New York draw attention, Unmesh Bhide, director at LSEG, notes that the Sunbelt region, including Houston, Austin and Dallas, is now witnessing rising vacancy rates, signalling broader market shifts.

Damon Caputo, head of CMBS valuations at LSEG, observes that the upheaval is largely driven by evolving office sector dynamics post-pandemic. “Remote work adoption has spiked vacancy rates in urban hubs, with San Francisco’s soaring from 3% to 30%,” he says.

Commercial real estate adjustments move at a more gentle pace. The retail sector, for example, is experiencing widespread transformation due to a decade’s trend towards e-commerce, a path that can act as a road map for office properties. As recession fears loom, hotels see continued recovery but retail, especially legacy malls, remains vulnerable.

Rising interest rates pose additional challenges, potentially diminishing property valuations secured during the low-rate environment of the pandemic. This contrasts sharply with the period following the financial crisis that began in 2007–08, when property values were caught in the safety net of declining interest rates. Now, with remote work and e-commerce trends compounded by rising interest rates, properties need to be revalued and reassessed based on current conditions.

Down but not out

The current situation resembles past real estate downturns, such as the overbuilding in Dallas during the early 1990s, but the response differs markedly. Unlike residential mortgages, where foreclosures lead to immediate losses, the commercial sector is employing an ‘extend and pretend’ strategy.

In this scenario, borrowers unable to secure new loans because of high vacancy rates seek extensions from special servicers. Servicers may require borrowers to deleverage using debt payment or additional investment as a condition.  

Contrary to the initial expectations of a sudden wave of loan maturities in the office real estate market, property owners are opting to extend the maturity dates of their loans, for example. Large institutional investors, who own significant office portfolios, typically extend for two to three years. This strategic move allows them to navigate the evolving market conditions and mitigate potential risks.

Hazy signals

The pricing of mezzanine and B notes, which are junior to the A notes seen in CMBS, are often assets of real estate funds, many of which are now underwater due to the current fundamentals of the office market. There has been limited price discovery from liquidations of associated assets, so the extent of the losses to investors holding these notes is unknown.

Concerns also loom over the collateralised loan obligation (CLO) market, primarily dealing with multifamily loans, especially those with transitional properties. These loans, taken at low rates during the pandemic, face challenges as initial plans falter and extensions expire. Additionally, a wave of multifamily constructions threatens oversupply in certain cities, compounding market uncertainties. Here, the interplay between stagnant rental income and escalating funding costs is squeezing property valuations. From the perspective of the internal rate of return, this compression is particularly evident among rent-controlled multifamily housing units.

Bhide remarks that, unlike in more fluid markets, appraisals are not conducted frequently in commercial real estate, making it difficult to gauge real-time property values. “Office properties, for instance, typically undergo appraisals ranging from 35% to 40%, but dispersion in valuations is often wider,” he states. This amplifies the importance of secondary effects. The departure of an anchor tenant, for instance, can send ripples through surrounding properties, highlighting the pivotal role location plays in real estate dynamics.

Uncertain future

Damon Caputo, LSEG

Caputo observes that spreads in CMBS were largely frozen throughout 2023, but began to tighten towards the end of the year, influenced by the upward trajectory of the stock market. “Though some market participants have adopted a bullish stance, it is challenging to discern genuine sentiment from mere positioning,” he says.

The collapse of Silicon Valley Bank in March 2023, along with the more recent troubles experienced by New York Community Bank, underscores the idiosyncratic risks facing the market. Regional banks’ exposure to commercial real estate introduces another layer of uncertainty, particularly regarding the timing of maturity walls. In a higher-rate environment, refinancing becomes a critical issue, with the capacity to significantly impact cashflow. The risk of a savings and loan crisis reminiscent of those in the 1990s remains if conditions deteriorate further, prompting speculation about potential government intervention.

The heavy deficits of the Group of Seven nations add to the complexity, potentially stoking supply/demand imbalances and inflationary pressures. As a result, the future trajectory of the market remains uncertain.

Slow commotion

Bhide notes that commercial real estate, historically, moves slowly. “The transition to e-commerce from 2012 to 2020 significantly impacted traditional retail spaces, with malls gradually declining,” he says. Similarly, the hospitality sector’s response to the pandemic has been gradual, with hotels making significant adjustments over longer periods of time. In the office real estate market, a measured approach to managing financial obligations amid uncertainties can be seen, reflecting a shift towards proactive loan modifications and extensions.

Understanding the gradual nature of market shifts informs LSEG’s approach to analysing trends and anticipating future developments. “We don’t just react to immediate changes but instead take a proactive stance, considering the long-term implications of evolving market dynamics,” says Bhide.

Property-specific analysis

LSEG adopts tailored, property-specific analysis, covering multifamily, commercial real estate, retail, hospitality, data centres and industrial properties. By dissecting each property type, LSEG’s evaluators gain insight into their unique characteristics and market dynamics.

For instance, in conduit deals with office properties, LSEG focuses on evaluating extension risk, aligning assessments with market expectations of two to three years. This insight assists clients in navigating the uncertainties related to loan maturities. The level of extension risk varies, depending on factors such as borrower type and property characteristics. These evaluations also take into account diverse lender profiles, as each may present unique extension risk considerations.

Similar principles apply when analysing multifamily properties and commercial real estate CLOs, where emphasis is placed on property type and loan-to-value ratios as key drivers.

Granular approach

LSEG employs a meticulous, granular analysis, scrutinising property-level details to understand micro and macro implications. This approach evaluates broader impacts across transactions, highlighting interconnectedness within market segments, including those involving multiple deals and secondary effects, such as migration up the value chain.

Noting the firm’s ability to harness vast repositories of detailed data, Bhide remarks: “LSEG is shaping the next generation of valuation models.” Partnering with LSEG’s Yield Book analytics enhances capabilities, combining macro and micro data to address market intricacies and offer timely insights.

Guiding light

As the US commercial real estate and CMBS markets stay the course in this slow-moving train wreck, investors remain agile and proactive in their approach. By leveraging granular analysis, embracing a property-by-property approach, and staying attuned to the gradual shifts reshaping the industry, LSEG provides invaluable insights and guidance to investors navigating the complexities of today’s markets. LSEG’s deep expertise and collaborative solutions empower clients to make informed decisions in an uncertain environment.

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