By Kayla Kremer, CFA, Structured Finance Research Analyst & Glen Kneeland, Structured Finance Portfolio Manager
Market participants are largely optimistic on commercial real estate fundamentals; however, macro uncertainty and political tensions are weighing on investor sentiment. Despite uncertainty and volatility in the market, we believe commercial mortgage-backed securities (CMBS) remain an attractive investment opportunity as the key themes are generally positive.
Stable fundamentals outweigh slow growth fears
The current US expansion is now the longest on record and we are experiencing late-cycle symptoms in several areas of the credit market. Today, commercial property prices, as measured by Real Capital Analytics' Commercial Property Price Index (CPPI), are 30% above their August 2007 peak. However, we believe commercial real estate remains an attractive opportunity for investors in a slow growth environment.
Commercial real estate (CRE) fundamentals remain strong with robust demand amidst limited construction. Net operating income growth is expected to remain above inflation and continued low interest rates make low cap rates look attractive on a relative basis. CMBS 2.0 performance, vintages issued post-financial crisis, is stable with delinquencies relatively muted at 0.84% overall, according to Trepp Research as of June 2019. The stable fundamental trends are expected to continue and will offer support against the developing narrative around slower growth.
Exhibit 1: CMBS conduit 2.0 loans are reporting delinquencies significantly lower than legacy
Source: J.P. Morgan, Trepp as of 7/31/2019.
Disciplined underwriting has led to a healthy outlook
Since the global financial crisis, commercial real estate fundamentals have improved and underwriting practices have become more disciplined. Loan debt service coverage ratios are over 2x. We believe this will result in low term default risk. The pro-forma cash flow underwriting seen pre-crisis has been largely absent. An increase in interest-only loans has been offset by lower loan leverage. Finally, credit enhancements are almost two times higher than legacy conduit issuance. Lower leverage, coupled with higher credit enhancements means the leverage at each tranche is also significantly lower than pre-crisis. Exhibit 2 depicts some of these trends.
Exhibit 2: CMBS conduit underwriting
|Net cash flow debt-service coverage ratio||2.05||2.16||2.00||1.38||1.47|
|Net operating income debt yield||11.4%||12.5%||11.0%||10.0%||10.6%|
|% of interest only (full or partial)||77.6%||73.9%||66.3%||85.5%||74.4%|
|Avg. AAA (junior) credit support*||21.3%||21.1%||23.4%||12.1%||12.0%|
|Average BBB- credit support||7.6%||7.3%||8.5%||3.3%||3.1%|
Source: Aegon AM US, deal documents. *Note: AAA (Super Senior) was consistently 30% over the time periods noted above.
Low net supply is supportive for the CMBS market
Net issuance of private label CMBS remains fairly light and is expected to remain constrained this year given the limited refinance volume and increased competition for loans from other commercial real estate lenders. At the same time, demand has been robust. The CMBS maturity pipeline is light because fewer 10-year loans were originated from 2009 to 2011. Given the lending landscape for commercial real estate loans is very competitive, this has been a challenge. CMBS market share is down to roughly 16% of CRE origination compared to 54% in 2007. From a technical perspective, these supply constraining factors are supportive for the CMBS market.
Exhibit 3: Private label net issuance has turned slightly positive after years of negative net supply
Source: Morgan Stanley as of 6/30/2019.
Commercial real estate fundamentals remain stable with CRE construction easily absorbed by demand, slow but positive NOI growth, and a current low interest rate environment. Since the 2008 financial crisis, CMBS underwriting has remained disciplined exemplified through higher debt service coverage, lower leverage, and increased subordination at all rating levels compared to transactions issued prior to the global financial crisis. Despite these broad positive trends, idiosyncratic risk remains a concern. It is important to remain diligent in underwriting credit risk. The credit curve is flat and investors are not being compensated to go down in credit. In conduit, we prefer super-senior AAA bonds which offer the potential for less volatility and significant enhancement against both macro and idiosyncratic events.
Exhibit 4: BBB- spreads are near four-year tights with high volatility during periods of weakness
Source: J.P. Morgan Data as of 6/27/2019.
What we like
- Single-asset/single-borrower deals with low leverage on trophy properties in primary markets
- Industrial properties with high barriers to entry or last mile locations
- Biotech lab space in life science corridor
What we're watching
- The pace of CRE property price growth is decelerating and is subject to risks from slowing NOI growth and increased supply; however, lower rates are supportive for cap rates and prices
- Rising natural disaster occurrence and the impact to CMBS exposure and rising insurance costs
- Impact of policy and regulation such as rent regulation in multifamily or local tax incentives that stimulate growth
What concerns us
- Markets exposed to industry concentration, e.g. Houston and North Dakota oil impact
- Single tenant office, particularly in suburban market locations
- Tired retail properties in areas with weak demographics (class B/C quality malls)
Property type at a glance
The future of office is changing and employees are showing an increasing preference for collaboration, amenities, and convenience. Location remains important and suburban office continues to experience weakness. Watch out for small markets, concentration risk, and single-tenant properties.
The bifurcation between the haves and have-nots in retail continues. Look for retail properties with strong, well-capitalized sponsors who are willing and able to invest in the properties. We believe the top-performing property in a given market will outperform over the long term as tenants look to locate in the highest traffic centers.
The hotel industry is highly cyclical. Certain markets are beginning to feel the effects of oversupply, particularly in the limited service sector. Remain cautious of markets with heavy supply and slowing RevPAR (revenue per available room) growth.
The industrial sector has the most positive outlook; however, not all properties are created equal. Location factors such as high barriers to entry and last mile properties, age, and clear height are important to consider for industrial investments.
There is large demand for affordable housing; however, most new supply is targeting luxury/class A properties. We remain concerned about luxury supply and are watching rent stabilization controls and the (dis)incentives it may create.
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