CMBS delinquencies edge up in October

The delinquency rate on commercial-mortgage backed securities jumped slightly in October, but the story continues to be that bubble-era loans backing CMBS are being refinanced and paid off, Morningstar Credit Ratings reported.

The delinquency rate increased two basis points to 3.51 percent, but remains 64 basis points below the level of one year ago, Morningstar reported.

Analysts have been concerned about a wave of highly leveraged loans in CMBS that were originated during a period of looser standards between 2005 and 2007.

In its latest surveillance report, however, Morningstar said that the principal balance of CMBS declined by $9.97 billion in the month, an indicator that payoffs on 2005-to-2007 era loans are picking up.

The delinquent balance fell to $27.67 billion in October, down 13.6 percent in one year, Morningstar reported.

Commercial Real Estate Property Brokers Experience Profit Drop as Market Slows Down

Commercial Property companies are starting to experience decrease in their profits as the commercial real estate market start to lose its heat.

According to Bloomberg.com, CBRE Group Inc. and Jones Lang LaSalle Inc. experienced their biggest loss since 2011 due to difficulties in equities. The loss brought a 14% drop for CBRE Group and 16% for Jones Lang LaSalle. HFF Inc. dropped with 20% in August while Marcus & Millichap Inc. dropped with 17%.

The possible further decrease in real estate transactions is raising concern among big brokerage firms that their profit will also decline together with the transactions. The possible drop in profit might cause for the firms to lease their properties instead of selling them.

Brad Burke, analyst at Goldman Sachs Group Inc., said that the profit growth at the companies "is in the rear- view mirror at this point. This is a natural maturing of the real estate cycle."

According to Real Capital Analytic Inc., commercial real estate transactions in the U.S. increase with 23% during last year's second quarter. Major several sales made early last year had "front- loaded" the first half volume of $255.1 billion. Two industrial portfolio were included in the transaction, namely Manhattan's Waldorf Astoria Hotels and Willis Tower in Chicago.

Sam Chandan, founder and chief economist of Chandan Economics, said that "We have had a very rich transaction market for some time, so the rate of growth in activity has necessarily begun to taper off. It's not the kind of growth we saw when we were coming off the bottom."

According to ChicagoBusiness.com, a quarterly report from Federal Reserve Data revealed that "the expansion in real estate lending is slowing." A 2.7% increase in outstanding commercial- mortgage debt in 2013 was observed and it raised again by 4.2% last year.

Various factors affect the slowdown in commercial property market business. Some of those factors were a strong dollar's effect non- U.S. profit, drop in oil prices that causes decrease in real estate demand "energy hubs" such as Calgary and Houston.

Commercial real estate market getting overpriced

The commercial real estate market is shifting to an overpriced market, especially for core properties in the top markets, said real estate research firm Situs RERC, in a second-quarter report issued Tuesday, August 18, 2015.

“In the previous cycle (that ended in 2008), prices increased over true values by more than 50%, and it would not be surprising to see something similar in the current cycle,” the report said.

Commercial real estate transaction volume rose 23% for the year ended June 30, the report said, citing data from research firm Real Capital Analytics. Prices increased on a year-over-year basis for four out of five property types: up 10% for the industrial sector, 11% for both retail and apartments, and 19% for the hotel sector. Office prices were flat during the period.

Overall, commercial real estate value was higher than property prices in the second quarter, with a rating of 5.2 on a scale of 1 to 10, with 10 indicating excellent value compared to the price. Apartment and hotel sectors are somewhat overpriced with price ratings below 5, with apartments at 4.6, the same rating as in the first quarter and the second quarter of 2014, and hotels at 4.8, down from 5.4 in the first quarter and 5.7 in the second quarter of 2014. Retail was the only sector with an increased value vs. price rating in the second quarter, up to 5.5 from 5.1 in the first quarter and 4.9 in the second quarter of 2014.

Soaring CMBS spreads highlight new risks on both sides of the Atlantic

Widening CMBS spreads on both sides of the Atlantic reflect an uptick in supply but also highlight that investors are increasingly wary of the latest structures and collateral, and are demanding higher compensation as a result.

Data show US spreads have widened to their highest levels in almost two years, while the latest pricing from Europe - Deco-2015 Charlemagne, a multi-jurisdiction deal - illustrates that issuers need to pay hefty premiums to place non-Triple A bonds.

Market sources told IFR this reflected heightened investor awareness of the risks ratcheting up in CMBS deals. "Complexity is creeping back into the structure and the general quality of the collateral has been deteriorating," a European investor said.

After the financial crunch, European issuers soothed investors with straightforward structures, simple collateral such as German multi-family properties, and strong sponsors. But over time they slowly reinserted risk into the deals - with weaker sponsors and secondary/tertiary properties.

"The first post-crisis issues were really investor-friendly, but this is becoming less and less the case now, which is causing investors to take a step back," one investor said.

US conduit CMBS spreads on new-issue deals rated Single A- rose as high as 275bp in July from as low as 190bp in April, according to Morgan Stanley data. The last time spreads in the middle of the capital structure were this wide was the third quarter of 2013, according to JP Morgan data.

Another factor pushing pricing power back into the hands of investors is that issuers that exclude unfavourable ratings on lower-rung tranches end up paying for it. They are able to demand beefier margins for tranches that fail to get solid ratings from at least one major agency, according to Bank of America Merrill Lynch analyst Alan Todd.

Investors Less Naive

That trend, which Todd said had now more clearly crystallised since mid-May, might indicate that investors are less naive about the quality of the underlying collateral.

The fact that, contrary to other asset classes, the CMBS segment has not bounced back from heightened global economic uncertainties - specifically negative Greek and Chinese headlines in early summer - would appear to confirm this.

With Greek debt woes on the backburner, CMBS spreads have continued to languish at wider levels. Growing concerns over real estate loan underwriting standards could explain this, one investor at a New York-based asset manager said.

"I continue to be surprised by what I see getting underwritten."

The US investor said the continued onslaught of new deals had also kept pressure on spreads. CMBS issuance of US$71bn this year is running 26% higher than the same period of 2014, according to Bank of America Merrill Lynch data.

The European primary has also witnessed a surge in supply - with two deals pricing in the same week for the first time since the crisis. Deutsche Bank had to pay plus 525bp on BBB-/BB bonds and plus 425bp on BBB+/BBB notes at the end of July to place its Deco-2015 Charlemagne deal - 145bp more than initial talk.

Single As were also priced significantly wider to initial levels, at 290bp against 220bp.

While the two bankers blamed the painful results on general market weakness and mounting CMBS supply, the European investor was more suspicious, saying: "Investors may not want to spend their time taking a long hard look at CMBS structures and collateral that have wrinkles in them." 

High Leverage for Apartment Loans Troubles Moody’s

With prices so high for apartment properties, any loan based on today’s appraised values is going to look very large compared to historic prices. But multifamily CMBS loans are especially troublesome, according to Moody's Investors Service.

“The credit quality of U.S. conduit/fusion commercial mortgage-backed securities (CMBS) continues to deteriorate, with conduit loan leverage in the second quarter pushing past its 2007 peak,” reads a July report from Moody’s.

These loans may look relatively modest compared to the appraised value of the apartments properties now. But if prices were to fall, a number of these loans might be in serious trouble. Lending experts argue that problems may be mitigated by stronger loan underwriting standards overall. Also, property prices may have even more room to rise relative to the income from apartment properties, and don’t have to fall anytime soon, as interest rates creep upwards, according to some apartment experts.

“Lenders are holding to pretty good underwriting standards,” says Bill Hughes, senior vice president for Marcus & Millichap Capital Markets. For example, lenders still resist to the urge to offers loans with interest-only periods longer then a few years, unless the loan is relatively low leverage, covering less than 60 percent of the property’s appraised value.

Moody’s: Underwriting way past the peak

The average CMBS loan was equal to 117.8 percent the value of the property in the second quarter, as measured by the Moody’s loan-to-value (LTV) metric. That’s very high–largely because Moody’s LTV compares loans to historic property values, instead of the high values that properties are appraised for in today’s market. The average CMBS loan was equal to 66.4 percent on average of the underwritten value of its property over the same period, according to Moody’s.

“The appraisals on Q2 collateral fully reflect the run-up in commercial property prices to levels that top the pre-crisis peak, while our values use a through-the-cycle approach,” according to Moody’s.

Just to compare, in the third quarter of 2007 the average CMBS loan has an average Moody’s LTV of 117.5 percent on average of the underwritten value of its property over the same period. In response to rising leverage, Moody’s is getting tougher in its CMBS ratings, giving fewer bonds in every CMBS issue the coveted AAA rating because the rating agency expects losses.

“Loans sized to 70 percent of peak values likely will under-perform those sized to 70 percent of trough values, as can be seen by comparing loans from the 2007 peak with those from mid-cycle 2003,” says Tad Phillipp, Moody's director of commercial real estate research.

Sky-high prices

The issue of leverage affects the whole business of lending to apartment properties, not just the CMBS business, because it is driven by high prices for apartments.

Lenders are still avoiding some of the worst practices of the real estate boom, however. For example, lenders still require borrowers to show the expenses from a property on a trailing, 12-month basis, says Hughes. Also, borrowers typically can’t get away with forecasting rents that would justify a larger loan, even though the property has now history of earning those high rents.

“I’m not really seeing any of that,” says Hughes. That restraint makes measurements like a loan’s debt service coverage ratios much more meaningful today than it was during the last boom, when giant loans were made based on rosy projections of high rents and low expenses.

Even though apartment properties are selling at historically high prices, by at least one measure prices have room to rise even further. Apartment properties now sell at average cap rates of 5.5 percent. That’s 320 basis points higher than the yield on 10-year Treasury bonds. Just to compare, in 2006 at the height of the boom, cap rates were just 100 basis points higher, according to Institutional Property Advisors.

Cap rates are likely to get a little closer to the yield on 10-year Treasuries. “As investors seek opportunities in secondary and tertiary markets throughout 2015 and compress cap rates there, the spread nationwide to the 10-year will continue to narrow,” according to Institutional Property Advisors.

Interest rate outlook: Federal Reserve

The benchmark yield on 10-year Treasury bonds is also likely to stay relatively low for a long time. “Even the anticipated increase in the Federal Reserve’s benchmark later this year will likely have minimal short-term effect on long-term rates,” according to Institutional Property Advisors. That’s because the bond markets have expected the Fed to inch rates upwards for a very long time, and there is not much in the latest economic reports to pressure the Fed to act quickly. A strong dollar and low energy prices are helping keep inflation below the Fed’s target of 2 percent. “The Fed has the maneuvering room to adjust rates very slowly,” according to Institutional Property Advisors.