Is CMBS Finally Rebounding? A Panel of Experts Weigh In
Like much of the markets, commercial mortgage-backed securities (CMBS) struggled in 2020. With many businesses and economies reopening in the first half of 2021, CMBS issuance began to reemerge, to the delight of pent-up investor demand. But CMBS deals look different today. Will post-pandemic CMBS trends be short-lived or are they here to stay? Commercial real estate (CRE) experts weighed in on a recent webinar.
4 June 2021
As CMBS delinquency rates continue to steadily decline, there’s an air of optimism in the CRE community. I recently participated in a panel discussion with industry experts from UBS, the Commercial Real Estate Finance Council (CREFC) and Riverpark Funds who provided more context about the CMBS resurgence. Below are four takeaways from the conversation.
A tale of two cities: not all CMBS flourishing post-pandemic
Activity is certainly on the upswing, as issuers work through the backlog of transactions from pre-COVID-19 and get to work on new originations. Many predict 2021 could set a new record in full-year issuance. Typically, the CMBS market is dominated by conduit transactions: commercial mortgages packaged into a pool with other similar types of loans, securitized and sold to institutional investors. These days, however, SASB (single-asset, single-buyer) and CRE CLOs (commercial real estate collateralized loan obligations) are outpacing conduit CMBS.
The CRE CLO trend is particularly remarkable: Both JPMorgan Chase and Bank of America bumped up their projections for 2021 total issuance, at USD 22 billion and USD 25-30 billion, respectively. Why are CRE CLOs so popular right now? One reason is that their shorter-duration profile aligns nicely with distressed properties needing immediate financing and therefore helps to curb catastrophic losses. Another reason is that this asset class is more suited to hold loans on transitional assets (which there is an abundance of now) versus more stable assets which are more favorable for conduit CMBS. On the flip side, investors may gravitate toward CRE CLOs as they offer higher yields and provide a hedge against inflation.
Underperformance (and under issuance) of conduit CMBS is related to the challenges faced in retail, hotel and office, including those mortgages in multi-loan transactions.
According to Lisa Pendergast, executive director of CREFC, leverage on CRE CLOs is fairly low, and spreads are better than more stabilized securities that make up conduit CMBS: “CRE CLO is more of a transitional asset; I suspect it will slow as we move forward and properties begin to stabilize to pre-pandemic levels; you might see some of that CRE CLO issuance slow down and more going into fixed-rate [conduit] products.”
Chris LaBianca, managing director for real estate finance at UBS, agreed: “The harbinger of good things to come is what’s happening in the CRE CLO market; those deals have a very good chance of converting to a fixed-rate conduit.”
Varying fates based on the property type, and even among sub-property types
Compared to the same period in 2020 year-to-date, CMBS activity is up this year by more than a quarter (based on data from Finsight). But not all property types are thriving. According to Ed Shugrue, managing director and portfolio manager at Riverpark Funds, “New issuance is focused on three categories: Industrial, Life Sciences, and multi-family properties … there’s good demand, good pricing, good execution.”
Meanwhile, offices, Retail and Hotel and Leisure continue to struggle. Ed described it as a story of “haves and have-nots”: “The haves are well-leased and well-occupied offices and hotels. ‘Average’ offices pre-pandemic you would never have to think about and now you [do] … those are now trading behind your trophy assets.”
This is consistent with the issuer side, as noted by Chris. He said that there’s a bifurcation within property types. For example, for Hotels and Leisure, business travel is not going to come back as quickly as leisure travel so business hotels and convention centers won’t perform as well as resorts and similar properties. “There’s pent-up demand to get out this summer … it’s very difficult to get hotel rooms in some places already and even more difficult to staff those hotels.”
Office spaces are the great unknown at this point. According to Chris, “This is the most challenging asset class to underwrite. It’s very cloudy what return-to-work looks like … it will take time to play out; people are going to weigh tradeoffs between being in the office and working from home … making a 10-year loan on an office building today [will be difficult].”
Lisa echoed the sentiment on uncertainty around office space, noting that the office vacancy rate in Midtown Manhattan is at 20 percent, a historical high. She said that convention and conference hotels will show well over the next 12 to 18 months, but it won’t be the same for run-of-the-mill business travel. “Will you take that trip for 48 hours to L.A. if you don’t need to? I think decisions like that, on the margin, are going to significantly harm business hotels.” A major concern is inflation, she said, “[because of] all of the cash and stimulus, we’re enjoying low rates right now but we could see inflation pick up and rates rise ─ this could be a significant issue.”
No regulatory surprises expected for “safe and sleepy” CMBS
From a risk and regulatory perspective, none of the panelists felt that there would be any changes or surprises for CMBS. According to Ed, in its 25-year history CMBS has traded and performed very well ─ COVID was an anomaly. “It’s quite durable, with higher standards … we can review every single lease, 10 years of historical cash flows and expenses; that level of data and analysis … really gives the investor a significant leg up.” He also said, “Regulators are much more focused on bitcoin and cryptocurrency; CMBS is safe and sleepy.”
Lisa agreed and noted that while CMBS may have been sullied by the 2008 global financial crisis, it was the complete opposite during the recent pandemic. “We went into this pandemic with higher debt service coverage, lower leverage, increased transparency.”
Another reason for minimal regulatory attention is that CMBS makes up a small portion of the broader group of securitized products, so it has less of an impact on the investing universe overall.
ESG adds a new dimension to post-pandemic CMBS due diligence
Environmental, social and corporate governance (ESG) considerations have become even more pronounced amid the pandemic. Lisa talked about how the industry was usually comfortable underwriting office property CMBS, but that’s changed post-COVID-19; ESG adds a new dimension when evaluating CMBS opportunities. The market will favor newer buildings that are more “pandemic” ready; meanwhile, older properties will suffer. “ESG will become a core component whether you do a loan, size a loan, and it will unfortunately negatively impact older assets that need retrofitting … and for investors … their ability to buy bonds will depend on how much information we can share on the sustainability of a given asset.”
This is certainly true from the investor perspective as well; according to Ed, “There are two new checklist items ─ first, is this a COVID-19-ready asset in terms of air filtration, how they move people around, etc., and then ESG; if you can check the COVID box and the ESG box, you will take that deal versus another deal where you can’t check those boxes.”
Just like the rest of the world, there are signs of life in the CMBS markets ─ but it looks a lot different from the pre-COVID-19 era. The structure of transactions, property types, due diligence, regulatory and ESG considerations that factor into CMBS have shifted significantly. Whether these changes are short-lived or here to stay remains to be seen.
Watch the full replay of the webinar for expert CMBS insight.
Alexa has been an account executive at Intralinks since 2018. She's responsible for helping clients in the debt and equity capital markets with the secure exchange of information. Alexa manages relationships with over 200 firms, advising on deal lifecycle solutions for commercial mortgage-backed securities (CMBS), insurance-linked securities (ILS), debt private placements and other securitization transactions.