CMBS 2016 Review and Outlook

Monthly Commentary

January 04, 2017

The CMBS market was supposed to have record-breaking issuance in 2016. With risk retention looming in December 2016 and a wave of 2006 and 2007 10-year loans coming due, the CMBS market was projected to have over $100+BN in issuance during the year (the highest since 2007). But then February happened. With macro volatility in the broader markets and commodities struggling, CMBS issuance abruptly paused post the spread widening in February 2016 due to wider loan spreads and tighter lending standards. What followed was only $7BN in issuance in 2Q 2016, the lowest for any quarter since 2013.

Quarterly CMBS Issuance Volumes ($BN)

Source: Source: J.P. Morgan, Commercial Mortgage Alert

With that slowdown in issuance, the right-sizing may have ultimately been beneficial for the CMBS market. Since the second quarter, there has been a broader trend towards all-bank originated transactions, which tend to have lower leverage and more exposure to top 25 MSAs. These transactions have provided further clarity into the collateral pools, as they typically have fewer loans and more accountability from the issuer. There have also been a few proposed risk-retention transactions, in which the deal issuers have suggested a commitment to holding a 5% vertical slice of the entire transaction for at least five years. The slowing volume and a trend toward larger originators have led the CMBS market to an estimate of $60BN in total issuance for the year (much lower than initial expectations).

Since the significant spread volatility and spread widening in February, CMBS AAA LCF spreads have moved from the wides of 165/n to around 110/n today, while single A spreads have moved from the wides of nearly 500/n to 250/n today (still lagging, however, the 2015 tights of around 200/n). The bank-originated transactions have led to stronger retail interest from insurance companies and could provide a potential recipe for risk-retention compliant transactions in 2017. The number of loan originators into CMBS conduit deals has decreased from nearly 40 in 2015 to 30 in Q4 2016. The anticipation is that number will continue to fall as risk-retention makes it more difficult for smaller loan contributors to compete.

Along with lower issuance volume, one of fallouts of the spread widening we saw in Q1 2016 was the evolution of the buyer base within the subordinate part of the CMBS market. Hedge fund investors who used to be a large percentage of the BBB- space have largely been supplanted by specialized real estate investors. In the B-piece space, some of the hedge funds that were involved have been replaced by traditional special servicers or specialized real estate funds. These investors typically use less leverage and could have fewer liquidity concerns during periods of volatility.

Share of 10yr BBB-Conduit Bonds Purchased by Investor Type (%)

Source: J.P. Morgan
Note: Reflects only deals in which J.P. Morgan was involved. Specialized RE represents specialized real estate investors. Hedge fund groups include hedge funds and private equity

In the Agency CMBS space, meanwhile, issuance in 2016 was the highest on record, with new-issue volume eclipsing $100BN for the first time. Freddie Mac issuance was $50BN, while Fannie Mae was nearly $51BN, and combined issuance was 35% above their issuance numbers for 2015.For the first time, the size of the Agency CMBS market exceeded the size of the Non-Agency CMBS market in 2016 and issuance is expected to be over $100BN for 2017 as well. Compounding that growth has been the increasing percentage of Agency CMBS within the Barclays Aggregate Index as Agency CMBS has seen its exposure grow from 40bps at its original inclusion in 2014 to 66 bps today. That number is expected to continue to increase as the FHFA has kept Fannie Mae and Freddie Mac’s cap unchanged for 2017 at $36.5BN.

Annual Agency Issuance

Source: Wells Fargo

In terms of performance, Agency CMBS spreads also widened in the beginning of the year but have since tightened to levels last seen in Q3 2015. A positive trend for Agency CMBS is that while Non-Agency CMBS balance sheets for dealers continue to shrink, balance sheets for Agency CMBS have remained relatively flat and are expected to increase over time. Furthermore, as the Liquidity Coverage Ratio compliance requirements continue to step up (banks will need to be 70% compliant by the end of 2016 and 100% compliant by the end of 2019), banks will continue to receive favorable capital treatment from Agency CMBS. In fact, according to the financial data provider SNL Financial, US Banks have increased their exposure to $179BN in Agency CMBS securities as of Q2 2016 vs. $24BN at the end of 2011. These tailwinds are likely to continue to support the Agency CMBS market.

CMBS Primary Dealer Balance Sheet

Source: Federal Reserve Bank of New York

In terms of CRE fundamentals, net cash flow (NCF) growth for most property types continues to be modest but steady. NCF for retail and office properties grew by 2% on average during 2016, while industrial and multi-family outperformed with nearly 4-5% growth. One area of the market that has seen weakening are hotel properties in major MSAs. NCF growth was -2.2% for full service hotel properties in 2016, the first time since 2009 we have seen negative revenue per available room (revpar) growth within the hospitality space. Part of the lower cash flow growth has been due to increased construction within the hotel space, particularly in a few MSAs such as New York and Miami. The strength in the U.S. dollar has also hurt hotel markets that have higher exposure to foreign travelers.

Looking forward to 2017 NOI growth prospects, most property types will be supported by limited construction, except for the multi-family space in certain MSAs. Much of the construction has been limited to markets that have seen significant employment and population growth since the crisis, but 2016 will be the third consecutive year where net completions have exceeded net absorption within the multifamily market (the MF market also had four consecutive quarters of slowing effective rent growth). There also has been recent construction within the industrial space, but most of the supply has been limited to larger MSAs in which industrial properties have had significant recent revenue growth.

From a macro perspective, U.S. commercial real estate continues to see strong net demand from foreign investors. There was $59BN in CRE acquisition volume by international investors in 2016. This was nearly 20% lower than the 2015 level but still high on a historical basis. Foreign investors have demonstrated a strong preference for top-tier cities, partially leading to the significant outperformance of those markets over the last four to five years. They also remained the largest net acquirers for U.S. CRE, leading to positive technicals for larger markets.

Cross Border Investors Remained the Largest Net Acquirers of U.S. During 2016

Source: Real Capital Analytics

That preference for larger MSAs has led to significant CRE price appreciation differences between larger and smaller markets. According to the Moody’s CPPI, CRE valuations in major MSAs are 39% above the pre-crisis peaks while non-major markets are only 8% higher than the 2007 highs. In the office market in particular, central business district (CBD) office prices are 43% above the pre-crisis peak, while suburban office properties are still 6.5% below their 2007 levels. For other property types, the valuation difference has been less pronounced, but the valuation gains have been steady. Year to date, multi-family property prices are up 10.3%, while industrial properties have similarly outperformed with 10% price growth.

In addition to equity investments in U.S. CRE, foreign investors have also shown a preference for high quality fixed rate single-asset/single-borrower (SASB) CMBS transactions, particularly at the bottom of the capital stack. The SASB market continues to grow, with over $20BN in issuance in 2016 and is now over $100BN in notional outstanding. The market has had one proposed horizontal risk-retention compliant transaction in 2016, and the credit stack within the space has remained relatively flat, emphasizing the high quality nature of the space. Looking forward to 2017, the SASB market should be able to adapt well to a risk-retention environment, considering that a significant percentage of subordinate investors within the space are buy-and-hold insurance companies and shouldn’t have significant issues holding a horizontal slice of the transaction until maturity.

When it comes to risk retention, none of the issuers that have held vertical risk-retention pieces on balance sheet have had feedback from the regulators thus far. What remains to be seen, in particular, is the potential liability risk of a horizontal risk-retention structure within the CMBS conduit market. For example, there was a conduit transaction proposed in Q4 2016 with a horizontal risk-retention compliant tranche, but the issuer and the B-piece buyer could not come to an agreement in terms of the indemnification risk for both parties. A similar issue applies to foreign buyers within the SASB space, as there is uncertainty regarding the limits of indemnification liabilities to parties outside of the US. Overall, the CMBS market has made significant strides since the beginning of the year, when there was uncertainty regarding how investors would receive potential risk-retention transactions and if risk retention would make CMBS less competitive of a lending source versus other CRE lenders. And while CMBS has certainly lost market share within the overall CRE lending landscape, the market is healthy overall with issuers open to holding vertical risk-retention pieces on their balance sheets and third-party investors open to holding horizontal SASB risk retention pieces for the life of the loan.

Another area of concern was the CMBS ‘Wall of Maturities’ and how the overall CRE market would be able to handle the significant amount of loan maturities. Due to lower rates and an overall favorable CRE lending environment, the prospective amount of maturities for 2016 and 2017 has decreased significantly to $120BN (down from $200BN at the beginning of the year) remaining to mature from the universe of 2005-2008 legacy transactions. And while the refinance rates of 10-year conduit loans have been quite high (exceeding 70%), the remaining loans scheduled to mature during 2017 face more difficult refinance prospects as there has been a pull-forward effect (i.e. better quality loans paying off with defeasance or paying off at the first open period) and thus, in a lot of times, the remaining loans are adversely selected. Nearly 50% of the loans maturing in 2017 have less than a 9% debt yield, and thus, could be affected on the margin by a less favorable lending environment.

Looking forward to 2017, the changes that occurred during 2016 could create a healthier CMBS market going forward. The levered investor base that kept spreads compressed at the bottom of the capital stack have, in large part, exited the market. Furthermore, balance sheets of dealers, which historically have been net sellers during periods of volatility, have significantly decreased as a percentage of the overall Non-Agency CMBS market and could help the supply balance going forward. Lastly, risk-retention could keep issuers more disciplined in issuing better quality collateral and reduce the number of originators making lower quality loans that find their way into the bottom portion of the collateral pool.

CMBS investors have already responded to some of these changes by showing a preference for bank-originated lower-levered collateral pools, with AAA tranches on some deals pricing 10-15 bps tighter than traditional conduit deals, while the BBB- tranches have priced 100-150 bps tighter. That’s a wider basis than previous years and that pricing power from investors hs pushed issuers to include collateral pools with a larger percentage of properties within primary markets. The downside of the new bank-originated transactions are that the collateral pools are smaller and include a larger percentage of pari-passu loans, leaving the investor more exposed to idiosyncratic property issues. However, a market that is more transparent and consistent in its issuance standards will create a longer standing CMBS market (albeit smaller) in the future.

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This material is for general information purposes only and does not constitute an offer to sell, or a solicitation of an offer to buy, any security. TCW, its officers, directors, employees or clients may have positions in securities or investments mentioned in this publication, which positions may change at any time, without notice. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. The information contained herein may include preliminary information and/or "forward-looking statements." Due to numerous factors, actual events may differ substantially from those presented. TCW assumes no duty to update any forward-looking statements or opinions in this document. Any opinions expressed herein are current only as of the time made and are subject to change without notice. Past performance is no guarantee of future results. © 2017 TCW