After a difficult year that saw loan volumes plummet, the fortunes of commercial mortgage-backed securities (CMBS) are on the rise. Despite continued pandemic-fueled confusion surrounding new variants, lenders have become increasingly comfortable transacting on most property types, and are helped by the reopening and rebounding economy.
This, in turn, will again make it possible for commercial mortgage brokers to secure financing via the CMBS route. Expect positive, increasingly stable trends to continue in the coming months.
Undoubtedly, the COVID-19 crisis badly hurt demand for CMBS. According to the Mortgage Bankers Association, CMBS origination volume was down by 26% year over year in first-quarter 2021, the second-largest annual decline among major investor types after commercial bank originations. Similarly, CMBS delinquency rates for retail and lodging properties remained in the double digits this past June, Trepp reported, even as the overall CMBS delinquency rate has decreased significantly since the height of pandemic-induced distress.
That said, the outlook is improving on both the demand and supply side of CMBS financing. First, investors are showing renewed appetite for CMBS loans, which generally have a favorable view compared to other structured products in the capital stack.
Despite the improving outlook for lending and the economy, COVID-19 was a shock that affected how CMBS lenders evaluate borrowers and deal proposals. Although CMBS lenders generally showed discipline pre-pandemic, they tend to be more cautious today. Lenders are scrutinizing the primary borrowers more closely than ever. The borrower’s relevant experience within an asset type and their knowledge of a particular region are critical factors in the lending decision.
Lenders are looking for a strong credit profile, including verification that the principal borrower is of a strong character. This is often the first and most important item reviewed, followed closely by the quality and credit profile of a particular property. Generally speaking, lenders will not approve loans that exceed the borrower’s net worth, although this is a guideline rather than a hard-and-fast rule. When loan amounts get much larger or when circumstances warrant, lenders may consider moving away from this standard.
To ensure that the loans don’t fall into delinquency and the bond investors get paid, CMBS lenders are typically looking for borrowers to hold enough reserves to cover several months of debt service or as much as 10% of the loan amount. This depends largely on the risks associated with a particular property, including tenant rollover, costs to re-tenant, leverage and location.
Lenders are looking for a strong credit profile, including verifying that the principal borrower is of a strong character.
Evolving standards
Typical conduit leverage sits anywhere between 60% to 75%. The range can be broad, depends on the circumstance and reflects many factors — including property type, market, sponsorship, the leverage level of the principal borrowers, cash equity and ownership history. Typical debt yields are 7% and up. For example, 7% is often the lowest level for very strong multifamily assets in top-tier markets and debt-yield requirements increase from there. Interest rates from conduit lenders today are in the range of 3.5% to 4.25% and, for 10-year spreads, could be 200 basis points or less depending on leverage and the property-specific underwriting criteria.
Delinquency and distress metrics across CMBS are improving. Trepp’s CMBS delinquency rate continued to decline this past May with the rate posting its largest drop in three months. Following two huge jumps in May and June of last year, the rate had declined for 11 consecutive months.
Today’s conduit finance activity is busiest where the
asset performance has been the strongest: multifamily and
manufactured housing, followed closely by industrial.
Improving performance
The overall delinquency rate for CMBS loans shot up to 10.3% in July 2020 at the height of virus-induced lockdowns, Trepp reported. As of this past June, the rate had fallen to 6.1%. There were still areas of concern. Lodging and retail delinquencies remained at 14.3% and 10.7%, respectively, but the delinquency rates of office, multifamily and industrial assets were hovering near 2% or less.
Not surprisingly, today’s conduit finance activity is busiest where the asset performance has been the strongest: multifamily and manufactured housing, followed closely by industrial. Self-storage, office, retail and mixed-use properties also are back in favor as lenders aggregate loans to meet demand from CMBS bond investors.
On the multifamily side, conduits often compete directly with agency programs, including Freddie Mac and Fannie Mae. Many factors play into which path is chosen. The scales often tip differently depending on the appetite of lenders and investors, market preference and year-to-date production goals. Some private lenders offer both agency and conduit loan programs. These can give borrowers multiple options that take advantage of the natural ebbs and flows within multifamily finance.
Despite the stress caused by COVID-19, finance activity within both the retail and office sectors also continues to rebound. Lenders now have some pandemic operating history as a baseline for how these property types will perform. Retail properties that are anchored by grocery stores and pharmacies, and even those that are shadow anchored or unanchored, are experiencing relatively strong performance and have fared well over the past few months.
Likewise, multitenant office properties with limited single-tenant exposure and reasonable occupancy levels are performing well. There’s a growing openness to these deals as investors demonstrate a willingness to accept these assets. Lenders now pursue these transactions when they include well-located properties and strong sponsorships, which is a polar shift from peak pandemic times when lenders heavily shied away from these deals.
Eye on hospitality
COVID-19 hit the lodging sector the hardest of all commercial real estate asset classes — not a surprise given the sheer volume and intensity of damage inflicted once all business and leisure travel ceased globally. Hospitality is still struggling to recover, but it is starting to see signs of improvement.
In May 2021, hotels added 34,600 jobs, according to the U.S. Department of Labor. This suggests that leisure travel is bouncing back. Hotels also are demonstrating impressive declines in their shares of delinquent loans, with a year-over-year drop of about 10 percentage points this past June. As the economy continues its return to normal, delinquency rates should continue to fall.
But this is minor progress in the grand scheme of hospitality. While everyone is rooting for the economy to stay on track and bolster the recovery of hotels, it’s still predicted to be a long time before the operating performances of many assets recover.
CBRE is predicting an uneven recovery for the hotel industry over the next three years, with domestic leisure-travel destinations recovering first and business-travel destinations rebounding more gradually. The overall outlook, however, is brightening as leisure-travel volume is up and companies are starting to resume business travel.
One thing is certain with CMBS: The market reacts to interest rate changes, partly due to their impact on capitalization rates. Interest rates and cap rates significantly impact the investment-sales market, which has historically been a meaningful demand driver for CMBS loan activity.
Additionally, the industry is continuing to monitor a key structuring element as the economy recovers — the confidence of lenders to continue to relax cash reserves when appropriate. This trend is already well underway and these decisions are being made based on the individual property in question, including its type, history and other variables. And finally, eyes are on investor demand for CMBS bonds. The return of retail-property financing has been a positive for lenders looking to meet bond demand.
The bottom line for commercial mortgage brokers and their clients is that the worst of the pandemic is likely behind us. CMBS is once again a viable option for many borrowers. ●
