Lenders Press Forward, but Outlook for CMBS Remains Reserved
Carl Gaines Sept. 7, 2012, 8:30 a.m.
Commercial real estate lenders are growing more confident, or at least more inclined to resume risk-taking. Bucking headwinds from the weaker economy and job market, underwriting standards for loans on well-positioned assets eased in the second quarter and through the summer. Competition to fund high quality borrowers showed increasing spillovers from the febrile apartment sector, with a small but growing number of development projects and cash-out refinancings registering alongside new office, retail and hotel mortgages.
From the vantage points of operating, investment, and lending, apartments continue to set the high bar. Long-term fixed-rate financing for stabilized apartments fell to a national average of 4.0 percent in the second quarter, the lowest on record. For larger and higher quality assets, rates lower. In New York and Washington DC, in particular, the prevailing notion that lending spreads are in line with historically supportable levels is being tested. As risk-free rates skirt bottom, we should expect a far-sighted market to offset with wider cushions. For some lenders, competitive pressures from peers and from the sector-dominant agencies are clouding the long view and limiting risk-based pricing power.
Short-term risk metrics reflect the apartment sector’s strong cash flow momentum. Even as debt yields inched lower, the combination of cash flow gains and lower rates allowed debt service coverage to improve slightly in the second quarter. But more comfortable measures of term risk belie the elevated maturity risk embedded in the most aggressively priced loans. Too many loans in the second quarter assumed a “new normal” in the interest rate environment while also affording a healthy uptick in cash flow growth.
Baseline projections for interest rates anticipate ten-year treasury yields in the vicinity of 4.5 to 5 percent when today’s new permanent financings mature. In a moderate economic growth scenario where the economy expands below its potential rate, that is a reasonable working assumption. Even though treasury yields have generally been falling for more than three decades, they were fairly steady at just below 5 percent in the years leading up to the financial crisis. However difficult to imagine today, higher rates will be even more difficult to digest at refinancing, in particular for the rising count of apartment loans with up-front interest-only periods.
The lender landscape is not as sparsely populated as it was a few years ago. Banks with healthier balance sheets and even healthier regulatory relationships are continuing to support their legacy borrowers’ needs and are slowly engaging new business. Underwriting standards suggest that banks are betting the economy will strengthen, though bets are being hedged on the rising tide lifting value-add assets. Life companies are dominating opportunities to fund large loans for public REITs and other liquid borrowers. The agencies are ceding some share of apartment lending but have seen the absolute volume of their apartment lending programs hold steady or increase.
The CMBS outlook is less sanguine, principally as a result of bond investors’ shifting tastes and tolerances. Securitization volume inched up just 6 percent in the first half of 2012, though the pace has improved with third quarter deals through mid-August pushing volume closer to $25 billion. There are currently eight deals on track to price in September and October, with a projected average pool balance in the range of $1.2 billion. On its current trajectory, issuance will fall short of $40 billion in 2012, up from last year but still just a fraction of the market’s potential.
Even as some master servicers struggled with excess capacity, limited CMBS volume is supporting a rally in bond prices. After widening unremittingly over the course of the second quarter, spreads have narrowed in the weeks following the most fretful moments of the sovereign bond crisis, when corporate spreads opened up. For the time being, the more recent improvement in CMBS trends is being read as a signal of the market’s appetite for more.
It remains unclear how much spreads will widen if volume picks up or the European dilemma reasserts itself in force, requiring higher yields from all risky investments. Europe’s current détente has come too late to stave off recession in the United Kingdom and on the Continent. The semblance of a return to order will give way yet again if German ordoliberalism and demands for austerity do not bend for its restive and increasingly unemployed neighbors.
Current assumptions could also be upset if conditions in Europe improve substantially. Rock bottom treasury yields reflect global risks and are not a vote of confidence in American fiscal policy under either presidential election scenario. The Fed’s readiness to accommodate is not in question; but monetary policy will strain to hold long-term rates anywhere near current levels if investors’ perceptions of global risk improve.
The vagaries of the bond market and the ever-present potential for disruptive reforms are not the only qualifiers to the CMBS outlook. For investors in search of diversification, the overweighting of pools to anchored and unanchored retail properties is also a consideration. If conduit lenders had perfect foresight into the long-term performance of their originations and if the ratings models were equally prescient, the underwriting standards would adjust in kind to reflect the risks of each retail loan.
In practice, investors that have been active in buying recent CMBS may wary of the idiosyncratic risks associated with overexposure to the retail sector. By dollar volume, almost 40 percent of second and third quarter CMBS was in the retail sector. Diversification into apartment loans might enhance the investment attractiveness of new deals, but conduit lenders are not typically positioned to compete with agency lending and the advantage conferred by the guarantee.
Pricing in early August, a $1.3 billion Deutsche Bank and Cantor Fitzgerald deal offered investors an opportunity to diversify their new issuance holdings towards office exposures. Less than one in four dollars was backed by retail property income, one of the smallest shares of any deal this year. If the conduit is to reassert itself in force, it will have to follow that lead and stave off its recent niche persona.
Sam Chandan, PhD, is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at firstname.lastname@example.org.