For securitization, the best of times may come and go very soon. Whether by the absolute yardstick of deal volume or by more subjective measures of investor sentiment, commercial mortgage-backed securities are set to wrap up their strongest year since before the financial crisis. But the bar is rather low. Heading into the fourth quarter, issuance of new CMBS had rolled past $75 billion, hastened in part by the imminent implementation of Regulation AB II. Shy of expectations set early in 2015, aggregate deal volume this year will just surpass the $100 billion milestone.
What next? Compared to post-crisis benchmarks, market participants are relatively bullish on CMBS activity in 2016, even if they are less sanguine in their reading of the broader economy. Contributors to the Urban Land Institute’s Fall 2015 Real Estate Consensus Forecast echoed the views of a broader class of economists—modest economic and job growth, a plateau in commercial real estate transaction volume, a weaker pace of asset price appreciation and a measured increase in cap rates that implies lower valuations on properties with poor management.
Barring an external shock, volume is projected to increase in 2016 even as financing activity as a whole approaches a cyclical plateau. The potential decoupling of CMBS volume from the broader market implies relatively stronger demand for real estate-backed bonds and securitization capturing a larger share of the financing pie. Those conditions are hardly assured. The qualifiers to improving CMBS activity cross a wide and sometimes contradictory gamut of risks, ranging from the extent of competition to the eventual inflexion in the business cycle.
Commercial real estate capital market conditions have changed radically since the early days of the recovery. Segments of the market that suffer undue constraints in accessing capital are few and far between, and have been so for some time. In place of the lean years, the market for institutional-quality properties now grapples with a surfeit of historically low-cost equity and debt that has played a significant role in lifting prices above fundamental value.
On the debt side of the equation, competition across different classes of lenders has coaxed an increasingly observable deterioration in loan quality. Winning deals in an environment of looser lending standards will be a pyrrhic victory for some. The alternative is unpalatable. Second-guessing prevailing standards almost certainly implies ceding near-term market share for lenders that hold their ground on underwriting.
CMBS has seen important changes in the aftermath of the financial crisis, all crafted to improve the informational transparency and symmetry of the marketplace. But in terms of fundamental structures, the basic relationships of borrowers to originators, originators to issuers and issuers to ratings and investors remain largely the same. In preserving those relationships, the market has also preserved the incentive conflicts that contributed to intentional and unintentional pre-crisis risk-taking. Underwriting standards in CMBS were tight in the aftermath of the crisis, but that reflected a predictable cyclical feature of the lending market. As the memory of the crisis has receded, the appetite for risk has returned. A resulting change in loan performance or investors’ perception of loan pool quality may well threaten demand for bonds.
The timing and impact of higher interest rates have been amongst the market’s primary preoccupations. While a December increase in the Fed Funds target seems a near certainty, it is a steepening yield curve that is ultimately of greater importance for long-term fixed-rate lenders and borrowers. On one hand, a 25 basis point increase in the target rate is easily managed. However, as the first rounds of tightening in nine years shift the interpretation of forward guidance, the market will respond with relatively larger increases in long-term bond yields. The end of deep and long-standing distortions of the cost of capital will exert headwinds for real estate asset values market-wide.
Lenders must look beyond the immediate issue of interest rates. Historically, the average expansion in the United States lasts five to six years. Our current expansion is already more than six years old; it may not feel like it in the labor market, but in terms of aggregate economic activity, we have been growing since mid-year 2009. Few lenders stress their exposures against the next contraction in economic activity. But it is there and then that the resilience of today’s CMBS lending will be put to the harshest test.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School, University of Pennsylvania. He can be reached at firstname.lastname@example.org.