Rating Agency Mavens Weigh in on What 2019 Holds in Store for CMBS

Commercial Observer: What were the key CMBS trends in 2018? Did anything surprise you?
HS: CMBS performance has been what we expected this past year: stable overall with pockets of concern. We expect more of the same in 2019. Retail remains the most problematic of CMBS property types with Fitch placing a negative rating outlook on many lower-rated tranches of retail-heavy deals. These tranches will be tested as the loans approach maturity. We are also focused on multifamily and hotel properties, both of which are at performance peaks and have the potential to reverse course if the economy sputters. Additionally, new office construction will contribute to higher vacancies and minimal effective rent growth.

What are your predictions in terms of 2019 CMBS and CLO issuance, and what will be the key drivers of that issuance?

ZL: We project approximately $90 billion in non-agency CMBS issuance for 2019, which is in line with 2018 levels. That said, conduit issuance may decrease due to lower maturing volume and competition from other lending sources. Additionally, CRE CLO issuance will increase based on demand for floating-rate paper.

DBRS
Erin Stafford, Managing Director and Head of North American CMBS

What were the key CMBS trends in 2018? Did anything surprise you?
CMBS issuance in 2018 was slightly down in 2018, which was consistent with expectations at the beginning of the year. However, the market saw Single-Asset Single-Borrower (SASB) issuance overtake conduit as volume of the latter pulled back, which was a surprise. Although bankruptcy filings by large retailers were in the headlines, the CMBS default rate continued to push lower. While this is somewhat counterintuitive, the strength of the economy continues to keep most properties above water, for now. Another area that ran counter to expectations was that originations of loans on regional malls ticked a bit higher as the market becomes more comfortable in drawing a line between tier-1 properties that have lower near-term risk versus lower quality assets.

What are your predictions in terms of 2019 CMBS issuance and what will be the key drivers of that issuance?

Indications from originators point toward a slower start in 2019 for conduit, but that should end up tracking 2018 volume to slightly lower. Conduit volume remains low due to intense competition in 10-year fixed-rate product at a 60 percent-65 percent leverage point. If conduit lenders adjust standards to accommodate increased leverage, borrowers may favor CMBS compared to other lending products.

The trend of increasing rates will continue in 2019. This may push some borrowers to eschew shorter-term floating rate loans and try and lock in long-term fixed rate debt. However, two factors may push conduit originations lower. The sharp reduction in lending in 2009 means that the volume of loans needed refinancing will be lower. In addition, the trend of rising interest rates may dampen acquisition volume as borrowers reduce expectations for real returns going forward.
Agency issuance should remain flat year-over-year. Trends have pointed to an improvement in the national homeownership rate; but rising interest rates will continue to reduce affordability in this sector, making renting the best option for many Americans. SASB issuance is at an all-time high as a percentage of issuance; however, much of the gain was in larger floating-rate refinance transactions driven by spread compression and M&A activity such as Brookfield’s recent acquisitions. It is uncertain whether these trends will continue going into 2019; but DBRS does not expect higher levels of SASB issuance next year.”

What can we expect in terms of CLO issuance volume in 2019?
There will likely be increased issuance in the CRE CLO space in 2019; but this may also come with increased risk. The large number of new entrants in the transitional space has significantly increased competition for loans. This is analogous to 2015 in the conduit space when the volume of lenders was more than 40, which significantly increased competition for loans and raised investors’ concerns about underwriting quality. While banks may retreat from transitional lending as a result of the capital requirements that they must hold, these new lenders are rapidly filling the gap. At the same time, borrowers may be taking on additional risk in order to generate similar returns as in the past. Toward the end of 2018, the market saw more loans that have higher execution risk, including construction risk. This trend may continue into 2019. There is increasing concern among market participants about a ‘race to the bottom’ with regard to credit standards, especially by new lenders seeking to establish a foothold.

Kroll Bond Rating Agency
Larry Kay, Senior Director of CMBS Surveillance

What were the key CMBS trends in 2018? Did anything surprise you?
The underlying convention is that when the Federal Reserve’s monetary policy becomes less accommodating, it’s a sign of a strong economy that could withstand some liquidity contraction. Although, the Fed’s rate increases do not appear to have had a meaningful impact on the economy, it does seem to be influencing investor and borrower preference for CMBS shorter-term, floating-rate debt. While the desire for floating-rate paper did not surprise us, the extent of it did.

We thought more borrowers may have wanted to lock in rates considering their recent upward movement, hints of higher inflation and property prices that appear to be nearing a peak. Of the single borrower deals year-to-date November 2018, 76 percent of it consisted of floating-rate paper compared to 57 percent in 2017. The preference change could be due to that with increased market volatility and rising interest rates, a shorter time horizon is desirable to gauge the economic and commercial real estate climate.
We also saw a rise in interest-only loans with full-term interest-only loans leading the charge, as well as KBRA’s capitalization rate which increased to 9.36 percent from 9.23 percent in 2017. Year-to-date, the average proportion of loans secured by assets situated in secondary and tertiary market exposure rose by 570 and 70 basis points, respectively, which likely influenced the rate increase.

What are your predictions in terms of 2019 CMBS issuance?
We expect that single-borrower (SB) deals will be relatively in line with the low end of our current 2018 forecast of $35-40 billion, but conduits will experience a year-over-year decline again in the coming year to $30 billion from our 2018 forecast range of $35 billion to $40 billion. Some of the key drivers for SB issuance in 2019, we believe are similar to those in 2018 including the desire to participate in trophy properties, and a single or few assets which enables investors to better understand the quality of the collateral. In addition, investors may also want SB floating-rate paper to take advantage of rising rates/yield, as well as shorter duration periods which are less sensitive to interest rate increases, potentially limiting bond price declines. We expect conduit issuance to decline in 2019 due to fewer loan maturities, a competitive lending environment, and a continued rise in the ten-year treasury rate which could further dampen the attractiveness of loan refinancings.

What can we expect in terms of CLO issuance volume in 2019?
Considering the number of lenders that have entered the segment, as well as continued investor demand for higher yielding, floating rate paper, we are projecting that we will continue to see robust CRE CLO issuance in 2019. This year, CRE CLOs are expected to almost double 2017 levels of $7.7 billion to end 2018 at $15 billion. We are forecasting that next year issuance will be fairly flat due to a number of factors including a smaller number of new entrants to the sector, as well as the challenges with sourcing loans, which have experienced declining margins in 2018. The health of the economy and real estate markets will have a strong influence on CRE lending, but probably more so for CRE CLOs since a majority of the collateral securing the loans are on transitional non-stabilized properties.

Morningstar Credit Ratings
Kurt Pollem, Managing Director

What were the key CMBS trends in 2018, and what were some of the surprises?
In our view, one of the key CMBS trends in 2018 was the shift in issuance between conduit/fusion transactions and CRE CLOs. Fixed-rate conduit volume is on track to decrease from 2017, while CRE CLO new issuance has more than doubled since then.

Another key trend in 2018 continues to be property type composition and performance in securitized loan pools, with the spotlight continuing to shine on the retail sector. Driven in part by ongoing retail weakness, especially in shopping centers with exposure to troubled tenants, the volume of servicer watchlist loans continues to grow. And although CMBS retail property performance has been deteriorating, the resilience of the sector has been a surprising trend this year. Larger retail loans that transferred to special servicing during 2018 included a mixture of tenant bankruptcies, such as Bon-Ton department stores and Tops grocery markets, and secondary/tertiary market enclosed malls that had long been expected to default.

Countering this have been retailers back-filling the empty space. For example, the list of bidders for Toys “R” Us properties demonstrated that several local chains (Scandinavian Designs and Ollie’s Bargain Outlet, for example) needed space to expand into new markets. Moreover, we were impressed by the short lease-up time for many vacated retail spaces.

What are the prospects for CMBS issuance in 2019?
Conduit fusion transaction volume will likely continue to level off or even decline into 2019, influenced in part by low refinance activity. CMBS lenders still face strong competition—not only from each other but also from both traditional balance sheet lenders, such as banks and life insurance companies, and now the growing nonbank real estate finance businesses. As interest rates have been rising, there has been mounting debate as to whether rising borrowing costs will slow new issuance. However, the greater threat might be a slowdown in U.S. economic growth. A growing chorus of market participants are wondering not if but when the U.S. economy will slow, filtering down to commercial real estate.

Single-asset or single-borrower volume has been robust in 2018, stimulated by acquisition activity. Because commercial property sales activity has slowed, 2019 SASB issuance may not match this year’s numbers. Overall, CMBS private label issuance may drop below 2018 totals, reaching only $70 billion in 2019.

What can we expect in terms of CRE CLO issuance volume in 2019, and what’s driving the market’s expansion?
Barring any surprise credit market disruptions, we anticipate next year’s CRE CLO issuance to meet or exceed 2018’s volume, putting it at about $25 billion in 2019. The fundamentals behind the growth in CLOs remain positive. A volatile and rising interest rate environment creates sustained demand from investors for floating rate, short duration paper that still offers a yield increase over traditional CMBS. Typical corporate CLO buyers may also find CRE CLOs attractive from a relative-value basis and for diversification of their existing portfolios.

From the issuers’ perspective, CLOs offer another financing vehicle for their transitional loan business outside of traditional credit lines and repo facilities, with competitive pricing that allows for match-term financing as well. Fueling the entire CLO machine are borrowers’ appetites for bridge loans, as they opportunistically acquire properties with plans to increase net operating income and value over a short-term holding period.

S&P Global Ratings
James Manzi, Senior Director of Structured Finance Research

What were the key CMBS trends in 2018? Did anything surprise you?
We expect $75 billion to $80 billion in U.S. CMBS issuance for 2019, roughly flat year-over-year compared with 2018. Economic growth and stable fundamentals should support that level of issuance, as there isn’t much in the way of maturing volume to speak of. We expect the single borrower sector to account for about half of the volume again next year, as it did in 2018, up from roughly 40 percent in 2017 and 30 percent in 2016. The level of growth of the single borrower sector over the past few years came as somewhat of a surprise, especially for those of us who have been around since the [2000s], when it was a much smaller percentage of issuance! Market dynamics will continue to drive the decision to either include pari passu pieces of larger loans in conduits, or not.

What are your predictions in terms of 2019 CMBS issuance?
Credit trends we’re watching include the ongoing evolution of retailers’ business models, single-tenant suburban office exposures, and the length of the hotel market cycle—as occupancy is at a historical peak, supply is increasing, and revenue growth is slowing in some locations. Overall, however, we believe that CRE sector fundamentals remain generally stable, and absent a considerable external shock, rating activity should continue to remain stable in 2019.

What can we expect in terms of CRE CLO issuance volume in 2019? What’s driving the market’s expansion?
CRE CLOs should be flat to slightly up in 2019, in our view.