Finance  ·  Analysis

Investors Flocked to 5-Year CMBS Conduit Loans in 2023: KBRA

Higher interest rates last year made CRE investors wary of parking their money into 10-year conduit loans


If you care about commercial mortgage-backed securities (CMBS) — and are looking for a number to lock in on in 2024 — go with lucky number five. 

A new report from Kroll Bond Rating Agency (KBRA) on metrics across the CMBS space found that five-year loans represented 45 percent of CMBS conduit issuance in 2023 and are expected to take an even bigger slice of the pie in 2024. 

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At the heart of the trend lies one culprit — interest rates. Federal Reserve Chairman Jerome Powell has forecasted at least three rate cuts in 2024 and giddy investors have already pushed yields on the 10-year Treasury rate down by 50 basis over the last month. 

“Even though the five-year loans generally have higher interest rates than 10-year loans, people don’t necessarily want to be tied into these high rates, especially as people believe these [Treasury] rates will come down,” said Roy Chun, senior managing director of CMBS surveillance at KBRA. “It’s as simple as that.”

Ten five-year conduit CMBS deals — multi-asset, multi-borrower loans — were issued in 2023 for a total amount of $8.8 billion, and two more have already been prepared in early January, according to KBRA. 

While year-end totals for 2023 CMBS issuance haven’t been widely released yet, Commercial Observer reported in October that private label CMBS and CLO (commercial loan obligation) issuance had declined by more than two-thirds from $92.3 billion in September 2022 to $30.7 billion in September 2023, with conduit CMBS issuance down 27 percent, according to the Commercial Real Estate Finance Council.

Loan-to-value (LTV) ratios also declined in 2023 for both five-year and 10-year CMBS deals. While the KBRA LTV metric on five-year deals hit 92.4 percent in 2023 (a number that KBRA calculates using higher cap-rates across the board, which ultimately draws the LTV rate higher), the more widely-used industry standard — appraisal-based LTV rates — on five-year and 10-year deals touched 52.2 percent in 2023, dropping from 53.2 percent in 2022 and 55.4 percent in 2021, according to the firm.  

“KBRA LTV is at its lowest level since we started tracking the metric in 2012,” said Larry Kay, a KBRA analyst. “I think that it’s been influenced by the market’s risk appetite being [down].”

Chun noted that besides the lower appetite for risk, the real culprit for the decline is elevated interest rates. Both the Federal Funds Rate and the 10-year Treasury Yields reached higher peaks in 2023 than at any other time in the last decade, yields that cramped the investment assumptions that most CRE borrowers and CMBS originators made on their loan terms. 

“When people issue debt, they’re looking at both loan-to-value and debt service coverage,” explained Chun. “And higher interest rates put a cap on how much proceeds you can get on the loan, so that pushes down the balances of the loan, in turn creating lower loan-to-value ratios.”   

One place weary CRE investors have moved in the last year has been into the interest-only loan space. Full-term, interest-only loans — where borrowers pay merely the interest each month and the principal is paid at term, rather than both over time during amortization — represented nearly 92 percent of five-year conduit loans and 79 percent of 10-year loans in 2023. 

The main reason for an expanded appetite for interest-only loans? Better debt service coverage, it seems.  

“If you’re only paying interest-only, your monthly debt service is lower than if you’re paying interest and principal payments,” Chun said. “With the higher interest rates keeping debt-service-coverage higher, a lot of these loans have gone interest only, especially for the five-year [loans], where you probably don’t get that much benefit from amortization in five years anyways.” 

Another interesting wrinkle to note is that amid the higher interest rate climate, CMBS pools in general have become smaller, with the number of loans packaged within the average five-year and t10-year CMBS conduit deal dropping to 29 and 31, respectively, in 2023; by comparison, the average CMBS conduit carried an average loan count of 48 in 2022.  

“It’s a function of lower origination values. The issuers are not able to originate as many loans,” said Akshay Maheshwari, senior director at KBRA. “CRE volume and transaction activity has been lower [in 2023], owing to higher interest rates, and as a result, what gets originated is being put into securitization, so the overall volume is lower.” 

In March 2023, KBRA published a study on the default and loss rate of five-year loans relative to 10-year loans, using 25 years of data from 1995 to 2020. KBRA found that the cumulative default rate of five-year CMBS loans was 25 percent compared to roughly 17 percent for 10-year loans. 

The big driver of that difference appears to be that five-year CMBS loans gained wider acceptance prior to the 2008 Global Financial Crisis (GFC), and that many defaults occurred in the harrowing years after the full extent of the crisis began unfolding in late 2008.  

“When you look at that 25 year history, a lot of those five-year loans were done prior to the GFC, and that influences why that default [rate] is relatively high,” said Chun. “Only time will tell whether these [2023] five-year loans behave like those five-year loans.”  

Brian Pascus can be reached at