How Did The Pandemic Really Affect CMBS? Let KBRA Credit Profile (KCP) Explain.

During a recent Commercial Observer webinar, Mike Brotschol, a managing director at KBRA Credit Profile (KCP), a division of KBRA Analytics, presented an overview of the CMBS market’s past four years, discussing the turbulent path from the start of the pandemic to today.

“In 2020, when the pandemic struck, private label issuance plummeted due to widespread uncertainty, especially in sectors like retail and hospitality,” said Brotschol. “Looking at deal count in Q1, there were 31 private label deals that closed, and that dropped dramatically in Q2 with only 11 deals closed, including just one in April 2020.”

Overall, private label issuance fell by 44 percent in 2020, landing at $54.2 billion at year’s end after a robust $96.6 billion in 2019.

After numerous fluctuations since, especially given the eleven interest rate elevations between March 2022 and July 2023, this September’s rate cut — and the building anticipation of it in the months prior — saw issuance begin to climb.

“Private label issuance totaled $41 billion in the first half of the year and $68.1 billion by the end of the third quarter, putting the market on pace for approximately $90 billion by year-end,” said Brotschol. “The rate cut enacted in September, along with any potential future cuts, should be accretive to issuance going forward.”

On the agency side, the pandemic was a significantly less relevant factor, as agency issuance rose slightly from $61.5 billion in 2019 to $63.5 billion in 2021. But if the world’s shutdown couldn’t stop the power of agency, rising interest rates could.

“Agency issuance fell considerably in 2022 down to $46.5 billion, and then further to $33.3 billion in 2023,” said Brotschol. “By Q3 of this year, agency issuance was at $17.9 billion, on track for about $23.9 billion.”

Brotschol also notes that after a surge in 2021, CRE CLOs have faced a similar decline.

“The higher cost of capital has led to fewer property transactions and a decline in originations, as many borrowers now face steeper debt service,” said Brotschol. “CRE CLOs have become less attractive as a financing tool for CLO issuers due to higher interest rates and market volatility. As a result, many issuers are turning to more flexible and cost-effective options like warehouse lines for short-term financing, allowing them to manage loan originations and defer securitization until market conditions improve, with additional rate cuts on the horizon.”

Brotschol then steered the discussion toward the office market, recalling how the office sector was a staple of securitization pools until work-from-home and the office crisis reshaped investor sentiment.

“This shift is evident in both private label CMBS and CRE CLOs over the past few years,” said Brotschol, who noted that for the former, office garnered a 37 percent share in 2020. The private label percentage then plummeted, to 29 percent in 2021, 22 percent the following year, 11 percent in 2023, and only 10 percent in the first half of 2024.

For CRE CLOs, the share of office declined from 25 percent in 2020 to 15 percent in 2021, which Brotschol notes was driven less by asset class concerns than by a surge in transitional multifamily originations.

“Of the three CRE CLOs that closed in the first half of 2024, none included office collateral,” said Brotschol. “Of the six deals that closed in Q3, there was about $110 million in office exposure. So, in total, for the first three quarters for the CRE CLO market, office exposure was around two percent.”

Brotschol displayed several slides placing some of the related trends into sharper focus. An index called the KBRA Loan of Concern (K-LOC), which illustrates the percentage of conduit loans KBRA has designated as in default or in danger of such, shows that December 2022 saw a post-pandemic low at around 17.5 percent, which rose to 24 percent by this past August. The chart, broken down by sector, also makes it clear that the bulk of the increase has occurred in the office market, while the lodging category has exhibited a marked decrease in default since December 2021.

The office portion of this concern was further highlighted in a separate chart showing that while “distress was initially suppressed by longer-term leases and uncertainty regarding return to office,” the sector’s K-LOC index has “more than tripled since the onset of the pandemic.” After hovering at around 10 percent in June 2020, that index is now around 34 percent, continuing a steady rise that has failed to abate since the start of the pandemic.

And in a chart titled “Analyzing an Evolving Office Landscape,” KBRA cites elevated interest rates, rising operating expenses, and the flight to quality as key factors in evaluating the health of the sector.

Later in the webinar, Maverick Force, senior director of CMBS at KBRA Analytics, turned the discussion toward specific market forces, addressing some of the challenges facing major markets in California on the retail and office fronts.

“We’ve seen a retail exodus in San Francisco, with more than two dozen high-profile luxury retailers leaving the downtown and Union Square areas,” said Force, citing factors such as rising crime, political turmoil, and tax increases put in place by voters in 2020. “With a limited number of tenants interested in occupying the ground level as well as technology tenants being more amenable to remote work or hybrid structures, it’s created a perfect storm of vacancies there. The San Francisco Travel Association is not expecting business convention travel to reach pre-pandemic averages until at least 2030. So, operators of retail, office, and hotels are in for a long road to recovery.”

In Los Angeles, Force said that the city’s diversity of industries — as opposed to San Francisco’s intense focus on technology — has eased the pain a small amount by comparison. But even in L.A., office vacancies in the city’s central business district still skew north of 25 percent.

“Office there is a pretty capital-intensive asset class,” said Force, “and we’ve seen operators needing to offer very competitive concession and tenant improvement packages in order to attract and retain tenants.”

The New York City office market is similarly benefiting from a diversity of industries, according to Force.

“Office vacancy there is north of 20 percent. However, the market has seen some positive trends in terms of office visitation that have improved considerably,” said Force. “Utilization there still trails the pandemic, but according to REBNY, Manhattan office visitation reached 78 percent of 2019 levels in July 2024 excluding the holiday week, with Class A+ properties seeing visitation in July at 86 percent of 2019 levels. So, there are definitely some bright spots there.”

Later in the webinar, Patrick Czupryna, a managing director of CMBS at KBRA Analytics, talked about trends in office maturities of late, and how they’ve been influencing credit quality and underwriting standards.

Czupryna said that the long-anticipated rate stability caused by the Fed’s recent rate cut has helped overall CMBS issuance climb upward from 2023 lows.

“On the whole, we’ve seen traditional bank lenders pull back a bit from CRE lending in recent periods, but the roster of financing sources available to would-be borrowers has remained diversified,” said Czupryna. “We’ve seen private capital step in to fill the void in many cases to get some of these deals done.”

On the other hand, for existing office loans, Czupryna notes that stagnating cash flows, value depreciation, and borrowers that aren’t as well-capitalized are all contributing to growing levels of distress, and an increase in CMBS defaults.

Displaying a chart on recent office maturities, Czupryna demonstrated a stark decline in payoff rates for office loans, including a decrease in repayment rates from over 90 percent in 2022 to 36 percent in the first half of 2024, as well as a 43 percent increase in KBRA-calculated loan-to-value ratios for office versus pre-pandemic.

Looking at anticipated upcoming maturities based on a year-end 2023 MBA survey, KBRA cites $600 billion in expected maturities in 2025, $450 billion in 2026, and $330 billion in 2027, but acknowledged these figures are likely to increase owing to “lower repayment rates and expected defaults and extensions.”

KCP is a subscription-based research service that was launched in 2014. With a team of over 40 CRE credit professionals, the firm surveils over 1,300 transactions comprising about a hundred CRE CLOs and over 1,200 CMBS securitizations, including private label conduit, large loan, single borrower, and agency deals. KCP’s goal is to identify loans they believe exhibit elevated credit risk, value the underlying mortgage collateral, and forecast loan and bond-level losses.