Editor’s Note: A new column, “Capital Trends,” makes its debut this month. Written by David Lynn, an institutional real estate investor, strategist and portfolio manager, the column will analyze trends and issues with a heavy emphasis on research. Lynn serves as managing director and head of the research and investment strategy group at ING Clarion Partners. Look for his column to appear monthly.
The credit crunch effectively ended a period characterized by the availability of abundant, inexpensive commercial real estate debt. Anxiety regarding residential mortgage-backed securities (RMBS), which spiked in the wake of growing subprime foreclosures, spilled over to affect commercial lending.
Commercial mortgage-backed securities (CMBS) financing played a critical role in expanding liquidity during the most recent market upswing, with originations increasing steadily from 2002 to 2007. However, tightening credit conditions and concerns about the performance of commercial properties pushed CMBS spreads to unprecedented levels following the Lehman Brothers bankruptcy filing last September (see accompanying chart).
The CMBS market responded enthusiastically to the announcements in April and May that the Federal Reserve would expand the Term Asset Backed Securities Loan Facility (TALF) program to include both new and previously issued CMBS assets with up-to five-year maturities. The BBB CMBX Index spread over swaps declined by almost 2,500 basis points from its peak in late-April to mid-May.
Meanwhile, the AAA CMBX Index spread narrowed by about 200 basis points during the same period. Frustration over delays in the TALF program combined with news of increasing default rates and expected downgrades of AAA CMBS bonds by Standard & Poor’s helped to fuel another spike, however, with the BBB spread widening by over 1,000 basis points recently.
The historically high BBB yields indicate continued concerns in the market about the risks associated with all but the most senior CMBS bonds.
Default rates on CMBS loans continue to climb. While the default rate (60 or more days delinquent) remains low compared with RMBS, it continues to climb steadily. The number and dollar amount of loans in special servicing also continued to climb in June, reflecting the ongoing deterioration in credit quality.
Trepp LLC reports that 5.4% of the total outstanding balance of CMBS — some $3.8 billion — is now in the hands of special servicers. We believe that as real estate asset values fall, rents face downward pressure, and refinancing becomes more challenging, the default rate will continue to climb.
Despite these threats, we believe that CMBS securities may represent attractive values, particularly at the most senior AAA tranche, also known as the super-senior level. Currently, it appears that either the market has lost faith in the strength of super-senior CMBS credit, or more likely the market is underestimating the structural and property-level credit support of the top-rated tranches.
The repayment of principal — including the amount recovered from loan workouts — is distributed first to the super-senior tranches until they have been paid off at par, while losses due to default are first absorbed by the subordinated tranches. With subordination levels of 30%, we believe that super-senior CMBS must be exposed to an unprecedented level of defaults before facing any loss of capital.
Careful analysis of underlying properties, tenants, underwriting criteria, and loan vintages may identify CMBS tranches that offer excellent risk-adjusted return potential.