Anyone watching the CMBS investment market in recent weeks has seen some warning signs. Spreads have widened, while ratings agencies such as Moody’s have expressed concerns about “deteriorating credit quality.”
“There is some definite nervousness in the market, and it is not clear yet which way the market will move,” says Manus Clancy, senior managing director at research firm Trepp. CMBS spreads started to widen in June, including one big move that occurred in late June/early July and a second big move in early August as it relates to new issuance.
“We believe that has more to do with the general skittishness of the global economy, the slowing growth in China and the potential unintended consequences of a rate hike from the Fed than it has to do with the credit quality of CMBS per se,” says Clancy.
Concerns related to credit quality have been around for the past six to 12 months. People have been talking about factors such as the weaker underwriting standards, loan to value (LTV) ratios creeping higher and lower credit quality properties.
“That didn’t really seem to spook the market at all during the first half of the year. It was only really when people started focusing on weaker global economic issues that we really started to see spreads start to widen out,” Clancy notes.
The spread has expanded by about 30 basis points at the AAA pool level compared to nearly 100 basis points in the BBB- pool. So there has been a lot more pain endured by people who had big positions in the BBB space, notes Clancy. In terms of BBB- deals, the concern is that buyers will assume greater credit risk in a slowing economy. As such, investors may be more discriminating in buying the lower-rated CMBS credits if there are real indications of shifts such as lower retail sales or lower oil prices.
“I don’t know that it has so much to do with the real estate quality and fundamentals as it does general fixed income pricing and other micro events going on,” says Dan Rosenberg, managing director of capital markets with real estate capital services firm Cohen Financial in Chicago. As of the week of Aug. 18, the new-issue spread over swaps was averaging 115 basis points for AAA deals compared to 428 basis points on BBB- new-issue fixed-rate conduits, according to Commercial Mortgage Alert, an industry newsletter.
To some extent, wider spreads have been offset by a lower treasury rate. The 10-year Treasury was at 2.18 percent as of Aug. 27, which is down from 2.32 on July 1. So the all-in interest rate for the AAA borrower, for example, isn’t tremendously different than it was 90 to 100 days ago. And, in the grand scheme of things, CMBS loan costs for borrowers are still very low on a historical basis, says Rosenberg.
One explanation is that the CMBS market could have been a bit ahead of the volatile shift that occurred in the broader securities market, with swings in valuations and stock sell-offs during the last week of August. “We did see a really meaningful widening about a week before stocks sold off, and we joked about whether the shoe has already dropped, or is the other shoe yet to fall,” says Clancy.
Only time will tell what the answer to that question is. It could turn out to be a great bargain buying opportunity, or there could be more turbulent times ahead, depending on how the market moves in September. Getting real clarity will have to wait until new issuance resumes after Labor Day.
Despite recent hiccups, CMBS has been very active year-to-date with total U.S. issuance as of early August at $63 billion compared to $50.4 billion during the same period in 2014, according to Commercial Mortgage Alert. “There is liquidity. Loans are closing and transactions are being funded,” says Rosenberg. “But, at this particular snapshot in time, no one is sure what the appropriate levels are, and people are hedging because of the movement over the past 30 days.”