Fitch: Watch Property Performance in a Peaking Market

Although Commercial Mortgage-Backed Securities 2.0 property cash flows remain strong, participants should watch property performance in a peaking market, noted Fitch Ratings, New York.

“Property performance has flourished over the last five years and cap rates are at an all-time low, resulting in values reaching an all-time high,” Fitch said. “But it’s only a matter of time before the commercial real estate market reaches an inflection point.” 

Fitch said that questions “continuously arise” about underwriting differences between the current cycle and the cycle nearly a decade ago. “While pro-forma [estimated] cash flow analysis has not returned, current underwriting practices may not be sufficient to properly address the peaking real estate cycle,” the ratings firm said.

Looking at those CMBS 1.0 CMBS loans, Morningstar Credit Ratings, Chicago, estimated a 50 percent to 60 percent payoff rate for those 2007-vintage loans next year. “Poor underwriting and a decline in cash flow may cause a significant portion of aggressively leveraged legacy loans made in 2007 to face difficulty refinancing,” the ratings firm said. 

Lower CMBS securities issuance, tighter underwriting standards and uncertainty around risk-retention rules taking effect Dec. 24 may hamper refinancing “borderline” 2007-vintage loans into new CMBS deals, Morningstar noted.

Selection bias will further stress the repayment rate because many stronger-performing 2007-vintage loans have already paid off, leaving mostly weaker-performing loans. “Across all five major property types, retail and office–which represent 63.6 percent of loans by balance maturing in 2017–will struggle with refinancing,” Morningstar said, noting that fewer than half have conservative sub-80 percent loan-to-value ratios. 

With little new supply coming to market, retail occupancy rates have stabilized and net operating income has improved, Morningstar said. It predicted that the office payoff rate, currently 69 percent, will sink lower because a “substantial” portion of office-backed loans remains overleveraged. But there is hope for office CMBS loans, Morningstar said: “Despite the weak metrics for maturing office loans, we believe that office space will see slow but consistent growth in the years ahead because of minimal new supply and a slowly expanding economy,” the firm’s November Maturity Report said. “While older properties may become increasingly obsolete because of technology changes, we believe that well-located Class B office space will likely attract startups and smaller companies looking for space in a bustling urban location.”

Fitch noted that it does not envision rapid performance declines for CMBS 2.0 loans. “What’s more likely to take place in the short term are net income levels turning negative,” the ratings firm said. “This could squeeze a borrower’s ability to service the debt if their loan has been aggressively underwritten.”