KBRA 2020 CMBS Preview

MBA NewsLink interviewed Kroll Bond Rating Agency Senior Managing Director Eric Thompson and KBRA Senior Director Larry Kay about their firm’s 2020 outlook for commercial mortgage-backed securities.

MBA NEWSLINK: In KBRA’s CMBS Outlook, you mentioned that while CMBS 2.0 lenders “maintained discipline” for much of 2019, credit metrics exhibited signs of worsening in the fourth quarter. Is this time different? At this juncture, are you concerned?

ERIC THOMPSON: In the fourth quarter we observed increases in loan-to-values as well as full-term interest-only loans. As a matter of fact, after rising to 75.6 percent in Q4, KBRA’s IO Index year-to-date is at a record high 65.7 percent. (The pool’s weighted-average IO Index measures a transaction’s exposure to interest-only loans.)

But despite these increases, lenders have generally stayed away from CMBS 1.0 proforma loans–something we have yet to see in 2019 despite increased leverage and IO–and utilized in-place cash flows when underwriting and analyzing commercial real estate loan collateral.

We compared CMBS conduit 2.0 transaction credit metrics to CMBS 1.0. What we found was that to date, 2.0 loans had lower leverage and higher credit enhancement levels. Despite the increasing prevalence of IO, CMBS 2.0 loans issued to date appears to be better positioned than their 1.0 counterparts based on credit enhancement, underwriting standards and credit metrics.

Looking forward, whether or not this holds true will remain to be seen. If there is continued erosion, the finding may not hold.

NEWSLINK: Despite some deterioration in credit metrics, you are forecasting 2020 CMBS issuance will be up compared to 2019. What would drive the increase?

THOMPSON: The 10-year Treasury rate, which fell to a year-to-date low of 1.47 percent in the third quarter, likely contributed to the rise in third-quarter conduit volume as CRE borrowers sought to lock in long-term rates.

With historically low interest rates and the general attractiveness of CRE relative to other asset classes, we are forecasting that conduit, single-borrower and CRE Collateralized Loan Obligation issuance will increase in 2020.

In addition, with increased conduit issuance, we could see some of the potentially smaller single-borrower loans end up in conduit executions.

We believe single-borrower issuance should continue to benefit from the ability of the securitized market to finance loans that maybe too large for other lenders. Case in point: Blackstone’s two industrial property securitizations, which included the largest deal since before the financial crisis at $5.6 billion–BX Commercial Mortgage Trust 2019-XLP–as well as a scheduled $4 billion deal for the pending acquisition of Colonial Capital’s industrial property unit.

Our CRE CLO issuance forecast is based on current deal announcements, investor appetite for yield and favorable pricing and terms for issuers relative to other capital sources. In total, we are forecasting 2020 issuance could rise to about $120 billion from our 2019 estimate of between $105-112 billion, with conduits next year contributing $52 billion, single-borrower $43 billion and CRE CLOs $25 billion.

NEWSLINK: You’ve said historically the low unemployment rate and subdued construction have helped support property fundamentals and valuations. Do you believe the current economic environment will continue to provide the backdrop for positive property fundamentals and price growth?

LARRY KAY: With the U.S. now in its 125th month of economic expansion and with positive GDP growth expected to continue for the foreseeable future, expectations are the current expansion will continue its record-setting trend.

In its MarketBeat report, Cushman & Wakefield said it expects real GDP growth in the mid-2 percent range for 2019, which it called a healthy backdrop for CRE. And property fundamentals remain positive due to strong tenant demand and supply constraints–the CoStar Group reported office, retail and industrial deliveries as a percentage of inventory averaged just 0.2 percent over the last four quarters; that’s half of the levels seen in 2007 and 2008.

As CRE prices continue their upward trajectory in line with the wider economy, a slowdown in price growth is not unexpected this late in the cycle. This has already been showing up in the numbers as CoStar’s two price indices (Equal-Weighted and Value-Weighted) have both declined from the double-digit annual growth rates recorded earlier in the cycle.

With the length of the economic expansion continuing into uncharted territory and with the Federal Reserve’s three rate cuts so far in 2019, the positive momentum that CRE has experienced should carry over into 2020 and be supportive of property fundamentals and price gains.

NEWSLINK: With price growth slowing, a rising tide may not still be lifting all boats. Do you expect this could translate into fewer upgrades and more downgrades?

KAY: As we believe that property operating cash flows and valuations may have their best years behind them, upgrades may level off and even decline. In addition, with the increasing levels of KBRA Loans of Concern, more downgrades could follow due to property-specific issues. These factors should continue into 2020 the compression in the upgrade/downgrade ratio that we have experienced over the last few years.

NEWSLINK: You mentioned earlier that loan-to-value ratios and full-term IO’s have recently exhibited signs of worsening. Based on the CMBS conduits that KBRA has rated so far this year, what are some of the other key credit metric highlights?

THOMPSON: The year-to-date KBRA debt-service coverage ratio increased to 2.03x from 1.92x in 2018. That’s the highest it’s been since 2012. This year’s figure has been influenced by the growth in full-term interest-only exposure.

The average proportion of loans secured by assets situated in primary markets rose by 280 basis points to 50.6 percent year-to-date compared to 2018, while secondary and tertiary market exposure fell 150 basis points (36.3 percent) and 130 basis points (13.1 percent), respectively.

KBRA’s capitalization rate declined to 9.08 percent year-to-date in 2019 from 9.37 percent in 2018. This year-to-date figure is the lowest since 2012. This we believe was partly attributable to the investment shift to primary markets, which tend to have a lower risk profile than secondary and tertiary markets. Single-tenant concentrations reversed trend after rising for six consecutive years, falling 150 basis points to 17.9 percent on a year-over-year comparison. Despite this, the concentration remains elevated and is noteworthy as single-tenant properties present higher credit risk than multi-tenant properties because the income comes from just one lessee.