KBRA Analysts Look to 2022 Commercial Mortgage-Backed Securities Sector
Kroll Bond Rating Agency, New York, just released its 2022 Sector Outlook—CMBS: Full Steam Ahead report. MBA NewsLink interviewed KBRA’s Larry Kay and Patrick McQuinn to get their insights on the current lending environment and property fundamentals as well as factors that may affect property performance in 2022. The report also reviews KBRA-rated CMBS conduit trends and metrics, 2021 ratings activity and ratings surveillance expectations for the new year.
Larry Kay is a Senior Director in the CMBS Surveillance Group at Kroll Bond Rating Agency. He focuses on commercial real estate securitization research. Prior to joining KBRA, he was a Director at Standard & Poor’s (now S&P Global Ratings), where he was involved in CMBS research, surveillance and analytics. Previous to that, he held various positions at Wall Street investment houses and major accounting firms.
Patrick McQuinn is a Senior Director in KBRA’s CMBS new-issuance group. He is a lead analyst on conduit and commercial real estate collateralized loan obligation transactions and oversees the analysis and presale publication of Freddie Mac K-series transactions for the firm. Prior to KBRA, McQuinn worked in asset management at Arbor Commercial Mortgage and was a civil engineering associate at architecture and engineering firm HGBD.
MBA NEWSLINK: Could you provide your commercial real estate securitization issuance forecast for 2022, as well as what KBRA considered when developing it?
LARRY KAY: KBRA expects private-label commercial real estate securitization issuance to end 2021 at about $149 billion, which is more than double 2020 volume ($62.2 billion) and above 2019 issuance of $116.1 billion. For 2022, we are forecasting private label commercial real estate securitization volume between $150 billion and $165 billion.
Increasing employment levels, a recovering commercial real estate sector and historically low interest rates including a federal funds rate anchored at between 0 percent to 0.25 percent should be supportive of continued issuance growth in the coming year. Other factors such as commercial real estate pricing, transaction volume, loan originations and the current momentum in the new issuance market were also considered. In addition, the securitization market will capture some refinancing activity among the $80 billion of 2022 CMBS loan maturities, as well as loan refinancings in commercial real estate collateralized loan obligations.
By transaction type, some of the drivers and our views for issuance levels include:
Single-Borrower. Investors have been attracted to single-borrower transactions, many of which are secured by high-quality properties with institutional sponsors. We expect issuance to stay heavily skewed towards floating-rate, which represented 85 percent of year-to-date October issuance and include all major property types, with industrial continuing its trend of higher than historical issuance.
CRE CLO issuance was supported by an expanded transaction sponsor base, with 28 CRE CLO issuers active in 2021. Most, if not all, of these CRE CLO sponsors are expected to be active issuers in 2022, alongside the potential entry of several new issuers. A key component of the market’s growing acceptance of the product has also been its performance during the pandemic, with a delinquency rate that is under 1 percent compared to the CMBS delinquency rate, which continues to decline but is still over 5 percent.
Conduit issuance may see an increase in refinancings as assets start to stabilize post-pandemic. It may also benefit from a steadily increasing number of loans maturing over the next few years. A long-term fixed-rate conduit execution could be appealing, particularly since the 2022 maturities were originally financed with coupon rates of about 4.5 percent to 5 percent, compared to the 3.5 percent to 4 percent rates available today.
NEWSLINK: What are some of the other new issuance/origination key takeaways that you would like to highlight from the report?
PATRICK MCQUINN: We expect 2021 CMBS (conduits and single-borrower/large loan) issuance of $105 billion, levels not seen since the peak issuance years of 2005-2007 with CRE CLOs adding another $44 billion of estimated issuance.
CRE CLO volume in 2021 will have a record year and for the first time surpass conduit annual volume. For 2022, we are forecasting continued growth in the sector that will again exceed conduit–a repeat performance.
Single-borrower issuance in 2021 is estimated to exceed its 2019 volume by nearly 60 percent, with its momentum carrying over into 2022, when we expect issuance of $70 billion. As in 2021, industrial and multifamily are expected to remain the major property types.
As of October 2021, approximately $19 billion of conduit loans will mature in 2022, with retail having the largest percentage (38.5 percent) of maturities. While this and other commercial real estate loan maturities will support conduit issuance, we expect volume to remain relatively low ($35 billion) compared to pre-pandemic levels given borrower preferences for floating-rate loans as the commercial real estate markets continue to stabilize. Such loans allow borrowers to maximize current proceeds while providing more payment flexibility than conduit financing.
Similar to private-label CMBS, Freddie Mac securitizations saw a shift toward floating-rate execution (49.1 percent year-to-date 2021 versus 26.7 percent in 2019), a trend which could continue into 2022. With the FHFA purchase limit raised, we could see an increase in K-Series issuance in 2022. However, multifamily has been capturing a larger percentage of conduit issuance, with double digits in first-half 2021 (13.9 percent) from high single-digits (9.9 percent) in 2018.
Overall, we expect healthy industrial and multifamily origination volume, while nonessential retail may continue to face challenges. Hotels in gateway cities–which have been more severely impacted by the pandemic–may experience some increase in loan originations, but on a selective basis. Office is likely to experience some weakening in 2022 and beyond, reflecting the ongoing shift toward hybrid work, which may weigh on demand.
NEWSLINK: In 2021, there was a bifurcation in the CRE market based on property type demand generators. Could you provide a brief review on how they varied and your outlook for each sector?
MCQUINN: For the office sector, 2022 could be an important year because of what may be revealed about the impact of hybrid (remote) work on the long-term trajectory of office demand. The transition is not expected to impact the sector as a whole, but for individual office properties with near-term tenant roll, the effects could be large, as tenants may attempt to negotiate lower rent on lease renewals and/or downsize their existing footprints. Furthermore, buildings that are better configured to meet the rising health and safety standards will be more attractive for tenants and may fare better than older, less-equipped buildings.
The retail sector’s 2021 performance, while stressed, has generally exceeded the market’s low expectations, although fundamentals are expected to weaken through the end of 2022. Retail performance may continue to be impacted by the spread of additional COVID-19 variants, changes in consumer sentiment, ongoing expansion of e-commerce, and a leveling off of enthusiasm after lockdown fatigue. On a positive note, new construction deliveries are projected to remain below historical levels, which may help support retail fundamentals.
In the lodging sector, commercial and group business as well as international travel are expected to continue its recovery next year. However, occupancy will be somewhat constrained by supply additions and as temporarily closed hotels, especially larger gateway city group hotels, continue to reopen. Increased costs for construction materials and labor, as well as supply chain issues, are expected to temper supply additions in the future. Given these factors and stronger than expected lodging industry performance in 2021 for certain segments, leading hotel analysts now expect a return to 2019 revenue levels in 2022 and 2023, a full year earlier than original expectations.
In the multifamily sector, there has been an increase in renter demand outside gateway cities, which appears to be fueling pricing gains for secondary markets. Not all renters will be content to stay away from the major metros, however, and demand for urban properties is beginning to rebound as the economy continues to open up and large corporations finalize their return-to-office plans. Class A and B assets are expected to see the largest increases in rental rates, given both had steeper rent declines during the pandemic compared to Class C properties.
Overall, KBRA expects the outlook for the multifamily asset class to remain positive and demand for these assets to remain high compared to some other segments of commercial real estate.
KBRA expects the industrial sector to continue to perform well through 2022. To account for significant transportation delays during the pandemic, businesses have increased their inventory levels and their reliance on third-party logistics partners, resulting in additional need for industrial space. Construction seems unlikely to keep up with demand due to costs and delays, which will help support lower vacancy rates and higher rental rates on new leases. It is worth keeping an eye on online consumer spending, as declines in consumer sentiment or a reversal back to brick-and-mortar retail spending could impact warehouse/distribution demand and fundamentals.
NEWSLINK: In KBRA’s rated conduit deals, various credit metrics are tracked utilizing the KBRA Comparative Analytic Tool. Were there any trends or other observations in 2021 you can share with us?
KAY: In-Trust KBRA LTV increased from 95 percent in 2020 to 98.2 percent year-to-date. The proportion of higher-leverage loans also rose this year, as loans with KLTV > 100 percent and 110 percent increased 440 basis points and 480 basis points, respectively, over 2020 levels.
The KBRA Interest-Only Index broke the 70 percent threshold in 2020 at 77 percent before dropping slightly lower to 75.8 percent year-to-date. KBRA debt service coverage has had a solid increase since 2018 (1.92x), rising to 2.63x.
Single-tenant concentrations were at 21.6 percent year to date, which is at its highest level since 2012. Single-tenant properties present higher credit risk than multi-tenant properties since the sole source of income is generated by one lessee. Technology tenants such as Apple, Amazon and Google have been a major driver of the increase in exposure as well as government tenants and large single-tenant retail portfolios. Industrial properties have become a larger share of a conduit pools’ composition, with many of these assets leased to a single user.
In terms of property type exposure, lodging continued its declining trend from last year, dropping to 3.4 percent year-to-date from 10.1 percent in 2020. CMBS lodging loans in KBRA-rated deals have sustained the highest delinquency rate among major property types since the outbreak of COVID in 2020. Facing uncertainty post-COVID, the office exposure has also decreased in 2021, to 37.2 percent yar to date from 41.3 percent in 2020. Multifamily, industrial, self-storage and retail exposures increased year to date. Industrial exposure, at 12.1 percent, increased for a fifth consecutive year.
With the lodging sector exhibiting signs of recovery and some retail assets starting to restabilize, these exposures may increase in the coming year. Office is likely to experience some weakening in 2022 and beyond, reflecting the ongoing shift toward hybrid work, which may weigh on demand. Industrial and multifamily are expected to have good participation rates, which are in line with 2021 and higher than some pre-pandemic years.
NEWSLINK: The report mentioned that due to the ongoing negative economic effects of the pandemic, rating downgrade activity this year has already exceeded 2020 levels. Was that in line with your expectations and how do you think 2022 rating activity will go?
KAY: The 322 downgrades year to date through October 31 has already exceeded the 292 for all of 2020, which itself exceeded KBRA’s combined downgrade actions for the prior nine years. The higher number of downgrades and the large number of high investment-grade downgrades is in line with KBRA’s expectation early on in the pandemic–that is, the longer the pandemic lasted, more negative actions would occur and higher rated classes would more likely be impacted. A breakdown of activity by transaction type reveals that much of the negative rating actions are across 93 conduits, or about one-third of KBRA’s rated conduit transactions. However, there were 62 downgrades across 18 single-borrower and large loan transactions.
As in 2020, sectors whose ratings have held up with no downgrades include Freddie Mac K-Series, single-family rental, CRE CLOs and small balance commercial. One of the primary factors helping these sectors outperform conduits, single-borrower and large loan transactions is that these sectors are dominated by loans secured by multifamily and residential properties. Multifamily and single-family rental occupancies, rents and values have generally experienced healthy growth even through the pandemic except for a few dense core urban markets. However, even these markets are reportedly bouncing back to pre-pandemic levels.
Most of the ratings downgraded (56 percent) were already rated below investment grade prior to the pandemic. In total, the AAA through A category-rated classes have maintained their ratings 97 percent of the time. As commercial real estate performance typically lags the general economy, we expect to see meaningful downgrade activity for the remainder of 2021, which could carry into 2022, albeit at a slower pace.
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