CMBS Sector Outlook: Continued Uncertainty Going into 2023
Kroll Bond Rating Agency, New York, just released its CMBS 2023 Sector Outlook, which looks at key credit trends from 2022 and forecasts U.S. issuance activity for the new year. MBA NewsLink interviewed KBRA’s Larry Kay and Andrew Foster to get their insights on the current lending environment and property fundamentals as well as factors that may affect overall property performance in 2023. The report also discusses year-to-date 2022 KBRA-rated CMBS conduit trends and metrics and looks at 2022 ratings activity and surveillance expectations for 2023.
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.
Andrew Foster is a Director in the CMBS Surveillance Group at Kroll Bond Rating Agency. He focuses on commercial real estate securitization surveillance and servicer evaluations. Prior to joining KBRA, he was an Associate Vice President at the Mortgage Bankers Association and before that he was a Director at Fitch Ratings and an Associate Director at S & P Global Ratings responsible for servicer evaluations. He began his career in CRE finance at C-III Asset Management (now Greystone) as an asset manager responsible for the management and disposition of a portfolio of REO properties.
MBA NEWSLINK: What were the factors that contributed to your 2023 U.S. CMBS issuance forecast, and how does it compare to the full-year 2022 estimate?
LARRY KAY, KBRA: With the current market uncertainty, U.S. commercial real estate transaction volume, pricing, and returns have been negatively affected. While lenders and investors scrutinize deals more closely, they are also reducing leverage, increasing pricing or just moving to the sidelines as interest rates continue to rise. In addition, there are increasing concerns of meaningful property value declines. Borrowers appear to be retrenching and readjusting to the new reality of lower leverage and higher CRE mortgage rates, although some may just be waiting for rates to stabilize or even come down. In either case, market participants appear to be in a holding pattern.
All these factors, as well as expected rising interest rates, will weigh on private label issuance, which we believe will be meaningfully lower, tracking the 2022 quarterly downtrend into the new year. To that end, we forecast total 2023 issuance at $71 billion–with CMBS (conduits, single borrower/large loan (SB/LL)) of $54 billion and CRE collateralized loan obligations of $17 billion. This is down 29% year-over-year from our full-year 2022 total issuance forecast of $100 billion. By transaction type, we forecast YoY conduit volume to be basically flat, while SB/LL and CRE CLO will be lower by 31.2% and 41.4%, respectively.
NEWSLINK: Your forecast includes a significant decrease in issuance for both SB and CRE CLO deals, what do you see impacting issuance by transaction type?
KAY: Much of the SB issuance has been floating-rate loans. With the rise in interest rates, widening loan spreads and potentially lower take-out proceeds, SB borrowers appear more likely to pay the increasing costs of interest rate caps, rather than refinance in the current environment. Interest rate caps are typically required by lenders to exercise available extension options. This seems to be playing out as we are seeing an increasing number of SB borrowers extending existing loans, rather than refinancing. Despite this, we still expect capital to be made available for high-quality single-asset SB deals, which may be too large for other lenders to finance. They will also continue to appeal to buyers, as they are easier to underwrite and spot risks versus pools of assets.
CRE CLOs typically fund properties that are in various stages of transition, and sponsors generally have stabilization plans to increase cash flow and value. These plans will inevitably be more challenging to achieve given inflation levels and their impact on operating costs, as well as downward pressure being exerted on rental rates. However, as most of the underlying assets tend to be multifamily, the product benefits from short-term leases and the ability to more rapidly reset rents to account for rising expenses. Nonetheless, the uncertainty in the market triggered a widening in spreads and increased the cost of execution. These factors, we believe, will continue to suppress issuance until there is more rate visibility.
We believe that conduit issuance will be slightly lower, and may have even already reached a floor. As in the past, conduits continue to face competition from other lending sources such as banks and credit unions. And while the pace of rate increases remains an open question, volumes will be suppressed as borrowers and investors avoid locking in fixed rate, 10-year loans. With weighted average coupons (WAC) approaching 6% on recent KBRA-rated securitizations, there will be refinancing challenges for 2013 and 2014 maturing loans, which have rates averaging 4.5%.
NEWSLINK: In 2022, upgrades have exceeded downgrades for the first time since 2019. What do you believe helped drive that reversal and, more broadly, what is the expected shape of ratings surveillance for 2023?
ANDREW FOSTER, KBRA: Year-to-date through early November, the upgrade to downgrade ratio was 1.45x. This was the first time since 2019 that upgrades outpaced downgrades. Most of the upgrades resulted from the strong housing rental market benefiting ratings on KBRA-rated Freddie Mac and single-family rentals. Despite the reports of multifamily and SFR value and rent growth slowing and even declining in some markets, the lack of sufficient supply and high homeownership costs will provide some protection to the sector.
KBRA expects a modest rise in delinquencies through 2023 due to the current interest rate environment and economic uncertainty, as more loans may transfer to special servicing, particularly those nearing their maturity date. This will result in negative ratings drift for certain transactions, but at present, we do not expect a meaningful increase in the number and severity of downgrades. As of November 4, 2022, there were 164 downgrades, which is less than one-half in 2021 (371) and less than 60% of the number in 2020 (292).
Overall, we expect that higher interest rates and economic uncertainty will have a dual effect on ratings. On one hand, the conditions will limit sales activity and refinancings, which could impact loan payoffs and transaction deleveraging, as well as the amount of defeasance, resulting in fewer upgrades over the next year. Conversely, with the economy slowing and expected to enter a recession, property operating cash flows and valuations could come under pressure, which could lead to loan underperformance as well as refinancing challenges and potentially more downgrades. However, we do not expect downgrades to reach the levels that were experienced in the aftermath of the pandemic.
NEWSLINK: It was mentioned earlier that lenders are reducing leverage. Have you seen this in the conduit deals that you rated? Can you share any other credit metric observations?
FOSTER: Yes, we have been seeing lower leverage in conduit deals in 2022. In fact, In-Trust KBRA loan-to-values are currently lower than at any time in the past nine years. The All-In Cutoff KLTV continued to fall YTD 2022 to 102.8%, which is at its lowest level since 2013. Total subordinate debt also dropped to 23.7% after reaching a high of 41.6% in 2020. While KLTV has been dropping, interest-only loans have continued to rise. The KBRA IO Index, which provides a measure of the transaction’s exposure to IO loans, is the highest it has been since we began recording the measure in 2012, although it has started to flatten out. While partial-term IO loans have exhibited a declining trend, the increase in full-term IO loans YTD 2022 contributed to the higher index.
In addition to KLTV and IOs, KBRA’s debt service coverage fell YTD 2022 to 2.25x from 2.60x, which likely partly reflects the higher WACs, which rose 100 basis points to 4.50% from 3.50% in 2021.
Continuing its trend since 2020, primary market exposure decreased to 47.6% from 54.7% in 2021. The shift away from primary markets could be due to the lasting effects of COVID, with lenders more willing to originate loans outside of major urban centers. Multifamily and industrial exposures each fell by about 300 bps YTD 2022 to 13.6% and 9.6%, respectively, compared to 2021, while retail rose a modest 50 bps to 23.4% during the same period.
Lodging exposure jumped YTD 2022 to 8% from 3.1% in 2021, while office (which is facing major challenges) declined for the second consecutive year, to 36.4% YTD 2022 from 36.8% in 2021 and 41.3% in 2020. Outside of the major property types, self-storage exposure increased for the fifth year since 2017, to 7.3% YTD from 6.8% in 2021 as this sector continues to attract strong investor interest.
NEWSLINK: With the continuing concerns for the office sector, can you provide your views and outlook for this segment, as well as touch on your recent report on CMBS office lease rolls.
KAY: Although the office sector weathered the pandemic as long-term leases helped landlords retain tenants, the sector faces several economic headwinds heading into 2023. These include the prevailing rate environment, inflation, and recessionary concerns which are prompting some companies to defer leasing decisions and possibly reduce office footprints. Furthermore, the sector continues to be challenged by structural shifts toward permanent hybrid and remote work schedules.
Based on a survey of 160 major employers conducted by The Partnership for New York City, it was found that just about one-half of Manhattan office workers were at their desk on an average weekday in September 2022. Only 9% of employees were working from an office five days per week. The shift to hybrid and remote work is widely expected to cause employers to reduce or eliminate office space, which in turn will weigh on demand and drive rents lower as existing leases expire.
In our CMBS Office Lease Roll: Markets and Transactions Examined report, we point to a noteworthy trend heading into 2023 and beyond: large office tenant expirations within CMBS transactions. Analyzing the top five tenants within conduit transactions, 45.1% of these tenants’ square footage is set to expire between 2023 and 2027. As leases roll, look for a flight to quality as employers gravitate toward Class A properties with ample amenities to lure workers into the office. Class B and C properties may struggle to compete for tenants, especially as employers begin to reevaluate their office footprints.
NEWSLINK: Hospitality was one of the most challenged asset classes in terms of performance as the pandemic took hold in early 2020. What is the outlook for this sector heading into the new year?
FOSTER: The U.S. lodging industry continued its recovery in 2022 after experiencing its worst year of performance on record in 2020. The improvement in U.S. lodging industry revenue per available room can be attributed to the successful rollout of vaccines, elimination of travel restrictions and requirements, and strong pent-up demand from consumers. However, it is an uneven recovery, with resort and leisure drive-to destinations faring the best due to pent-up demand, and center-city and group-oriented hotels more impacted as commercial travel and group business have returned more slowly.
While the 2021 RevPAR increases were primarily driven by occupancy, 2022 increases are largely being driven by average daily rates as hotels maintained strong pricing power throughout the pandemic. With previous downturns, hotels discounted their room rates which resulted in a slower recovery; however, this is reportedly the first time that a lodging sector recovery is being led by ADR as opposed to demand and occupancy.
While performance has been strong, there are headwinds such as labor shortages, the rising cost of debt, supply chain constraints, and elevated inflation and operating costs which could limit the assets recovery and profitability.
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