KBRA CMBS Outlook: Cloudy, With a Glimmer of Hope
(Photo credit: Derek Story via Unsplash)
Kroll Bond Rating Agency, New York, just released its CMBS 2024 Sector Outlook, which forecasts U.S. issuance activity for the new year and highlights key credit trends from 2023. MBA NewsLink interviewed KBRA’s Larry Kay and Andrew Foster to get their views on the current lending environment and property fundamentals as well as factors that may affect overall property performance in 2024. The report also reviews year-to-date 2023 KBRA-rated CMBS conduit trends and metrics, takes a closer look at this year’s ratings activity and provides surveillance expectations for 2024.
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. 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 is KBRA’s commercial real estate securitization issuance forecast for 2024 and why do you believe there will be a bounce back from 2023 levels?
Larry Kay: KBRA projects that private-label CRE securitization issuance will bounce back from 2023 lows with a 23.6% year-over-year increase to $55 billion, as this year’s positive quarter-over-quarter trend is expected to continue in 2024, with increasing growth anticipated for 2H 2024. This assumes a somewhat steady interest rate environment, along with our expectation for a generally rocky capital and CRE market in the near term that will begin to exhibit signs of stabilization as 2024 progresses. This will be the result of an increasing number of borrowers accepting the new rate environment and lower valuations, and no new significant CRE or macroeconomic surprises.
Additionally, given performance pressure on existing loans, we could see increased loan pool sales and reemerged securitizations of distressed debt, which could add to issuance volume not reflected in our 2024 forecast.
There is a significant volume of maturing loans starting in 2024 and through 2030, when $2.6 trillion is scheduled to come due. During this period, 2024 has the largest amount of maturities scheduled, totaling about $500 billion. Of these, $89 billion consists of CMBS, and of the 10-year maturities, the weighted-average loan coupons for KBRA-rated deals are about 4%-4.5% compared to current conduit loans being originated with coupons closer to 8%.
Loan modifications have been increasing, because borrowers may often find it less expensive to modify loans, pay expenses, and cover servicer fees rather than refinance into a loan with an 8% coupon. As a result, this could suppress some new issuance activity, as not all borrowers will seek refinancing for these 2024 maturing loans.
However, of the 2024 maturities, $88 billion of loans are coming due for regional and local banks. The CRE securitization market could capture some refinancing activity from them as the banks try to carefully manage real estate exposure amid the challenges facing CRE, including capital requirements, and as they more closely examine their real estate credit exposures. While there could be some spillover into securitization, some of the regional/local bank loans may not be refinanced in the capital markets, as borrowers may not be willing to have securitization-friendly features, be subject to third-party servicing, or meet industry reporting requirements.
MBA NEWSLINK: By transaction type, what could be some of the drivers impacting issuance?
Larry Kay: By transaction type, we forecast that conduit issuance in 2024 will have the lowest percentage growth from 2023 levels relative to single borrower and CRE collateralized loan obligation deals. This reflects borrower concerns of locking in long-term 10-year rates, instead preferring shorter term loans, especially for those that believe interest rates will decline. As a result, the conduit market in 2023 introduced five-year fixed-rate origination deals, which has been received favorably by both borrowers and investors and is expected to continue into 2024.
With the rise in interest rates and loan spreads, as well as the utilization of floating rate loans, more SBs are paying the increasing costs of interest rate caps as they exercise available extension options, rather than refinancing in the current environment, which will also likely limit issuance. SB issuance in 2024 is forecast to increase about 25%-30% from 2023 estimated levels, and they will continue to attract capital for high-quality properties. In addition, life insurance companies in 2024 potentially may not be as active in financing larger loans, which could benefit CMBS SB volumes.
For CRE CLOs, transaction sponsors generally have stabilization plans in place to increase cash flow and value, with the bulk of the transactions primarily composed of floating-rate multifamily loans. Stabilization plans for these assets will likely be challenging to achieve given inflation levels, as well as the slowing rental growth that is coming off the robust levels of prior years. In addition, costs to execute a transaction have been meaningfully impacted due to elevated interest rates and volatile spreads, which will likely continue to suppress issuance relative to prior years that benefited from lower interest rates.
MBA NEWSLINK: What does KBRA anticipate in terms of surveillance themes and ratings activity in 2024?
Andrew Foster: The 2023 rating downgrade activity ran at a higher pace compared to the prior year, as the CMBS distress rate, which includes delinquent loans and loans that are current but with the special servicer, meaningfully increased since the start of the year by 207 basis points to 7.1%.
With higher interest rates and the economic uncertainty carrying over into 2024, we do not expect any meaningful changes in the breadth and magnitude of upgrade or downgrade actions. As a result, we anticipate the ratio of upgrades to downgrades will remain consistent with 2023, with downgrades meaningfully exceeding upgrades and a majority of those downgrades occurring on non-investment grade ratings. Upgrade activity will be limited by lower levels of property sales activity and refinancings, which will impact loan payoffs and transaction deleveraging, as well as the amount of defeasance. As for downgrades, continued office struggles are expected to contribute to a meaningful number of downgrades. However, many other property types are expected to exhibit more stable performance, which should mitigate a meaningful increase in overall distress levels and prevent negative rating actions rising significantly over 2023 levels.
MBA NEWSLINK: KBRA’s conduit credit metrics are tracked through its Comparative Analytical Tool. Year-to-date in 2023, there have been several clear trends observed, including the direction of key credit and concentration metrics. Could you highlight these, as well as possible reasons for the paths they have taken?
Larry Kay: KBRA loan-to-value and KBRA debt service coverage are at their lowest levels since KBRA started tracking these metrics in 2012. The decline in KLTV has been influenced by the market’s reduced appetite for risk, as well as leverage levels being more frequently constrained by KDSC, owing to higher coupons.
Simultaneously, pools are the most concentrated since 2012, with loan count and loan Herfindahl Index metrics at their lowest levels since we began tracking them 12 years ago. As of year-to-date 2023, there was an average loan count of 30, which has decreased to 32 from 54 (about 40% fewer loans) on a quarterly basis since Q3 2022. This has been influenced both by the lower property transaction activity and loans taking longer to close.
The KBRA Interest-Only Index is at its highest since 2012 at 85.3% (full-term IO loans are at multiyear highs), as issuers seek to maximize loan proceeds that are now largely constrained by DSCs compared to prior years when loan proceeds were more constrained by leverage.
MBA NEWSLINK: The house views on major property type fundamentals, with the exception of office, are positive to neutral. Could you briefly describe how they varied by property type and their respective outlooks?
Andrew Foster: Starting with office, this sector is expected to face an uphill battle in 2024, driven by a near-perfect storm of high interest rates, underutilization, weak demand and economic uncertainty. Other factors—such as age, functional obsolescence and emissions mandates—could exacerbate the situation, especially for Class B or C properties. Together, the combination of cyclical and structural factors will likely cause vacancies to continue rising and property values to fall, creating more distress for the sector in the near term. A meaningful respite for office is unlikely before 2025 at the earliest.
Looking at the industrial sector, the demand for space declined this year, partly due to the uncertain economic conditions, which caused some businesses to hold off on expansion plans. However, the overall outlook for the sector remains positive, as companies continue to need warehouse and distribution space for e-commerce sales and to maintain inventory in the event of future supply chain disruptions. In addition, there has been a rise in onshore manufacturing operations to protect against possible supply issues, fueling demand for factory space. Retailers are also committed to increasing the speed of deliveries through the utilization of logistics facilities, providing further support for the sector.
Multifamily demand has benefited from high mortgage rates, a tight housing market, and the housing affordability gap. National home ownership affordability is at its lowest level since the beginning of 2006, according to the Federal Reserve Bank of Atlanta. On the supply side, after above-average multifamily deliveries in recent years, new construction activity is slowing due to rising financing costs. The limited additional supply should help to support the sector. While pricing and transaction volume have been exhibiting signs of softening from very strong levels, multifamily property fundamentals should remain favorable, reflecting positive demand factors and falling supply levels.
A review of retail property fundamentals shows that vacancy levels and rental rate performance have continued to fare well so far in 2023, which reflects the lack of retail construction activity and the strength of the U.S. consumer. Despite bankruptcy announcements increasing this year, the number of store openings are running slightly above closing announcements for the second year in a row. A large component of openings has been in the category of dollar stores, off-price retailers, discounters, and warehouse clubs. While the retail industry is recovering and growing, there will be challenges for the sector in 2024, including the performance of the economy and the consumer, as well as their effect on the retail tenant.
Lodging continues to outperform, with revenue per available room strengthening, primarily driven by strong average daily rate gains. While leisure demand remains strong, growth is moderating due to increases in alternative options, including outbound international travel and cruises, as well as limited inbound international travel due to the strength of the dollar. However, commercial and group demand have started rebounding, fueled by return-to-office trends and the need for in-person meetings. It is expected that demand growth from commercial travelers and groups will continue to offset softening leisure demand in 2024.
