Securitized Products
CommercialRealEstate:EmergingValueAmidsttheStorm
5 mins
The commercial real estate (CRE) sector has recently faced a slew of negative headlines highlighting high-profile office loan defaults and a sector-wide decline in valuations. Rising rates, tighter lending conditions, weakening fundamentals, and a looming maturity wall create a difficult environment for the asset class. Turmoil within the regional bank sector further raises the specter of more pain ahead. While fully acknowledging the challenges facing the CRE market, we recognize value in certain, more defensive parts of the CMBS capital structure that have sold off too indiscriminately. Our investment strategy focuses on high-quality conduit securities that may benefit from credit stress in the underlying pool of CRE loans and takes a highly selective approach to subordinate credit within single asset single borrower (SASB) deals.
Given the breadth of concerns around the intersection of regional banks and commercial real estate, we provide a brief overview of current conditions within the CRE market, assess the implications of tighter lending conditions, and share our investment views in the current environment.
Rising Rates and a Looming Maturity Wall
Rising interest rates have significant implications on CRE valuations. Higher rates increase a property owner’s financing costs and, in turn, reduce the owner’s return on equity. As a result, purchase prices for new capital investments need to be adjusted lower to achieve target returns. While we’ve seen some re-pricing of CRE assets, we believe the current level of rates implies further strains on valuations going forward (Figure 1). In aggregate, we believe asset values need to decline further with significant dispersion across property sectors. With loan-to-value ratios generally underwritten in the 60% to 70% range, junior debt and equity owners will likely face the brunt of the value erosion.1 However, senior lenders could experience principal losses as well, particularly on loans collateralized by office assets.
Figure 1
Repricing of CRE sectors to continue in 2023 (RCA CPPI)
RCA Capital Analytics and PGIM Fixed Income as of March 2023
Floating-rate debt poses additional (and more immediate) challenges for CRE loans. As debt service payments have rapidly risen above and beyond a property’s net operating income, borrowers could find themselves having to pay out of pocket to cover the difference. Moreover, floating-rate debt often comes with extension options which require the purchase of cost-prohibitive interest-rate caps (another potential out-of-pocket expense).
While fixed-rate borrowers may be better positioned, declining valuations and weakening fundamentals pose refinancing challenges for all types of debt. It is estimated that nearly $2 trillion of CRE debt is expected to mature over the next three years2 (Figure 2). Of the $700+ billion scheduled to mature this year, close to $400 billion is held by banks.
Figure 2
CRE Loan Maturities by Year ($ billions)
Mortgage Bankers Association as of Q4 2022
The Office Malaise
Whereas the softening in fundamentals across most commercial real estate sectors has thus far been moderate, the office market has been especially hard hit due to the work-from-home transition. The office availability rate, currently at 16.3%,3 has steadily increased since the pandemic and now exceeds the Great Financial Crisis peak (Figure 3). Given the long nature of office leases, it will likely take several years for companies to right size their footprints and for availability rates to stabilize. Some high-cost markets, especially those with a greater local economic slowdown, have felt acute pain. San Francisco’s availability rate has risen from 7.1% pre-pandemic to an astonishing 32.7%.4 Effective rents, which account for concessions (e.g., free rent or budget for property improvements), have also declined as tenants now have more bargaining power. Although the challenges within the office sector are meaningful, it is important to note that the office sector is only one segment of the CRE market, comprising approximately 17% of the total CRE mortgages outstanding.5
Figure 3
Office Availability Rates Now Exceed GFC Peak (Percent)
CoStar as of Q1 2023
Potential CRE Fallout from Banking Sector Stress
Recent bank failures have resulted in substantial deposit outflows across regional banks and highlighted liquidity risk within the banking system. Banks, currently responsible for approximately 50% ($2.7 trillion) of all CRE loans outstanding ($5.5 trillion) play a critical role in CRE funding6 (Figure 4). Over the past decade, banks have steadily increased their market share in CRE lending, with regional banks accounting for the lion’s share. Globally systemically important banks (GSIBs) and super regionals currently account for roughly 24% of all commercial real estate bank lending, while smaller regional and national banks account for the remaining 76%.7
Figure 4
Commercial Mortgage Debt Outstanding by Investor
U.S. Federal Reserve, as of Q4 2022
While the Federal Reserve’s Senior Loan Officer Opinion Survey indicates that banks began tightening lending standards for CRE loans in 2022, we expect the recent events in the financial sector to further impair lending availability and hasten property value declines. Regional banks are likely to limit new CRE lending activity as they focus on existing CRE exposures and seek to stabilize deposits. Furthermore, recent bank turmoil has increased the likelihood of additional regulation including: (a) higher liquidity requirements, (b) asset and liability hedging requirements, (c) higher capital requirements, and (d) more stringent underwriting criteria.
As stress within the CRE asset class builds and loan maturities are reached, loan defaults will likely rise within the banking sector. While modifications should be prevalent, they are not a cure-all for properties under considerable stress. Impairments and higher capital charges will likely precipitate distressed loan sales and could further accelerate property value declines.
CMBS Investment Opportunities
Amidst an uncertain economic backdrop, front-pay AAA conduit CMBS currently offers attractive risk-adjusted returns relative to other assets within the fixed income space. As seen in Figure 5, spreads have widened significantly in recent months and the basis between Conduit AAA CMBS and IG Corporates has now inverted (where CMBS is wider than IG)—something not seen in the past decade. While Conduit loans are generally weaker than those from balance sheet lenders, these securities are structurally insulated from credit and extension risk given their significant credit enhancement and payment priority within the deal waterfall. Due to rising rates and wider spreads, these securities generally trade at deep discount dollar prices and offer additional upside from defaults, which can result in unexpected principal payments at par.
Figure 5
Conduit AAA CMBS Now Trade Wide of IG Corporates (bps)
JP Morgan, Bloomberg, PGIM Fixed Income as of 4/21/2023
Opportunities also exist further down the capital structure for investors with the resources and capabilities to perform rigorous bottom-up underwriting. We prefer SASB securities (securities backed by a single property or exposure to a single borrower) versus its conduit counterpart as exposure to a specific sector or specific asset can be targeted. As seen in Figure 6, spreads over the past year have widened significantly across all property types, with office and retail securities underperforming industrial, multifamily, and hotel securities.
Figure 6
BBB SASB Spreads Have Widened Significantly Across Sectors (bps)
JP Morgan, PGIM Fixed Income, as of 4/21/2023
Spread widening across CRE has thus far been indiscriminate but has lacked dispersion within specific sectors as anemic trading volumes and a dysfunctional new issue market hinders price discovery. Spreads in the office sector have widened considerably as liquidity has largely dried up for most deals without regard to asset quality. While many office assets face functional obsolescence, the office sector, in the aggregate, will continue to exist and value is emerging within select properties and markets that are expected to survive. Correspondingly, while fundamentals within the industrial and multifamily sectors are generally sound, many loans originated at peak valuations over the past few years will likely struggle to refinance and mezzanine tranches could be at risk of principal losses in the event of further price erosion.
While the current environment presents many challenges for commercial real estate, investment opportunities are emerging across all parts of the capital structure for patient investors able to weather the price volatility in an asset class which is likely to see additional ratings downgrades, distressed workouts, and negative headlines.
1 Source: Real Capital Analytics.
2 Source: Mortgage Bankers Association (MBA), as of Q4 2022. Excluding owner occupied CRE and construction loans.
3 Source: CoStar, as of Q1 2023.
4 Source: Savills, as of March 2023.
5 Source: Mortgage Bankers Association, as of Q4 2022.
6 Source: U.S. Federal Reserve, as of Q4, 2022.
7 Source: SNL, Bank of America Research, PGIM Fixed Income, as of Q4 2022.
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