Industry Economic And Ratings Outlook: With Issuance Up And Delinquencies Down, CMBS Has Positive Momentum Going Into 2014
|Publication date: 09-Dec-2013 10:10:24 EST|
Over the past year, the U.S. commercial mortgage-backed securities (CMBS) market has benefited from low interest rates, better access to capital, and the recovery in property fundamentals. However, several economic risks still remain: the political paralysis in Washington, D.C., the ongoing federal budget sequester, the uncertainty surrounding the Federal Reserve's quantitative easing (QE) program, and the risk that ultra-low interest rates are likely to inflate asset bubbles. Because of the various headwinds, our economists have estimated modest 2014 GDP growth of 2.6%, while the risk of a recession is pegged at a 15%-20% possibility within the next 12 months. Despite this, we expect the CMBS market to continue to improve going into 2014, and thus we have a moderately positive 12-month outlook for the sector.
Standard & Poor's base-case 2014 outlook for the U.S. CMBS sector is somewhat favorable, based on the following fundamentals:
- Unemployment peaked at 9.9% in late 2009, and is now at 7.3% according to the Bureau of Labor Statistics' (BLS') October 2013 estimate.
- All five major CMBS property sectors (retail, office, industrial, multifamily and lodging) show declining vacancy trends based on historical data. However, multifamily vacancy rates are expected to increase in 2014 due to construction completions that will add to supply.
- Access to mortgage capital improved in 2013, as CMBS issuance was up 81% compared with last year, based on year-to-date issuance through Oct. 31, 2013. In addition, borrowers are benefiting from record-low interest rates, which supports acquisitions as well as refinancing vintage CMBS collateral.
- Loss severities declined to 34.7% year-to-date in 2013 from a peak of 50.4% in 2009. This likely resulted from a combination of improved market liquidity, faster delinquent loan workouts, and higher market values for liquidated collateral.
- The CMBS delinquency rate and amount both fell to multi-year lows in third-quarter 2013. The delinquency rate fell to 8.6%, compared with 9.8% at year-end 2012, and the total dollar amount of delinquent CMBS declined to $35.0 billion from $42.6 billion in 2012.
When analyzing U.S. CMBS collateral to form our near-term credit outlook, we examine certain macroeconomic factors that are most relevant to commercial mortgage performance, including the unemployment rate, economic growth, consumer spending, and interest rates, among others. Standard & Poor's economists' baseline credit outlook for U.S. CMBS collateral in the next 12 months reflects the following forecast:
- U.S. real GDP growth slowing to 1.7% in 2013 and then recovering to 2.6% in 2014;
- Unemployment of 7.4% in 2013 and 6.9% in 2014;
- Job growth of 1.6% in 2013 and 1.7% in 2014;
- Consumer spending growth of 1.9% in 2013 and 2.5% in 2014;
- Consumer Price Index (CPI) growth of 1.4% in both 2013 and 2014;
- Real nonresidential construction increasing 1.7% in 2013 and 2.9% in 2014; and
- Interest rates remaining low and capital remaining attractively priced and available. We believe real estate market capitalization rates will remain low as well, providing some stability in property values.
How might different economic assumptions affect CMBS performance?
Key risk factors to the baseline forecast are the ongoing euro debt crisis, gridlock in Congress, and any reversal of gains in U.S. housing construction, employment, or asset values. In addition, asset inflation resulting from the Federal Reserve Bank's zero interest rate policy combined with its QE program poses another risk. Although today's borrowers (and bondholders) are clearly benefiting from the Fed's accommodative policies, it is less clear what the future costs of these policies will be. For example, if (or when) the Fed ends or reverses its QE program, how will that affect interest rates and asset values? For many CMBS investors, the concern is that interest rates could rise, and that may hinder the refinancing of billions of dollars in commercial real estate loans.
Under our economists' baseline economic assumptions, we expect vintage CMBS collateral quality, on average, to improve moderately. Recent trends, such as rising property values and increased CMBS lending, benefit existing loans (and bondholders), since maturing loans are more likely to be refinanced at maturity with new CMBS debt. However, this may pose a problem in five to 10 years when these newly issued loans mature.
Under our downside scenario, CMBS delinquencies and defaults would likely increase because of weakening property fundamentals, increasing interest rates, or some combination of the two.
|2013-2014 Scenarios for The U.S. CMBS Sector|
|2013||2014||2013||2014||2013||2014||2012||Comment/outlook (baseline)||Baseline impact on collateral credit quality|
|Real GDP (% change)||1.6||0.6||1.7||2.6||1.8||4.1||2.8||Slow but steady economic growth should support our expectation for low rental rate growth and modest occupancy gains in most sectors.||Somewhat favorable|
|Real non-residential construction (% change)||1.6||(0.8)||1.7||2.9||1.9||6.3||12.7||Construction is still significantly below 2008 peak levels, but increasing, particularly with multifamily projects. New supply additions remain low in most property sectors; however, certain apartment markets may face supply pressure.||Somewhat favorable|
|Real consumer spending (% change)||1.8||1.3||1.9||2.5||2.0||3.3||2.2||Growth in consumer spending bodes well for retail and industrial distribution. Nonetheless, continued growth in internet sales will limit demand for retail stores.||Somewhat favorable|
|Unemployment rate (%)||7.5||7.6||7.4||6.9||7.4||6.0||8.1||The unemployment rate, although still high, is expected to gradually improve, which would aid the consumer and growth in other sectors, including the lagging office sector.||Somewhat favorable|
|Total nonfarm payrolls (% change)||1.6||0.7||1.6||1.7||1.7||2.4||1.7||Non-farm payrolls have yet to fully recover, being 1.5 million jobs short of peak levels. Growth is an important factor to CMBS credit, particularly for office collateral.||Neutral|
|CPI (% change)||1.4||0.8||1.4||1.4||1.5||2.1||2.1||Modest inflation is often favorable for commercial properties, as revenues will often grow faster than expenses, while interest payments are typically fixed-rate. Inflation of less than 2% is below the long-term average, and thus, less favorable.||Somewhat unfavorable|
|10-year U.S. Treasury (%)||2.3||2.0||2.3||2.9||2.4||4.2||1.8||With 10-year, fixed-rate mortgages available at rates below 4.5%, existing borrowers are better able to refinance at such historically low rates. With lower rates, coupled with more CMBS lending, fewer loans are defaulting at maturity.||Favorable|
|*Economic forecasts are from the "U.S. Economic Forecast: Two Economies Diverged In A Wood," published Dec. 5, 2013. CPI--Consumer Price Index. CMBS--Commercial mortgage-backed securities.|
We publish monthly our economists' scenarios of where we think the U.S. economy could be heading. Beyond projecting GDP and inflation, we also include outlooks for other major economic categories. This is our "baseline scenario," and we use it throughout our credit analyses.
We also realize that financial market participants want to know how we think the economy could worsen or improve from our baseline scenario. Any point-in-time forecast of the economy will likely be wrong; it is simply a question of how far wrong. As a result, we now project two additional scenarios, one upside and one downside. These scenarios are set approximately at one standard deviation from the baseline (roughly the 20th and 80th percentiles of the distribution of possible outcomes). The downside estimates the credit effect of an economic outlook that is weaker than the expected case.
Industry Ratings Outlook
At year-end 2012, the CMBS delinquency rate was 9.77%, its highest level since we began tracking delinquencies in 1999. But the tide has clearly turned: The delinquency rate fell to 8.56% in third-quarter 2013, and loss severity rates averaged only 35% year-to-date in 2013, compared with 40% in 2012. Meanwhile, year-to-date new-issuance volume was 81% higher compared to the same period a year ago.
Employment remains weak despite economic improvement
Employment both directly and indirectly fuels demand for commercial real estate. Demand for office space depends directly on employment sectors that hire office workers; demand for other property types depends on consumer spending and general economic activity that bolsters employment. BLS estimates that the U.S. unemployment rate has been declining since late 2009, but CMBS delinquency rates rose until fourth-quarter 2012 (see chart 1). Job creation has remained lackluster and labor force participation has continued to slow, with more workers retiring, going on disability, giving up on finding a new job, or simply settling for part-time work instead of full-time. Thus, despite an economic recovery that is well into its fourth year, the U.S. is still missing 1.5 million non-farm jobs compared to late 2007 employment levels.
Many other factors have contributed to labor issues: workers' real wages have stagnated, many new jobs are being added in low-paying sectors, and many higher-paying sectors, such as manufacturing and construction, also have not returned to pre-recession levels. Hourly earnings were flat in September compared with August rates and up only 0.9% from a year earlier. These factors, combined with the effects of inflation have weakened consumer purchasing power and negatively affected CMBS performance.
Occupancy rates have improved
At the loan level, collateral performance mainly relies on property revenues, which are a product of rent (pricing) and occupancy (utilization) rates. If vacancy levels rise, rents typically decline, resulting in less property cash flow available to pay debt service and possibly leading to more loan delinquencies (see chart 2).
Among the major property types, multifamily vacancy rates peaked in late 2009 at 7.4% and declined significantly to about 5% in late 2012. Lodging properties have more than recovered, with average daily rates (ADR) and occupancy levels that are in-line with 2007 peak levels. Office, retail, and industrial vacancy rates remain in the double digits but have significantly improved (see chart 3).
Capital markets remain open
Access to capital improved in 2013. As of Sept. 30, year-to-date CMBS issuance totaled $60.5 billion, which was a 96% increase from the $30.9 billion at the same time in 2012 (see chart 4).
CMBS Collateral Performance Variables
Aside from macroeconomic factors and property fundamentals, CMBS credit performance can be gaged by these statistics:
- Delinquency rates,
- Delinquency amounts (in aggregate),
- Loss severity rates,
- The ratio of resolved loans to newly delinquent loans, and
- The payoff rate for maturing loans.
The CMBS delinquency rate declined in third-quarter 2013 to 8.56% compared with 9.77% one year ago (see "CMBS Quarterly Insights: The Loss Severity Rate Falls To Multi-Year Lows," published Nov. 19, 2013). The amount delinquent fell slightly in the third quarter to $35 billion, down from $42 billion at the beginning of this year. The total amount delinquent peaked at just over $49 billion in late 2010 (see table 2).
|CMBS Collateral - Key Performance Variables|
|Key variables||2007||2008||2009||2010||2011||2012||1Q 2013||2Q 2013||3Q 2013|
|Amount delinquent (bil. $)||2.3||6.9||30.6||49.1||44.9||42.6||41.8||36.9||35.0|
|Delinquency rate (%)||0.34||1.1||5.15||8.89||8.95||9.81||9.7||8.89||8.56|
|Resolved loans vs. new delinquent loans||0.83||0.36||0.34||0.51||1.14||1.05||1.07||2.67||1.90|
|Loss severity rate (%)||27.0||31.2||50.4||46.6||42.6||40.1||40.2||44.1||25.0|
|Payoff rate for maturing fixed-rate loans (%)||N/A||91.7||59.7||57.8||64.5||71.9||84.4||86.0||88.2|
|CMBS--Commercial mortgage-backed securities.|
The loss severity rate (principal losses relative to the original loan balance) declined sharply in the third quarter to 25.0%, down from the peak of 50.4% in 2009. We attribute this improved performance (lower loss severity rate) to increased market liquidity, which affects gross liquidation proceeds. Excluding a $600 million loan that was liquidated without a loss, the third-quarter loss severity rate would have been 29.1%, close to pre-recessionary levels.
The ratio of loan resolutions (including delinquent loans that returned to current status or were liquidated) to new delinquencies has increased significantly in the third quarter to 1.90x. We view a ratio greater than 1.0x as favorable because it indicates that special servicers are resolving loans faster than new loans are becoming delinquent. Since 2011, the ratio has exceeded 1.0x, which is consistent with our view that fundamentals are improving, particularly for vintage transactions.
Existing CMBS collateral is composed predominantly of loans that originated between 2005 and 2007, most of which mature between 2015 and 2017. Therefore, the future CMBS performance is highly dependent on whether borrowers can repay or refinance those maturing loans. As indicated in table 2, the payoff rate for maturing loans has varied significantly over time, depending on the availability (or lack thereof) of capital relative to existing debt, as well as equity, carried by the mortgage borrowers. We attribute the rapidly improving payoff rate to a variety of factors, including better access to capital and stronger property fundamentals.
Given the exposure of CMBS to various property types, we often view overall CMBS performance as a composite of the multiple underlying property sectors. For example, we would expect the lodging sector (and to a lesser extent, multifamily housing) to respond most readily to changes in economic conditions because occupancy levels fluctuate daily, as do hotel room rates. Conversely, properties with long-term leases, such as office, retail, and industrial properties, are less reactive to changing economic conditions because contractual leases can delay the effect of lower demand (or higher supply), and thus rental rates and occupancy levels can decline over several years.
Not surprisingly, the lodging and multifamily delinquency rates have been declining since 2010. Retail and office delinquency rates have also been declining since early 2013. The industrial delinquency rate peaked in 2011 and has since been on a declining trend.(see chart 5).
Collateral Performance Scenarios
When analyzing loss rates for CMBS transactions, we consider various economic scenario forecasts that we believe will affect commercial real estate, borrower payment behavior, and overall commercial-mortgage collateral performance.
Under our baseline economic scenario, we expect the U.S. unemployment rate to average 7.4% in 2013 and 6.9% in 2014. In this scenario, commercial real estate vacancy rates would continue to steadily decline. We would also expect the CMBS delinquency rate to range from 7.0%-8.5%, and we believe the loss severity rate for resolved loans would range from 30%-35%.
Under our downside economic scenario, we would expect unemployment to average 7.5% in 2013 and 7.6% in 2014. Under this scenario, real estate fundamentals would likely stagnate. In this case, we would expect the delinquency rate to range from 8.5%-9.5% because of an increasing number of newly delinquent loans and slower loan resolutions. The loss severity rate for resolved loans would likely stagnate at around 35%-40%.
CMBS Credit Outlook
CMBS credit performance was positive in 2013 and has continued to improve. We expect new issuance (2013 vintage) CMBS credit quality to deteriorate due to increased competition among lenders and higher tolerances (lower standards) from B-piece buyers. However, new issuance greatly benefits vintage CMBS transactions, as evidenced by the significant uptick in maturing loan payoffs.
We believe that average credit metrics, including loan-to-value (LTV) ratios, the percentage of interest-only loans, and deal diversity were generally stable thus far in third-quarter 2013 conduit deals on a quarter-over-quarter basis. But, we believe these transactions are riskier than last year's and that slipping loan standards will eventually translate to higher loss rates for conduit deals issued during 2013 relative to other recent vintages (see "U.S. Conduit CMBS Update: Credit Metrics Were Stable In Third-Quarter 2013, But Transactions Remain Riskier Year Over Year," published Sept. 3, 2013).
The absolute level (dollar amount) of delinquentt loans has been declining for the past two consecutive years. Industry concerns regarding maturing 2007-vintage loans appear to have ebbed, as underlying property fundamentals, such as vacancy rates, indicate that conditions are improving for property owners. Under our downside economic assumptions, existing 'AAA' ratings would likely remain unchanged, and potential downgrades should be limited to lower-rated classes.
Appendix: Sensitivity Of Ratings To Changes In Key Collateral Assumptions
To assess the potential effect of key collateral assumptions on rated securities, we conducted a sensitivity analysis on a hypothetical CMBS transaction.
The hypothetical pool has 82 loans, an effective loan count of 31, and a concentration coefficient of 78%. The transaction is highly diversified; the largest loan exposure was 9% of the pool's principal balance, and the top 10 loans represent 47% of the pool (see table 3).
|Economics Of A Hypothetical CMBS Transaction|
|LTV||DSC||Cap. rate||NCF decline||Property value decline|
|Standard & Poor's (expected case assumptions)||81.2%||1.47x||7.7%||5.0%||15.3%|
|LTV--Loan to value. DSC--Debt service coverage. NCF--Net cash flow. N/A--Not applicable.|
In this hypothetical transaction, Standard & Poor's LTV of 81.2% was based on an expected case (or 'B') stress scenario and 15% property value decline, whereas the issuer's LTV of 67.5% was based on current market values as determined by appraisals.
We sized the expected case ('B') stress scenario, to expected losses based on our 5.0% stressed cash flow decline (compared with the issuer's reported net cash flow) and elevated capitalization rates. The result of this stress was that certain loans would default and take a loss because property cash flow and valuation would be insufficient to repay the loan in full. The threshold for 'B' losses is typically at an LTV of 95%, on a loan-by-loan basis. In our hypothetical pool example, the stress scenario resulted in a loss that would be less than the criteria minimum 'B' enhancement level of 1%, and thus, we assumed the minimum levels.
We sized the 'AAA' credit enhancement levels to withstand a stress in which property values would decline by 40% to 50%, akin to the Great Depression. The 'BBB' loss coverage level of 6.7% was based on a stress level that was less severe than in the 'AAA' scenario but more severe than in the 'B' expected case (see table 4). The 'BBB' stress would typically result in property values declining 25% to 30%, more or less depending upon where the real estate markets are relative to the economic cycle.
|Hypothetical CMBS Pool Scenarios|
|Scenarios||Scenario loss coverage levels (%)|
|B or expected-case scenario||1.0|
Our sensitivity analysis of the hypothetical pool highlighted potential changes to 'AAA' ratings in response to changes in the underlying rating assumptions (see table 5). In addition to the expected case ('B' stress scenario) described above, we subjected this hypothetical transaction to additional stresses that simulated modest ('BB') and moderate ('BBB') stress scenarios by declining property-level cash flows. In this example, the starting point was Standard & Poor's net cash flow (NCF), which was 5% lower than the issuer's underwritten NCF, while the Standard & Poor's capitalization rate was held constant at 7.7%. The potential rating migration was based on an NCF that would be both prospective and sustainable over the long term.
|Initial rating: AAA|
|Scenario||Potential rating migration|
|Decline in Standard & Poor’s NCF by 1% (or 6% below issuer’s NCF)||Modest (BB) stress: AAA|
|Decline in Standard & Poor’s NCF by 5% (or 10.0% below issuer’s NCF)||Moderate (BBB) stress:aa|
|NCF—Net cash flow.|
Related Criteria And Research
- Rating Methodology And Assumptions For U.S. And Canadian CMBS, Sept. 5, 2012
- CMBS Global Property Evaluation Methodology, Sept. 5, 2012
- U.S. And Canadian CMBS Diversity Adjustment Factor Matrices, Sept. 5, 2012
- Application Of CMBS Global Property Evaluation Methodology In U.S. And Canadian Transactions, Sept. 5, 2012
- Standard & Poor’s Ratings Definitions, June 22, 2012
- Principles Of Credit Ratings, Feb. 16, 2011
- Understanding Standard & Poor's Rating Definitions, June 3, 2009
- U.S. Economic Forecast: Two Economies Diverged In A Wood, Dec. 5, 2013
- CMBS Quarterly Insights: The Loss Severity Rate Falls To Multi-Year Lows, Nov. 19, 2013
- U.S. Conduit CMBS Update: Credit Metrics Were Stable In Third-Quarter 2013, But Transactions Remain Riskier Year Over Year, Sept. 3, 2013
- North American CMBS Default And Loss Study: Credit Metrics Continued To Improve Through June 2013, Aug. 30, 2013
- Industry Economic And Ratings Outlook: U.S. CMBS Delinquencies Are Elevated, But Fundamentals Are Stable To Improving, May 17, 2013
- Transition Study: We Expect Increased Ratings Stability For North American CMBS In 2013, April 30, 2013
- Global Structured Finance Scenario And Sensitivity Analysis: The Effects of The Top Five Macroeconomic Factors, Nov. 4, 2011
|Primary Credit Analyst:||Brian O Snow, CFA, New York (1) 212-438-3249;|
|Analytical Managers - U.S. CMBS:||James C Digney, New York (1) 212-438-1832;|
|Barbara A Hoeltz, New York (1) 212-438-3621;|
|Kurt C Pollem, CFA, New York (1) 212-438-1852;|
|Lead Analytical Manager - U.S. CMBS:||Peter J Eastham, New York (1) 212-438-5908;|
|Investor Relations Contact:||Ted J Burbage, New York (1) 212-438-2684;|
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