U.S. commercial real estate (CRE) prices reached an important milestone in September 2014: They recovered 100% of the sector’s peak-to-trough loss, as measured by the Moody's Commercial Property National All-Property Index. Lending conditions in the sector also continued to improve in 2014, with commercial mortgage-backed securities (CMBS) issuance exceeding $85 billion, an increase of more than 10% year-over-year.
PIMCO believes that while the CRE recovery has come a long way from the depths of the financial crisis, property prices are in the middle to late innings of their recovery and there is room for further improvement in 2015. However, the continued recovery in the sector requires increased caution among investors. This sentiment was reflected at a recent industry conference: Many attendees were concerned about the tradeoff between low yields and the need to deploy capital, whether or not valuations are justified by fundamentals and the potential contagion from volatility in other asset classes. These concerns were in stark contrast to the sentiment just a year ago, when the CMBS community seemed unanimously exuberant.
CMBS rebound continues
As with most asset price recoveries, credit availability has played a critical role in recent CRE growth. Secured by mortgages on commercial properties, CMBS is a primary source of financing and liquidity for real estate investors and, at over $640 billion outstanding, represents an important source of debt capital, filling the gap that traditional lenders such as banks and insurance companies cannot or will not fill. The sector accounts for approximately 20% of all commercial-mortgage-related debt outstanding in the U.S. as of 30 September 2014, according to Trepp and Federal Reserve data.
CMBS issuance has increased for five consecutive years, and projections for 2015 are for growth of 20%‒30%, driven largely by an increase in maturing loans on the supply side and the continued search for yield on the demand side. Despite improvements, 2015 has been viewed as an inflection point by CMBS investors for several years, as it marked the beginning of the dreaded “wall of maturities”: large amounts of 10-year commercial mortgages made in 2005‒2007 that were scheduled to come due. However, what was close to a $400 billion wall then is only a $300 billion wall today due to prepayments, liquidations and defeasance (see Figure 1). Scheduled loan maturities in 2015 are now only $71 billion, and if CMBS issuance this year is anywhere close to forecasts of more than $100 billion, there should be sufficient credit available to accommodate them.
While a positive in many ways, the growth in issuance in recent years does not come without concerns. A year ago, we highlighted the expansion of the “credit box” in CMBS loans, as increased competition among lenders led to a downward “creep” in underwriting standards. Throughout 2014, signs of this appeared in the form of incrementally higher leverage and looser loan terms. It appears that the CMBS market is poised to start 2015 in much the same way; CMBS underwriting will likely continue to slip, mostly because there is no near-term catalyst to slow the lender competition and the need to deploy capital outweighs credit concerns, at least for the time being. Though it is a borrower’s market, the deterioration in lending standards is at least a “disciplined deterioration.” Banks have far less ability and desire to recreate the conditions at the height of the 2006‒2007 lending craze, as regulatory oversight and rating agency scrutiny prevent the most dangerous pro-forma underwriting practices.
Fundamentals required to drive CRE recovery further
While the initial leg of the recovery was driven by the global compression in interest rates, and subsequently the discount rates that are used to value commercial properties, the next leg of the recovery will likely depend more on domestic growth and a subsequent improvement in property-level fundamentals. PIMCO forecasts real U.S. GDP growth of 2.75%‒3.25% in 2015, and expects further improvements in consumption and employment conditions. The result should be a supportive backdrop for both credit assets generally and CMBS specifically.
PIMCO expects CRE prices to rise 4%‒6% in 2015, driven by continued improvements in absorption rates and rents (due to still-low positive net supply nationally and an improving economy). Importantly, bifurcation remains a key theme in terms of both geographic location and property type. For example, prices of multifamily and office properties in select markets are well above their late-2007 peaks, while many industrial, office and retail properties outside of major cities are still 15%–20% below their pre-crisis highs. While we expect this trend to continue, secondary market properties that have underperformed in the past few years should benefit from improving commercial real estate finance conditions.
What can go wrong
While PIMCO remains constructive on both CRE prices and CMBS valuations, higher valuations and rapid increases in credit availability drive us to be cautiously optimistic. In addition to deteriorating underwriting standards, weakness in the retail segment continues to be a structural headwind for the sector, and recent volatility in oil prices has reminded investors of the idiosyncratic risk in commercial credits.
Lastly, regulatory challenges cannot be overlooked. Requirements born of the Dodd-Frank Act will require CMBS sponsors, or the investors that buy the most subordinate CMBS bond classes, to hold more capital against the securities and maintain those positions for a minimum of five years. The consequences of this are likely to be higher borrowing costs and reduced credit availability. While the goal of these measures is more responsible lending, as seen in the residential mortgage market, too much regulation can move the pendulum too far in the other direction, and the impact of the new capital requirements on CMBS overall is unclear. While we expect lenders and issuers to adapt to new regulations, legal complexities and high operational costs may result in less credit availability than the market has become accustomed to.
What does all this mean for CMBS investors?
Bolstered by tremendous demand for yield, CMBS spreads have remained resilient even amid expectations for another year of record post-crisis issuance and continued weakening in underwriting standards. PIMCO expects CRE prices to increase modestly in 2015, driven by healthy domestic growth and improving employment. Against a backdrop of lower risk premiums and flatter credit yield curves, PIMCO believes the CMBS sector as a whole is neither glaringly expensive nor cheap at this point. However, as compensation for risk has normalized in the post-crisis environment, security selection is king. This holds true even when investing in the most senior portion of the capital structure.
We continue to favor senior CMBS bonds with high-credit-quality collateral, as these bonds often have embedded downside protection at minimal cost. In more credit-sensitive sectors, we are wary of valuations but see attractive opportunities for investors that can perform granular loan-level analysis and identify mispricings. The bottom line: CMBS are largely fairly valued. We continue to maintain a healthy exposure to the sector given its unique diversification benefits relative to other credit sectors, as well as the excess-return opportunities that arise from the structural and collateral-level nuances of each CMBS deal.