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Markets Update for Fourth Quarter 2019

  • Jan 22, 2020
  • Research

We reviewed data on over 23,600 conduit loans, identifying any loan which defaulted or transferred to the Special Servicer during the calendar year 2019.

In this issue of the Capital Markets Update, we focus on the fundamentals and trends affecting national commercial real estate debt markets. Our feature reviews 2019’s credit performance and what we can infer about asset class default trends. We synthesize and present information gathered from various industry research, public resources, and our own research.

ECONOMY

The November jobs report noted that the economy continues to grow with 266,000 jobs created. Employment in the health care and professional and business services category again led in jobs creation as we may expect. Healthcare has added 414,000 jobs over the past 12 months, while professional and technical services added 278,000, while the financial services sector added 116,000 for the same period.

The unemployment rate remained stable at 3.5%, among the lowest levels since 1969. The participation rate also remained unchanged at 63.2%. Average hourly earnings showed some growth (3.1% year over year), continuing at a slow and steady pace. As of November 2019, El Centro CA, and Yuma AZ continue to have reported the highest unemployment in the nation, while the Dallas, TX, New York, and Los Angeles MSAs lead the nation in number of jobs created.

The 10-year US Treasury rate as of this writing was 1.77%, declining around 92bps from one year earlier. Much of the decline reflects overall concern around global trade tensions, economic weakness abroad, and geopolitical uncertainty. The 2/10 spread has now recovered to 27bp from inversion over the summer. In September 2019, the US budget deficit widened to almost $1 trillion, with the US trade deficit also widening to $884 billion. With record budget deficits at all-time lows in unemployment, our outlook is cautious on the economy, interest rates, and commercial real estate values.

PROPERTY MARKETS

Effective rent growth–National average shows an 1.72% one-year growth rate, the slowest growth rate in the past 5 years. Multi-family rents grew 3.1% for the year, while industrial was less than 1% year over year.

Vacancy rates–For the trailing 1-yr period, vacancy rates improved slightly in multi-family and retail properties, with deterioration in office and industrial properties. Estimated deliveries for 2019 increased by 4% for multi-family, but declined by 16%, 5%, and 16% for office, retail, and industrial properties respectively. Absorption was less than 1.0x for all property types. We expect continued vacancy increases as heavy construction pipelines are delivered.

National property prices–For multi-family increased by 7.85% on a rolling 3-year basis, while hotel properties showed a 3.3% increase after 6 consecutive months of declines. Continuing its macro-decline, retail has lost value per unit (3yr basis) nearly every month for the past 3 years.

DEBT CAPITAL MARKETS

Credit spreads generally tighten in 2019 with CMBS BBB- coming in approximately 140bps for the year. Year-end 2019 CMBS conduit issuance of $49.6bn is leading last year’s issuance by approximately 23%. Competing products such as SASB, FHLMC, and CRE-CLO have seen $45.4bn, $69.5bn, and $19.5bn of issuance at year-end 2019 respectively.

CMBS risk retention pricing–Horizontal subordinates in the 14% area, L-shaped subordinates imply pricing of the Non-Rated conduit bonds in the 16%-25% area.

 Conduit delinquency rates–Dropped to 1.40% this month, reflecting continued improvement.

THREE TRENDS WE'RE WATCHING

• Cyclical Highs In Property Prices
    »All property types experiencing price volatility at the national level. Multifamily, hotel, and industrial building on a very robust pace. Over-levered properties finding their way into rated securitizations.
• Sector Overbuilding
    » Hotels, student housing, multi-family, and now industrial are some of the most over-built asset classes across the market. Construction slowing somewhat relative to prior years. Helps absorption, however, we remain concerned about inventory already in the market.
• The Retail Purge
    » Retail assets from malls to local unanchored centers, to single-tenant, retail continues to struggle. Constitutes over half of all defaults in 2019. Maturing mall loans having difficulty refinancing even at lower leverage points.

FEATURE–YEAR IN REVIEW: 2019 DEFAULT TRENDS

One of the most common conversations among investment professionals begins with the question, “so what are you guys seeing”. Year-end 2019 gives us that opportunity to step back and take a look at the past year’s CMBS collateral performance and credit trends. This analysis helps us identify any consistent themes or patterns and helps to answer the common question.

We reviewed data on over 23,600 conduit loans, identifying any loan which defaulted or transferred to the Special Servicer during the calendar year 2019.

Overall results are identified below:

RealINSIGHT Marketplace Report

By balance, nearly 70% of conduit market exposure consists of retail, office, and hotel properties. One may reasonably expect credit and default patterns to be consistent with collateral proportions.

• Nearly $5 billion (1.4%) in current UPB defaulted during the calendar year 2019 consisting of 200 loans and participations.

•  Retail led the way, however, what is surprising is the disproportionate level of defaults relative to the overall market. At $2.6 billion, retail accounted for over 50% of the dollar defaults and nearly 40% of loans by count.

• Office property defaults were $1.1 billion (21%) in defaults across 31 (15%) loans, while hotels amounted to $627 million in defaults, with a loan count of 55. Hotels were the second-highest by loan count and made up over 25% of the year’s total defaults.

• Time to default: on average, the retail, office, and hotel loans defaulted (or re-defaulted) within 69 months or between 5 and 6 years from origination. Defaults included loans with both 5-year and 10-year terms.

For a deeper look at 2019 default patterns and the all-important reason for default across the various asset types, we selected the top 10 loan defaults in each of Office, Retail, and Hotel. We analyzed the loan basis at default, current performance, debt yield, and primary reason as we could best determine from published servicer comments and other research.

Results are presented below: Top 10 Loan Defaults 2019

RealINSIGHT Marketplace Report

Several observations can be made regarding 2019 credit and performance after reviewing this data.

•  Retail–Over 73% of all retail default dollars came from malls in 2019. All of the Top 10 retail defaults were malls. Almost all of the mall defaults were maturity defaults (some 5yr loans, some 10yr, some previously modified). Nearly all were significantly underperforming underwriting, and even with debt yields of over 10%-12%, malls appear to have a very tough time refinancing in today’s market. Beyond the Top 10, retail bankruptcies and single tenant properties with exposure to those credits resulted in numerous defaults in 2019.

•  Office–Over 70% of all office default dollars were contained in only 10 loans in 2019. Defaults spread across CBD, Urban, and Suburban locations. The most common default driver is the departure, bankruptcy, or termination option afforded to single or large proportion tenants. Loans written with maturity dates at or close to lease end dates contain a binary risk profile. Properties can go from full-value to no-value depending on tenant plans.

•  Hotel–By loan count, over 25% of all defaulted loans were hotels. Smaller loan sizes and higher property counts can sometimes make this category seem the largest. In over 50% of the default cases, borrowers cited local market overbuilding and added competition as the main reason for underperformance.

Lower room rates and occupancies lead to unfinished improvements, franchise defaults, and properties in disrepair, further reducing their competitive position in a crowded market.

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