KBRA Sees Falling CMBS Outlook Into 2023

CMBS loans have taken significant shocks since early in 2022. According to Kroll Bond Rating Agency (KBRA), that’s going to continue, and possibly accelerate, into the new year.

More uncertainty, higher mortgage rates, reduced leverage, and lower CRE transaction volume have all contributed to questions about “meaningful property value declines,” Larry Kay, senior director in the CMBS surveillance group at KBRA, said in an interview with the Mortgage Banker’s Association (MBA) newsletter. Many market participants are in a “holding pattern.”

“All these factors, as well as expected rising interest rates, will weigh on private label issuance, which we believe will be meaningfully lower, tracking the 2022 quarterly downtrend into the new year,” Kay said. KBRA expects a total 2023 CMBS issuance of $71 billion, down 29% year-over-year from the firm’s 2022 issuance forecast of $100 billion. “By transaction type, we forecast YoY conduit volume to be basically flat, while SB/LL and CRE CLO will be lower by 31.2% and 41.4%, respectively.”

Commercial mortgage-backed securities are an important part of CRE. By bundling commercial mortgages into bond-like financial instruments and providing fixed-income to investors in return for up-front payments, the CMBS structure helped lenders free up cash for more investing.

The environment has shifted significantly with the advent of major Federal Reserve interest rate increases since June in the organization’s attempt to rein in inflation.

In January, Morningstar thought the outlook for CMBS was still strong. “As more workers return to the office, demand for office space will improve and hotels will see higher occupancy from an increase in business travel,” Morningstar’s Steven Jellinek and Erin Stafford wrote at the time. “More efficient use of retail space, particularly in grocery- and discount-anchored centers, as well as a modest construction pipeline, will aid the recovery.”

In late March, KBRA wrote that “CRE securitization credit performance among conduit, single borrower/large loan (SB/LL), and CRE collateralized loan obligation (CLO) transactions has held up reasonably well.” Even in August, CMBS delinquency rates finally fell below 3% for the first time since the pandemic, as a Trepp report announced. But at the end of November, Fitch Ratings expected the delinquency rate to double from 1.89% this last October to between 4.0% and 4.5% by the end of 2023.

And Moody’s Analytics last month said that a third of new CMBS issuance had negative leverage in the third quarter. The firm calculated that 28% of those newly-issued securities showed signs of negative leverage, where the cost of debt outpaced projected returns on investment, even taking expected rent increases into account.

“Much of the SB [single borrower] issuance has been floating-rate loans,” Kay told MBA. “With the rise in interest rates, widening loan spreads and potentially lower take-out proceeds, SB borrowers appear more likely to pay the increasing costs of interest rate caps, rather than refinance in the current environment.” But he added that KBRA expects capital to be available for “high-quality single-asset SB deals, which may be too large for other lenders to finance” as well as appealing to “buyers, as they are easier to underwrite and spot risks versus pools of assets.”

CRE CLOs are likely to fall because “typically fund properties that are in various stages of transition, and sponsors generally have stabilization plans to increase cash flow and value,” Kay said. “These plans will inevitably be more challenging to achieve given inflation levels and their impact on operating costs, as well as downward pressure being exerted on rental rates.”