A recent report from Moody's forecasts significant challenges to U.S. and European CMBS markets. High interest rates above those of the last decade — which seem unlikely to immediately retreat — will make refinancing difficult and restrict leverage on new deals. There is also property valuation risk. Maturity defaults for existing transactions will rise.
However, some good news: in the U.S., economic growth will mitigate some of the valuation risk and new issuance will "steadily increase." And for existing CMBS, many cash flowing assets will see opportunities for extension modifications.
"If interest rates remain higher for longer, CMBS property valuations will weaken," Moody's wrote. "However, 2023 employment gains have been somewhat offsetting rate-related risk by supporting commercial real estate (CRE) net operating income (NOI), with variation by region and property sector."
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Depending on property segment, yields have already risen between 17 and 130 basis points since mid-2022. Valuations have begun to adjust in response, with low vacancies helping certain property types to offset valuation risk. Still, the result has been largely a return to 2021 value levels.
"Office values have decreased roughly 11% since peak levels in 2022, while the multifamily sector has suffered a 16% value decline," they wrote. "Economic growth and the shift to shopping from home has supported industrial property fundamentals, and spurred ongoing investor demand for industrial properties. Industrial is the only sector reporting appreciation since Q2 2022, with a value increase of 2%."
Industrial, multifamily, and retail have continued to perform relatively well as evidenced by vacancies in the 5% to 7% range. Even with significant increase in inventory, the national vacancy rate of multifamily is still a "low 5.1%," meaning positive fundamentals for most in the class.
Office is a different case. National vacancy has risen from 12.2% in the last quarter of 2019 to 18.4% now as tenants downsize. It varies greatly with markets. Some metros like San Francisco had low vacancies in 2019. They're now facing increases into the 20% range with larger rent decreases. But those that had pre-pandemic distress with mid-teens vacancy rates are seeing small vacancy increases and smaller losses in market rents.
Still, the potential for valuation risk has already resulted in wide bid-ask gaps, driving transaction volumes down to 2012-2013 levels.
New issuance will increase over 2023 levels because many CRE borrowers will no longer be able to avoid the higher rates the market offers as a growing wave of maturities develops. However, the volume increases will remain low. Loan-to-value ratios will be among the lowest in years because mortgage coupon rates of 7.21% makes it difficult for borrowers to show an initial 1.2 times the debt service coverage ratio.
"To refinance, many borrowers have had to pay down their mortgage, leading underwritten (UW) LTVs to decrease to 55% in Q3 2023 from 60% in Q1 2022," they wrote. "These higher interest rates have also caused the percentage of interest-only (IO) loans to increase to help borrowers show positive initial DSCR ratios."
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