Commercial Real Estate Debt

Within CMBS, the senior parts of the capital structure that led the market wider in March also led the market tighter during the second quarter. After trading as wide as swaps plus approximately 3.25%, AAA conduit CMBS spreads ended the quarter at approximately swaps plus 1.10%, roughly 20 basis points wide to pre-COVID-19 levels.

The tightening in AAA spreads improved economics enough to restart the new issue market. Although quarterly CMBS issuance was the lowest it’s been in eight years at $7 billion and a far cry from the $23 billion issued in the first quarter, it allowed banks to move commercial real estate debt exposure and free up some of their balance sheets, which were severely constrained at the end of March.

After AAA CMBS recovered, AA-rated securities were quick to follow. Eventually, we saw a similar dynamic in single A-rated bonds. In June, the rally extended to BBB-rated conduit CMBS. We are skeptical regarding the depth and long-term viability of these recent BBB conduit CMBS buyers. The more we hear buyers refer to CMBS as “cheap to corporates or CMBX,” the more we believe they are not focused on fundamental real estate risk and, therefore, the quicker selling pressure could increase should the broader markets grow cautious.

The one market segment that has seen more volatility than conduit CMBS credit tranches has been mezzanine CMBX tranches. As uncertainty persists, so could volatility in CMBX, which will likely influence trading levels for cash CMBS securities.

It is more challenging to generalize the Single-Asset/Single-Borrower (SA/SB) market because of the unique nature of each transaction. Unlike more complicated conduit deals, SA/SB transactions tend to be fairly straightforward, and a variety of new buyers – including traditional real estate private equity investors, family offices, and hedge funds – have moved into the space. This new capital improved prices quickly given limited overall bond availability.
Much of our concern regarding the viability of the run-up in prices is based on fundamentals. Property sales and leasing volume have cratered, leaving a significant amount of uncertainty relating to the magnitude of COVID-19’s impact on real estate valuations. This will take time to play out, but we already know that challenges exist. The conduit CMBS delinquency rate rose to 10.32% as of June 30th, two basis points below the record high set in July 2012. An additional 4.1% of loans are in their grace period; unsurprisingly, hotel (24.3%) and retail (18.1%) backed loans are showing the highest delinquency rates. In addition, rating agency downgrades have already begun and are likely to accelerate, putting further stress on prices for certain bonds.

We believe these factors continue to create an environment where investors with the ability to look through bonds and assess fundamental commercial real estate value can thrive.

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Q2 2020 saw the lowest quarterly private label issuance total in eight years.

The aggregate CMBS delinquency rate has reached GFC levels and is expected to hit a record high in the coming months.

$2.1 trillion of commercial real estate debt is set to mature over the next five years.

Although spreads have tightened from their peak March levels, they remain wide of pre-COVID-19 levels.

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AG Capital Markets Perspectives (“CMP”) provides our portfolio managers’ views on the credit, real estate, and private equity markets. To access this quarter’s CMP and past quarterly reports, please complete the form below.

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