Why did CMBS perform well in 2012 and what lies ahead
In 2012, the CMBS (commercial mortgage-backed securities) market had a significant rally as is evident from the table below showing bond spreads over swaps.
2011 Year End
2012 Year End
CMBS2 Senior AAA (A4)
CMBS2 Junior AAA
Not only were the spreads tighter significantly over the year, the performance was better than expectations by almost any measure. Issuance for the year was $48 Bn compared to forecast of $38 Bn. The new issue 10 year AAA spread to swaps ended at 90 compared to forecast of 140, and new issue BBB spreads ended at 410 compared to a forecast of 587 (all forecasts are averages of predictions by market participants as published in Commercial Mortgage Alert). The spread tightening was not limited to new issue either, legacy CMBS prices were up significantly too. Why did CMBS do better than expected, and can this trend of higher issuance and tighter spreads continue?
Why did Spreads Tighten?
There are two widely talked about reasons for spread tightening that generally apply to most of the spread products, and a third one that is specific to and very important for CMBS and commercial real estate.
First driver of spread tightening is the purchase of large amount of mortgage securities by the Federal Reserve under its quantitative easing programs and investors search for yield in this low yield environment.
Second significant factor is that the universe of spread product is shrinking as mortgage payoffs are greater than new issuance. $25-30 Bn of net negative supply per year in CMBS means that the money that was invested in CMBS is returned to investors and needs to be reinvested. More demand than supply leads to higher prices and tighter spreads.
The third factor is a chain reaction that is more interesting and significant. As the above two reasons lead to tighter spreads for new issue CMBS bonds, the borrowing cost for commercial real estate owners decreases. Lower debt service payments from lower rates mean they can get higher loan amounts on their properties. That means a lot of existing loans that were not re-financeable or were border-line and expected to default can now be refinanced and do not need to default. As more loans are expected to payoff and expected defaults decrease, investors expect smaller losses in legacy CMBS deals. That means tranches that were expected to be written off may be money good or have lower losses. So investors are willing to pay more for them, and as people move down the stack to these bonds with improved prospects, the result is tighter spreads for these legacy bonds. Lower financing cost resulting from tighter bond spreads also helps increase liquidity and activity in commercial real estate market as it allows more investors to put money to work at returns that meet their requirements. More activity in the real estate market leads to more confidence among investors and increases real estate values, further reducing expected losses in loans leading to even tighter bond spreads. This chain creates a sort of virtuous circle - the exact opposite of downward spiral we saw in previous years when the commercial real estate market deteriorated rapidly.
As the virtuous cycle mentioned above continues, barring any shocks, spreads can continue tightening and lower financing cost from CMBS means that it can compete more with other sources of financing which means that CMBS volume can keep increasing. Indeed, the forecasts for CMBS issuance for 2013 generally range from $55 Bn to $75 Bn, up from $48 Bn in 2012.
Spreads, however, have less scope for tightening than last year in my view. Looking at historical spreads in a somewhat similar environment (see What's Ahead for CMBS Spreads? April 4, 2011), CMBS2 AAA spreads could be tighter by 20 bps and BBB- by another 140 bps this year. Generally rising confidence in underlying assets should result in a flatter credit curve, which implies more potential for gains in the middle part of new issue stack. Spreads will move around. Given the unprecedented low yield environment, the search for yield by investors could drive spread slower than expected. At the same time, events in or outside US could cause unexpected widening. The market obviously remains subject to any macro shocks.
One concern cited by many investors is the potential loosening of credit standards by loan originators as competition heats up. That is a valid concern and if industry participants are not careful, history could repeat itself. However, though credit standards are becoming a little looser (LTVs were up to 75 in 2012 from 65-70 in 2011 and Debt Yields were down to 9-9.5% from 11% a year ago), we are nowhere close to where industry was in 2007. Still, investors should watch out for any occurrences of pro-forma underwriting if it starts to re-emerge.
Looking further ahead, maturities will spike up again in 2015-2017, with around US$100bn of 10-year loans coming due. This could cause distress, but hopefully the commercial real estate market will have recovered enough by then to absorb the maturities. Still, it is something that we need to be mindful of for next few years.
For me, one of the most important factors to watch out for is the continued supply of cheap financing for real estate owners. That has been one of the main factors that has brought us to this point from the depths of despair at the bottom and was the basis for programs like TALF & PPIP (see Solving the Bad Asset Pricing Problem) four years ago.
In the current low-growth and low-cap rate environment, investors cannot count on increase in NOI or further decrease in cap rates to drive real estate values significantly higher. That makes availability of cheap financing critical and much more important than historically for achieving their required rates of return to make investments.
Any disruption in availability of cheap financing can quickly reduce the capital flowing to real estate sector and may reverse the positive cycle that is driving spreads tighter and increasing real estate values. Anything that could reduce the availability of financing for commercial real estate owners will be the most important thing I will be looking out for this year other than the obvious factors.
In commercial real estate, hotels and multi-family have improved the most. Hospitality sector, with no long leases, was the first to suffer and among the first to gain as economy started improving. Multifamily sector has done well benefiting from the financing by GSEs. Office and retail sectors have seen increasing activity but face a high unemployment and low-growth environment. If the economy keeps improving at the current slow rate, I think the industrial sector will offer more opportunities and see more activity this year.
Note: The views expressed are solely my own and not of any current or past employers or affiliated organizations. A portion of these views was quoted in a 19 Dec 2012 news article in Structured Credit Investor.