Robin Marshall
Luke Lu
- CMBS market remains heavily exposed to Fed’s 500bp tightening
- Structurally lower demand for office and retail space impacting CMBS market
- Maturing non-agency CMBS fixed-rate loans data allows for analysis of the CRE market and projections for maturity fall rates in different Fed rate-cutting scenarios
It is well known that weakness in commercial real estate (CRE) helped drive several US regional bank failures in March/April 2023.
In a previous paper “CMBS and the Fed; is there a crisis brewing in the office?”, published in November 2020, we highlighted the risks in the non-agency CMBS sector, given the limited degree of government and Fed rescue programmes, and the structural challenges to the sector from Covid lockdowns.
Compared to relative stability in the residential housing market, where reduced housing supply has protected valuations, the US CRE market, has suffered from a brutal combination of higher rates and reduced demand for office and retail space, post-Covid.
The main Fed support to the CRE sector during the pandemic was via agency-CMBS purchases in the QE programme, but the non-agency sector was not eligible. Higher rates since 2022 have compounded the strains on the sector (see Exhibit 1) with overall delinquency rate rising from 3.29% (March 2022 when the tightening begins) to 4.82% (June 2024), vs. office loan delinquency rate jumping sharply from 1.52% to 7.34% in the same period.
With the market now discounting Fed rate cuts beginning in September, the question becomes will the rate cuts be too little and too late to prevent a major spike in defaults, and CRE crash?
Figure 1: Non-agency CMBS Delinquency Rates are Rising
The importance of fed rate cuts to maturity risk
Specifically, for conduit CMBS loans facing imminent maturity refinancing, what does the maturity wall look like over the next two years?
Here, we try to quantify the challenges in refinancing from the existing fixed loan rate, eg, 4%, to an ongoing market rate near 7%, and its impact on the debt service coverage ratio (DSCR) - a key metric in loan underwriting qualification. For conduit CMBS loans, typically a DSCR >=1.20x is required for loan refinancing approval.
As an example, consider a 4% rate loan with a current DSCR of 1.80x. A 7% refinancing rate will reduce the DSCR to 1.03x, assuming the net operating income (NOI) stays the same, and debt service is linearly proportional to the loan rate. This would disqualify it from refinancing.
But if we assume a Fed rate reduction of 100 bps, and a delta of 0.6 for the impact on 10-year Treasury yield, the 10-year yield would fall 60bp, bringing the new refinancing loan rate down to 6.4% from 7%. This would result in an underwriting DSCR of 1.27x, making refinancing possible.
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