Ratings Agencies Say Meaningful NOI Growth for Some Markets Still May Be 2 Years Away
Despite a slowly healing property market, two key property sectors of commercial mortgage-backed securities continue to struggle, according to a pair of new reports.
The value of office properties packaged as collateral in CMBS loans, which accounts for 30% of the total outstanding principal balance of rated CMBS, has struggled in comparison with other major property types. Office CMBS delinquencies accelerated in the first half of 2012, even as several large office loans underwent modifications, according to S&P Structured Finance Research.
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Although there are signs of recovery in the office sector, office loan delinquencies for those packaged as a part of a CMBS remain at record highs, and more than 50% of office collateral by principal balance experienced net operating income (NOI) declines in 2011, according to Larry Kay, director of S&P in an article he authored for the firm entitled A Recovering Office Market May Not Move The CMBS Office Credit Needle.
Meanwhile, several seasoned U.S. CMBS retail malls have recently experienced losses well in excess of the outstanding loan balance, according to Fitch Ratings, which is closely analyzing the negative trends that occurred in these specific cases and using them in its analysis of retail loans for new and existing CMBS transactions.
Office CMBS Payoffs Low, Losses Increasing
The payoff rate for maturing office loans hit a multi-quarter low of 40% in the second quarter, and the loss severity rate increased to 39% from 30% in the prior quarter, according to Kay.
Office was the only major property type to experience a year-over-year increase in the amount delinquent among CMBS loans, and it's also the only property type for which the delinquency rate continues to reach new highs, Kay wrote.
Kurt Pollem, a senior director in S&P's commercial mortgage group, this past month said that in regards to "the composition of conduit/fusion pools [this year], we've seen office and retail concentrations come down a bit-but retail still dominates at about 40%. And we've seen multifamily and hotel assets increase modestly."
If not for the strength in several major markets, recent CMBS office credit metrics would have been much worse, Kay said. The largest CMBS office market, Manhattan, accounts for 20% of total office principal outstanding, or $25 billion.
Secondary and tertiary markets, which account for two-thirds of CMBS office collateral, are experiencing the largest percentages of loans with NOI declines, according to S&P. This follows rental patterns, as rents in primary markets have generally been exhibiting stronger growth than those in the secondary and tertiary markets.
"It is our view that we may not start to see any meaningful NOI growth until 2015, when leases signed at the market's trough in 2010 start to benefit from rollover to higher rents," Kay reported. "In addition, corporate "restacking" by making offices smaller and more efficient, along with reductions in square footage per office worker, could curb demand for space."
Not surprisingly, Pollem attributed the under-performing office CMBS loans to the slow but steady pace of recent job growth, saying the amount of new jobs being added, while welcome, is not at a rate necessary to reduce vacancy rates or boost rents significantly in many markets.
"Rents are still 15% below their peak 2008 levels. We expect rent growth to be very gradual, and any gains resulting from the historically low completion levels will probably come first from increased occupancy," said Pollem. "As occupancies edge higher, steadier rent growth should follow."
Despite Challenges, Issuance Up
Overall "issuance has been pretty robust in the first half of the year, but getting to the more than $200 billion we saw in 2007 seems very unlikely any time soon, Pollem said." Still, it's better than 2011, when there was a slowdown because of the European debt crisis."
S&P is forecasting $35 billion in issuance this year (excluding Freddie Mac transactions)
"Though it seems that with the recent activity, it could actually exceed that," Pollem said. "There's still a wall of CMBS and commercial real estate
in general that has to be refinanced in the next three years."
Malls Present Unique Set of Challenges for Rating Retail CMBS
There are approximately 1,150 retail loans of more than $20 million in Fitch-rated transactions, many of them secured by malls. Of those, 126 have already been sent to a special servicer, 44 assets are real estate owned (REO). In many cases, these loans are the largest contributors to Fitch Ratings' overall expected deal losses and have already contributed to negative rating actions.
Fitch Ratings maintains a stable outlook for the CMBS retail sector but said that it is very cautious of mall performance.
According to Fitch, distressed malls have suffered from a variety of issues including changing demographics, increased competition, tenant downsizing, and the consolidation of anchor stores. As a result, some markets may no longer be able to support multiple malls. Mall operators are off-loading poorer-performing assets in favor of their top performers, sometimes in the same markets, a trend Fitch Ratings said it expects will continue.
Fitch Ratings has identified some malls in recent transactions that are the "only game in town" at the moment. But over a 10-year loan term, they may be more susceptible to downside risk from new construction because of significant available land and low barriers to entry.
Also, malls that have seemingly competitive sales performance today will have greater long-term cash flow volatility if anchor tenants have leases that roll during the loan term. Similarly, Fitch Ratings is wary of anchors that have more than one location in the market.
Although it is very difficult to predict the deterioration of a mall that is performing at or above market averages today, there are a number of specific market factors Fitch Ratings said it takes into consideration, with sales and occupancy costs continuing to serve as the primary factors in the agency's stress to current cash flow.
Counter-intuitively, a mall that enjoys above-average sales today and located in a robust demographic market may find itself struggling in future years as new competition enters the market. As a case in point, Fitch cited the Highland Mall in Austin, TX, which recently liquidated at over 100% loss severity.
As a result of these variables, Fitch Ratings said it has been unable to rate some newly issued single borrower or single asset CMBS transactions recently.
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