Erratic Economy Could Disrupt CMBS Market

While liquidity has been returning to the U.S. commercial mortgage backed securities (CMBS) market, current macroeconomic uncertainty has the potential to disrupt financing in 2012, according to forecasts from bond rating agencies Moody's Investors Service and Fitch Ratings.

Even if the Eurozone crisis moves forward from the present uncertainty, investors have plenty of other concerns, including the global economy's foundations are shaky with large trade imbalances, U.S. fiscal issues, lack of economic expansion, concerns of a hard landing for the Chinese economy, and tamed consumer spending. They could make for a potentially tentative lending environment with tighter lending standards and, as a result, lead to an overall lack of liquidity in the market.

The CMBS market depends on the availability of financing as term debt matures as much as the ability of commercial real estate properties to generate cash flow. A potential extended illiquid market would undermine the encouraging signs seen in property fundamentals in 2010 and 2011, which include increase in rent growth and occupancy levels in the multifamily sector, recovery in major metropolitan markets for the office sector, higher occupancy and revenue in the hotel sector, and the stabilization of the retail sector.

Moody's: Return to Peak Property Values Still Years Away

New CMBS issuance should hit $40 billion in 2012, down slightly from 2011, Moody's is projecting.

CMBS issued in 2012 in the U.S. will perform well given that the underlying loans will be underwritten to values and rents that are well below peak levels, Moody's said.

Property values in aggregate should remain at current levels or slightly lower into 2014, followed by moderate growth in subsequent years, Moody's said.

"However, even though low interest rates are currently serving as a mitigant, particularly for 5-year maturity loans that originated at the peak, we are concerned that ongoing volatility in the credit markets may reduce liquidity," said Keith Banhazl, Moody's vice president and senior credit officer.

The outlook for 2016 and 2017, when the 10-year loans originated during the peak 2006 and 2007 mature, is much more negative.

"We don't expect the peak valuations from 2007 to return before these 10-year loans mature. As a result, we're going to see numerous maturity defaults five to six years out, many of which will result in extensions to maturities," Philipp said.

"In 2012, new issue credit quality for CMBS will start the year consistent with that of normal pre-peak vintages, although there will be the risk of slipping as competition heats up among conduit lenders," said Tad Philipp, Moody's director of commercial real estate research.

Moody's expects $15 billion of the $40 billion of CMBS issuance in 2012 to come from the guaranteed portion of Freddy Mac sponsored bonds collateralized solely by multifamily loans.

Non Freddy Mac issuance will be light in the first half because of crimped conduit loan origination pipelines resulting from Euro area turmoil, but will ramp up as loan spreads tighten.

Moody's also said it expects the ratings of existing deals to remain stable, with the majority of loans maturing in the next two years in good shape for refinancing.

Moody's also said it expects the proportion of specially serviced and delinquent CMBS loans to remain within a few percentage points of their respective current levels during 2012. The current delinquency rate is near the high-water mark Moody's expects for this cycle.

Loans entering and leaving special servicing will remain roughly in balance during 2012. The delinquency rate will then transition downward until the problematic 2016-2017 refinancing years cause it to reverse, although not back to current levels.

Fitch Ratings: Slowly Improving Fundamentals

Property market fundamentals will continue the positive momentum from 2011 and slowly improve. Investment-grade ratings will be mostly stable in 2012, while non-investment-grade ratings will have greater potential for downgrades, according to Fitch Ratings

Hotels and multifamily properties, which through the cycle exhibited the worst delinquency performance, are now stabilizing or, in some markets, showing reasonably strong income growth. Conversely, properties with longer term lease agreements largely insulated against dramatic cash flow fluctuations, such as office properties, will continue to see mixed results, as major metropolitan markets may see rental growth and smaller, weaker, mostly suburban markets will show continued weakness.

Larger metropolitan areas will continue to outperform smaller cities, tertiary markets, manufacturing hubs, and markets with heavy exposure to the housing industry downturn. This continues to make the Washington, DC/Northern Virginia, New York metro, San Francisco, and Boston markets well positioned to take advantage of the economic recovery. Conversely, Phoenix, Detroit, Atlanta, Las Vegas, most Florida cities, and certain California markets will remain weak.

Multifamily:
Multifamily has recovered well and continues its positive momentum from 2010-2011. Most notably, properties in the Northeast and West regions continue to trade at lower cap rates, and have shown significant improvement, as vacancy levels have dipped. Occupancy levels and rent growth should continue to be bolstered by a positive trend in household formations, home prices not yet stabilizing, tightening lending standards for home mortgages, and a lack of confidence in the labor markets. Concessions are lessening as demand builds; Class A and B properties should perform best, as renters continue to trade up. Fitch does expect to see more building starts that will add inventory and have the potential to undermine any improvement in stronger markets.

Retail:
Although unemployment remains high, and consumer confidence has shown little improvement, there have been optimistic signs that consumer spending may be returning. Retailers continue to take a conservative stance managing their inventory in an uncertain economic and consumer environment. Luxury retailers continue to outperform the overall industry, and tenant sales have trended upward in 2011 from trough levels, particularly at top-tier malls. Fitch said it anticipates a slowdown in bankruptcy announcements similar to Borders and Syms/Filene's Basement, with expectations that retailers will need to be more measured about store expansion with the potential of store closing announcements similar to recent actions taken by Gap, Best Buy, and Lowe's. At the real estate level, retail properties will recover, though at a relatively slow pace.

Hotel:
Historically proven most volatile during period of economic stress due to daily rate resetting and generally limited advanced bookings, the hotel sector quickly turned positive as the economic recovery took place in late 2010 through mid-2011. Fitch anticipates that hotels will be able to continue to capitalize on the stabilization, helped by an uptick in corporate bookings.

Office:
The office sector is expected to show signs of a mixed recovery, as major metropolitan office markets will continue to outperform secondary and suburban markets. Major office markets were able to stabilize quicker than other markets, and vacancies and rents were not as severely affected. Historically, the sector has had exposure to rollover risk, as expiring leases are marked to market, but due to the so-called flight to quality trend in certain major markets, the risk has been mitigated due to improved economics in these markets.