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Real Estate
Quarterly commentary
Commercial Mortgage-Backed Securities (CMBS)
2017 first quarter
Market review
After trailing the rest of the broader fixed income markets for much of the fourth quarter, CMBS
was finally able to get out in front of the pack and post solid outperformance. With supply relatively
constrained on the new issuance and secondary fronts, the amount of cash looking to get put to work
overwhelmed the amount of available supply, leading to tighter spreads across the entire capital
stack. Additionally, we saw the credit curve flatten since the solid pool level underwriting metrics on
the new issue deals during the quarter allowed accounts to roll down the credit curve. At this point,
CMBS feels like it has done a decent job of catching up to the broader markets in terms of spreads.
There are still pockets of value, and security selection can still drive some positive performance.
However, it will be tough for CMBS to continue to rally much from here, given all of the macro
uncertainty surrounding future growth and the increasing geo-political concerns.
Strategy review
Technicals
First quarter saw 10 new conduit deals come to market for a total of $9.4 billion, which is down
roughly 24% from the average first quarter issuance of the prior four years. That level of supply
was easily absorbed since a number of investors received fresh 2017 allocations which they
immediately looked to begin investing. Meanwhile, this strong demand was met with limited
supply. Dealer balance sheets also remained light throughout most of the quarter because
investors turned to the secondary market since the new issue market wasn’t able to meet
demand. We did start to see that dynamic reverse as some investors sold AAAs heading into
the end of the quarter. That left dealers with a pretty decent overhand of 8 to10-year AAA
paper, which led spreads wider in conjunction with lower treasury yields. We are not expecting
a material uptick in supply in April, but the outlook for May and June is for more robust new
issuance. Overall, our estimate for 2017 private issuance (including conduit and SASB) remains
in the $55-$65 B range, but another quarter similar to the first could cause that number to come
down.
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Fundamentals (continued)
While commercial real estate fundamentals still remain on
decent footing, we have seen some indications that real estate
cycle is slowly maturing. There has been a significant drop
in transaction volume and the rhetoric on equity valuations
there failed to garner much interest, and the fact that there was
a greater supply of AAAs verses the rest of the stack. Finally, IO
spreads were also tighter for the quarter since a few accounts
looked to roll their legacy pay-downs into that segment of the
market.
has shifted to a much more cautious tone. However, supply/
demand technicals remain in a decent spot and we continue
to see positive income growth at the property level. There is
a feeling that the commercial real estate market has shifted
from a pro-equity environment to one that more strongly
favors commercial real estate debt instruments from a risk/
return perspective. In terms of the CMBS metrics that we track
to gauge fundamentals, the maturity pay-off rate remained
within expectations, the delinquency rate is slowly leaking
higher but remains manageable, and ratings remain very
stable. Delinquencies currently stand at 5.1% for the overall
conduit universe (with legacy at 20.4% and 2.0 CMBS at
0.2%), according to Wells Fargo. The pay-off rate for loans
that matured in 2016 remained an impressive 90% per Wells
Fargo. We expect that metric to dip as we move into the second
quarter of 2017, based on the more aggressive underwriting of
that subset of 2007 loans relative to the metrics from the 2006
and early 2007 vintages.
Outlook & strategy
New issue underwriting metrics continue to look relatively
conservative as the pool level leverage and coverage ratios
continue to move lower and higher, respectively. Combine that
with a continued balance in the commercial real estate supply/
demand landscape, and the fundamental story remains intact.
Legacy CMBS pay-downs continue to come in relatively strong,
which has kept money flowing into accounts as their legacy
positions pay down. Finally, the CMBS market’s ability to
successfully navigate the regulatory requirements on the risk
retention front has shown that the market can still find ways to
adapt to changing circumstances. Thus far, the market has seen
a number of vertical, horizontal, and L-shaped risk retention
deals successfully come to market.
The retail property type continues to garner a significant
amount of attention and headlines because the exposure to
Spreads/pricing
struggling retailers and continued store closures is weighing
CMBS spreads ripped tighter to begin the year and didn’t look
around the traditional enclosed mall format. As time goes
back until quarter-end when the market cooled off. The positive
by, the market is starting to shift away from the “all malls are
technical landscape not only brought overall spread tightening, it
bad” mentality, to a more balanced approach of trying to pick
also led to a significant flattening of the credit curve. One dynamic
winners and losers within that space. However, the media
that has persisted from the second half of last year is the sizable
headlines continue to gravitate towards the former mentality vs.
tiering that has created a wide dispersion of pricing, even on
the latter. In addition to the retail headwind, there are growing
bonds with the same rating and vintage buckets. With the credit
concerns surrounding the overall health of the macro economy
curve flattening, the lower rated A-/BBB- segments of the market
and a rising belief that the implementation of the much
outperformed during the first quarter. The AS/AA parts of the
anticipated pro-growth agenda may be severely hampered. If
capital stack also posted strong quarters since they remain the
you throw in a fragile geo-political landscape and an impending
focus for a number of insurance companies. The top of the capital
debt ceiling debate, the near-term outlook seems to be skewed
stack was the weakest performer because the absolute yield levels
to the downside.
heavily on that sector. The main focus continues to center
Quarterly commentary | Commercial Mortgage-Backed Securities 2
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Quarterly commentary | Commercial Mortgage-Backed Securities 3