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By Marshall L. Glick, Eric Goldstein, CFA, and Monika Carlson, CFA
The COVID-19 pandemic has changed the way we live and work by creating global changes and accelerating trends. For investors in real estate, profits mixed up.
The pandemic hurt small retailers because of the rapid transition to digital commerce and the elimination of office buildings by turning living rooms into workspaces. But warehousing and leisure-related spending increased as economies opened up, reflecting a shift in retail assets.
Recent problems in the banking industry have renewed concerns that the winds are turning against commercial assets. Of particular concern are central and local banks, which buy mortgage-backed securities (CMBS) and participate in mortgage lending. Local bank refinancing will result in a loan It’s a disaster related to land prices.
There is no doubt about the many challenges that commercial buildings face, but we believe that the issues facing banks are very different and not systemic. Additionally, the mortgage market is too diverse to paint with the same brush—the landscape varies by property type, location and quality. For investors, making the right decisions and choosing the right opportunities is never more important.
With Cost Increases, Quality Matters
Mortgage loans are a major component of commercial real estate lending, accounting for more than 13% of all commercial and multifamily mortgage loans outstanding. CMBS are mortgages used to finance the purchase of hotels, office buildings, apartments and other commercial properties.
To create CMBS, individual mortgages are pooled together, held in rated securities, and then divided into tranches based on credit quality. At the high end are AAA-rated banks with low credit risk. These above categories show credit enhancements that protect investors from potential problems, while stressing investors under the credit spectrum and the lion’s share of credit risk. instead of higher yields (Display).
Higher-rated CMBS bonds often have stronger credit enhancements
Past analysis does not guarantee future results.
The base scenario is a continuous decline for two years following stabilization and recovery, with a 38% default rate in offices (by market value) and a 5% reduction in office rents. Office Stress includes Base case assumptions and a more punitive version for office buildings with 68% of office debt being unpaid and a 10% reduction in rent. Retirement assumptions include specific reductions in more heavily weighted commercial business areas. From March 31, 2023
Source: Bloomberg, Real Capital Analytics, Trepp and AB
A second type of CMBS is made up of a single loan, secured by a single asset, or cross-linked by multiple assets in a single-asset-backed contract (SASB)—the same classification. of its risk to the selected categories.
In the current environment, we believe investors should focus on higher quality stocks to protect against downside conditions, although we also see opportunities to buy rated stocks. lower risk/return information.
Here, some historical context is in order: Even during the worst of the global financial crisis, we saw a crisis of confidence in mortgage-backed securities, CMBS. AAA rated those with 20% or more credit improvements not lost, and credit improvements have increased since then.
Know your wine: Newer is not always better
It is also important for investors to consider when the securities were issued. The newer vintages of CMBS—especially those issued between 2014–2018—have benefited from the appreciation of asset prices and the increase in current borrowings.
In contrast, funds under new-old bonds are more exposed to distressed bureaucracies (Display). It’s also more difficult to get money back, and the price appreciation in the underlying assets is less. For these reasons, it’s important for investors in the newer CMBS to stick with high-quality units.
New wines are more often displayed in offices
Past performance does not guarantee future results.
From March 31, 2023
Source: Bloomberg and AllianceBernstein (AB)
Valuing Different Asset Types
While it may be tempting to mix commercial properties, the real estate market is tough, and some types of properties are better placed than others.
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Department: The office sector remains a major concern as demand for office space has declined, particularly in the technology sector. While traditional CMBS is more common in offices, long-term leases mitigate this problem and provide more flexibility to the tenant. This sets the stage for what we believe will be an increase in delinquency as the tenant’s re-lease needs change after the lease ends. Old-style CMBS, on the other hand, has benefited from a reduction in and less exposure to agencies.
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Retail, Local Stores: Stores with lower sales per square foot—especially those in third-party markets—are still concerned. Many owners are reluctant to invest in property improvements unless they see a fair return on their capital. In terms of credit constraints, we are wary of traditional CMBS loans backed by low-quality securities and expect additional credit defaults and defaults. In contrast, better products—especially those in growth markets that have innovated to meet the needs of evolving consumers—will continue to grow.
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Commercial, Non-Malls: Non-mall shopping has proven to be surprisingly effective, benefiting from consumer spending and discretionary spending. Many retailers have been forced to refinance their brick-and-mortar properties in order to maintain financing costs.
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Residence: Corporate cost-cutting and declining business travel have taken a toll on full-service hotels that cater to businessmen. Low-cost hotels, on the other hand, have benefited from increased domestic and leisure travel. Low-service hotels, which offer more budget options, are less expensive.
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Many families: A lack of housing supply, high single-family home prices, and relatively high mortgage rates are driving multi-family housing. Rising labor, property and financing costs will slow construction in the coming years, supporting robust demand for housing stock. As a result, interest rate growth is expected to slow to support lending activity.
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Industry: Warehouses and data centers are among the biggest stores due to the growth of online shopping and cloud computing. Although rents have been rising, growth in this sector is expected to slow if the economy weakens and larger renters return to new leases.
Light, but should have better High-Quality credits
Commercial real estate sales are expected to continue to suffer from rising rates (a function of operating income and property values) and rising interest rates. As a result, we expect to see an increase in crime over the course of the year. However, we believe that the majority of credit impairments will be in the less rated CMBS and distressed categories such as office buildings.
For the CMBS market to function well, lending activity must continue. While we want a more flexible lending environment, we hope that high-quality lenders and borrowers will work closely together to provide financing and avoid foreclosure. Look for CMBS and SASB lenders to get the best terms from lenders.
The Federal Reserve is also considering changes that would allow banks to avoid reclassifying loans or taking reserves for potential losses if they have a reasonable expectation of survival. Similar actions were taken during the global financial crisis.
Investors may benefit from favorable technical conditions due to lower CMBS issuance. A reduction in supply will prevent spreads from widening and provide some level of price support. Over time, renewed confidence in mid-sized and regional banks should support the CMBS market and provide a better regulated market. Until then, investors should expect an increase in diversification – especially in the office sector – and a greater focus on credit quality.
The views expressed herein are not research, investment advice or marketing recommendations and do not necessarily reflect the views of the entire AB fund management team. Views change over time.
Original News
Editor’s note: Summary bullets for this article are provided by the editors of Seeking Alpha.
