IFR-CMBS Paradox: Record Delinquencies but Improving Valuation

The delinquency rate on US commercial mortgage-backed securities re-accelerated to a historic high of 9.65% in April. Yet the secondary market for subordinate bonds remains more active than ever, dollar prices continue to increase, and the primary market has finally gained traction.

Could it be that CMBS investors know something about the direction of commercial real estate fundamentals that the rest of us don’t?  

The delinquency rate for commercial real estate loans in CMBS spiked after three consecutive months in which it showed signs of leveling off, according to Trepp, a commercial real estate data provider. Despite this, investors are snapping up the bonds in the secondary market, and bond prices are unusually optimistic, even for securities currently rated as low as ‘CCC’.

 What’s more, the delinquency rate may not have reached its peak yet, despite the fact that the pace of increase has slowed compared to one year ago.  

Trading-price levels may indicate hidden value for some distressed CMBS, according to securitization specialists. Optimistic trading valuations for subordinate CMBS bonds belie actual expected losses on the securities, but may suggest that the market is anticipating a fundamental improvement in real estate values and refinancing conditions.  

Recent trading levels indicate this trend most clearly. Out of a sampling of recently available CMBS bonds seen trading in the secondary market, “four out of seven ‘CCC’ rated bonds take 100% loss in our [stress] scenarios, causing us to question their value, as we are concerned that they have negative yields under every scenario we can currently model,” wrote Darrell Wheeler, head of CMBS strategy at Amherst Securities, in a client note this week.

Yet the low-rated bonds trade at relatively bullish prices, some for 60 cents on the dollar or more.

 “These bonds provide a prime example of how technical trading may anticipate and take future fundamental property value improvements into account, but from a relative value viewpoint one should realize that these bonds require a very strong fundamental valuation improvement,” Wheeler added.  

CMBS insiders are betting that improvement in commercial real estate will occur.  

“I view the CMBS market as one where credit deterioration is stabilizing, not necessarily increasing,” said Richard Hill, CMBS strategist at RBS. Since delinquencies are rising at a decreasing rate, “I think it’s more of a positive than a negative.”

 Hill says the CMBS market is rather efficient in pricing.  “The increase in bond prices or decrease in spreads is a function of improving commercial real estate fundamentals, available leverage, and relative value to other products.”  

For instance, CMBS Triple As offer attractive relative value compared to corporate bonds. Corporate ‘AAA’ yields are approximately 2.7%, while 2007-vintage CMBS super seniors are yielding about 4.4% — representing nearly 2% additional yield.

 The result is increasing appetite for commercial real estate investors to buy at current valuations, with the view that valuations will increase.

“While the availability of commercial real estate financing is not robust, it’s the strongest it’s been in a long time,” Hill said.

 CMBS secondary spreads tightened across the board in April, with legacy super seniors inching in about 10bp to 15bp, according to Trepp.

 AVOIDING LARGE LOSSES

 The fact that delinquencies remain on an upward trajectory, therefore, is not deterring yield-seeking investors, despite the fact that some outstanding loans may yet default.  

“While the nascent real estate recovery and elevated loan resolutions are grounds for cautious optimism, it is still too early to say that CMBS delinquencies have reached a peak,” said Mary MacNeill, a managing director at Fitch. “There are still overleveraged loans that may potentially slip into payment default, meaning that CMBS delinquency volatility may persist.

 In April, the delinquency rate for US commercial real estate loans in CMBS increased 23bp — the highest reading in the history of the CMBS market, according to Trepp. The 23bp uptick is the biggest since December’s 27bp jump and indicates that the improvement in the legacy CMBS market may “continue to be bumpy in the near term,” the data provider said.  

However, as post-maturity loan resolutions continue (including loan modifications), the outcome could show some surprising CMBS upside for investors.  

Moreover, properties that had significant amounts of CMBS debt and were expected to take large losses might yet be rescued and recapitalized, taking the worst fears about the direction of commercial real estate off the table.  

For example, this past week, an investor group led by Bain Capital announced the purchase of World Market Center in Las Vegas, as well as International Home Furnishings Center and High Point Furniture Mart in North Carolina, for a total of approximately US$1bn.  

By doing so, all of the properties have been recapitalized with significant equity investments, according to RBS.  Both World Market Center and High Point Furniture Mart were encumbered by a significant amount of CMBS debt that was previously in default. The recapitalization likely avoids losses on these CMBS loans that may have otherwise been enormous, RBS said.

 INVESTORS REMAIN OPTIMISTIC

 There are still several factors that may put downward pressure on the delinquency rate: First, the 2010 CMBS deals generally have performed better and are current, so will eventually push the rate lower. Second, special servicers have been resolving a greater number of troubled legacy CMBS loans than they were 18 months ago, Trepp said.  

Moreover, term defaults have resulted in lower loss severities (sub 40%), according to Amherst’s Wheeler.  

Loss severities in the first quarter of 2011 averaged 37.6% overall, down significantly from levels that averaged 64.2% in Q3 2010 and 56.6% in Q4 2010.  

Investors may need to continue doing their own due diligence in order to highlight the bonds that can benefit the most from an ongoing improvement in the overall economy.  

Tracking losses is certainly one important aspect of this due diligence.

 Transaction losses can vary widely by vintage, and even on a deal-by-deal basis. For example, in Amherst’s sampling of CMBS bonds, many of the 2005 certificates might take transaction losses that range from 4.6%-10.3%, while some 2007 transactions could see losses as low as 4.0%.

Given this difference, it is difficult to frame expectations by vintage alone and there is clear relative value on a deal-by-deal basis, whereas the market is anticipating generic vintage-based losses in the 10%-20% range, Wheeler wrote.  

Some even say that the rating agencies went too far in tightening their CMBS criteria. There are cases where it becomes clear that rating agencies have made their CMBS bond assumptions too conservative relative to actual performance.

For example, Wheeler cites several bonds that have been downgraded below investment grade, but show no losses under Amherst’s new stress-case scenario, which has recently become more conservative. These bonds may have the potential to be upgraded by the rating agencies, he added.

Source:  Reuters

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