Executive Summary
- The Fed’s campaign against inflation, changes in bank regulations and stress in the office sector have collectively created an attractive investment environment for real estate debt investors, in our view.
- Commercial mortgages are offering yields not seen since the Global Financial Crisis (GFC).
- While capital market conditions are operating effectively for low-risk mortgages, they remain mostly dislocated for higher-risk mortgages, thereby presenting compelling investment opportunities.
- Debt investors have historically overestimated investment risk in the years following commercial real estate price declines.
The Transmission Mechanisms of Higher Rates
Commercial mortgages are at the intersection of evolving capital market conditions, shifting real estate fundamentals and complex regulatory landscapes. Today’s investment conditions in the commercial mortgage sector are unique, both historically and compared to other institutional asset classes.
Three factors in particular that are driving performance include:
- The rise in interest rates that began in the spring of 2022 caused property values to decline. Although we believe property values (office excluded) are near or past the trough, the valuation reset has caused many real estate investors to need more capital (in many cases a second subordinate mortgage) at maturity.
- The rise in rates has contributed to stress in the banking sector, especially among regional banks. Regulators have been increasing capital requirements and oversight1. This, as well as working through existing distressed loans, has resulted in a sharp pullback in commercial mortgage lending by banks. Banks have historically been an important source of capital for medium and high-risk loans, while other lenders such as commercial mortgage-backed securities (CMBS) and insurance companies have historically focused more on lower-risk financing2. Future regulatory shifts like the implementation of the Basel III Endgame may further weigh on the ability of banks to originate commercial mortgages. In the meantime, debt funds have been partially, but not completely, filling in the gap for high-risk mortgages.
- Since 2020, the surge in remote work has posed challenges for the office sector. While other sectors are stable, the strain from the office sector has led to an increase in risk premiums across the entire commercial real estate landscape. Lenders have bolstered their capital reserves as a defensive strategy to safeguard their portfolios against these pressures. This has reduced liquidity in the market and has caused spreads across the mortgage risk spectrum to widen.
As we look forward to the next several years, we only expect a gradual recovery in real estate capital market conditions as inflation and interest rates normalize. During most of 2023, the Fed Futures Market was pricing 150 to 200 basis points (bps) of rate cuts by the end of 2024, and real estate investors were often delaying financing decisions in the hopes of lower rates. More recently, stickier-than-expected inflation and robust economic growth has reduced expectations to just 25 to 50 bps.
Many market participants have seemingly accepted the new outlook on rates, evidenced by gradually improving real estate transaction volume in recent months.
Exhibit 1: Probability of 3+ Cuts in '24
Sources: MIM, Green Street, Data through May 2024.
A Whole New World (for Debt…)
Commercial mortgages have been uniquely impacted by recent macroeconomic conditions, which are now being observed in pricing. The spread between commercial mortgage rates and Baa corporate bonds, which has historically been highly correlated, widened to a level not seen since the GFC (Exhibit 2). However, unlike the GFC, it has remained elevated due to the conditions mentioned above, which we believe are distinct to the mortgage sector.
Exhibit 2: Spread to Corporate Debt Rises to All-Time High
Source: MIM, FRED, RCA. Commercial mortgage rate based on 7/10yr fixed-rate mortgages, first position only.
Moody's Baa corporate bond yield, not seasonally adjusted. Data through 1Q 2024.
While average yields for commercial mortgages have increased due to a rise in the secured overnight financing rate (SOFR) and treasury yields, spreads have also widened across the mortgage risk spectrum. Throughout much of the past decade, yields on mezzanine and other higher-risk real estate debt structures remained clustered relatively close together in a range of 5.5% to 6.5% with only moderate movements to account for investment-specific factors. In the past 18 months, however, this range widened significantly. Although spreads in the prior decade between senior mortgages and mezzanine loans were often in the range of 200 to 300 bps, today that range is likely closer to 400 bps to 650 bps (Exhibit 3).
Exhibit 3: Profile of Major Commercial Mortgage Debt Subsectors in 2024
The targets or other information generated by MIM regarding the targeted investment outcomes are hypothetical in nature, do not reflect actual investment results and are not projections or guarantees of future results.
We believe the wider spreads are due to the pullback in bank lending, as they have historically been an important source of capital for higher-risk loans. Increased regulations, and the implementation of the Basel III Endgame, are limiting their lending capacity, creating an opportunity for other lenders to step in.
Commercial mortgage investors now have multiple options across the real estate debt spectrum that offer potential returns within or beyond the target return ranges of their real estate allocations. As shown in Exhibit 3, yields range from 5.5%-7.5% for low-risk senior mortgages, to the mid-teens for preferred equity.
Cycle Timing & Systemic Overestimation of Risk After Downturns
Although absolute returns for commercial mortgages have increased, what about risk? Are investors today being compensated for the challenges the sector is facing?
In 2022, we partnered with Moody’s to examine MIM’s historical commercial mortgage loan performance datasets that ranged from 1957 to 2020. The resulting study, which also examined the full CMBS performance history, highlighted how the timing of loan originations within the real estate cycle significantly affects their outcomes. Specifically, loans that are underwritten later in an economic cycle tend to have higher loss rates compared to those initiated at the beginning of a cycle. This trend is not unique to commercial mortgages, and “don’t take credit risk before a recession” is neither a novel finding nor one that can easily be acted upon since downturns are unpredictable. However, what may be unique to commercial mortgages is that the risk measures used by most, if not all, lenders do not adequately capture the changing risk profile across different periods of the economic cycle.
Exhibit 4: Loss Rates by LTV Bucket & Vintage Year
Sources: MIM, Moody's. Historical loss rates for MIM and CMBS loans.
Lenders are focused on three measures when evaluating the credit of commercial mortgage loans: loan-to- value (LTV) ratio, debt service coverage ratio (DCSR) and debt yield. While these factors have established correlations with bond-equivalent ratings, the commercial mortgage market lacks a comprehensive understanding of how loan terms impact loan risk. The primary non-quantified factors include interest-rate caps on floating-rate loans, cash management and escrows for building capital, leasing costs, or other cash flow shortfalls. This gap in understanding leads to an overestimation of risk when loan conditions are more favorable to lenders (such as in 2010-2013) and underestimation of risk when they are not (such as 2005- 2007, or 2021), in our view.
In addition to loan terms, a more complicated but equally important factor is often overlooked: the relationship between real estate values and inflation. Real estate values have tracked inflation closely over long periods of time (Exhibit 5). This is logical, as the cost to build real estate is influenced by commodity prices and labor costs, which move with general inflation. After downturns, such as in 2009/2010 or 2023/2024, new construction starts slow or completely stop for some property types and in some regions of the country. As a result, “construction risk” or “overbuilding risk” is reduced during the initial years or entire term of a commercial mortgage loan. Yet lenders often treat a 65% loan-to-value loan as having the same risk or bond-equivalent-rating regardless of whether new construction is growing (such as 2007 or 2021), or in a period where new construction is contracting (such as 2010 or 2024).
Exhibit 5: Long-Term Pricing vs. Inflation
Sources: MIM, NCREIF, BLS. Value-Weighted MVI. Data through 1Q24.
Exhibit 6: Falling Multifamily Construction Starts
Sources: MIM, CoStar. Number of units in thousands. Data through 6/12/24.
Upon evaluating these two factors today, we believe that loan terms are lender favored, and almost to the level they were during the depths of the Global Financial Crisis. Construction starts are also decelerating at the fastest pace since 2010 (Exhibit 6). Both of these factors suggest that lenders may be overestimateing the risk profile of new originations.
As we look forward, there are signs that the real estate cycle has turned a corner. Within MIM’s equity real estate platform, we generally can’t purchase non-office assets at the prices they were available for in late 2023. Commercial real estate price indexes (which are lagged) have not yet reflected this trough in asset prices, although we anticipate that 2024Q2 readings could represent the trough for values this cycle (to be confirmed when 2024Q3 prices are released later this year). Within the office sector, however, we do not believe prices have found a trough.
Outside of our direct observation of transaction prices, our relative value benchmark (Exhibit 7) suggests that prices could or should be rising. More details on this analysis can be found in our recent market outlook report (Are We There Yet? The Road to Recovery for CRE). Taking all these factors together, we believe the real estate debt sector, and especially the higher-yielding portion of the mortgage risk spectrum, is worth considering today.
Exhibit 7: Real Estate Discount Rate vs. Baa + 200 BPS
Sources: MIM Discounted Rates, Oxford Baa, three month trailing average. May 2024
Conclusion
Over the past year, the commercial mortgage sector has experienced its most significant transformation since the Global Financial Crisis. A combination of reduced liquidity, falling property values and regulatory changes have marked the dawn of a new era for mortgage investors, an era that seems set to persist in the near future.
While the past 12 to 18 months have presented challenges, they have also unveiled opportunities. Specifically, current mortgage yields are offering attractive relative value, and it appears investors are being adequately compensated for moving up the risk spectrum. Moreover, pricing data suggest we may be at the start of a new cycle, which our research has shown is a uniquely opportune entry point for mortgage investors.
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Endnotes
1 FDIC.
2 Historically, loss experience has varied across banks, CMBS, and LifeCos. LifeCos experienced around 9 bps of annual losses between 2008 and 2023, compared to around 55 bps for banks and around 174 bps for CMBS during the same period. This is due in part to the structure of mortgages in various portfolios, with LifeCos generally offering lower leverage levels and targeting higher quality assets. MetLife’s average annual credit loss during this period was only 4 bps.
Disclaimer
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