Commercial Real Estate News / Investing / Rates Continuing To Rise Could Create Tipping Point For CMBS

Rates Continuing To Rise Could Create Tipping Point For CMBS

Published: 06-12-23 Category: Investing

MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.

This Wednesday, June 14, 2023, the U.S. Federal Reserve`s Federal Open Market Committee (FOMC) will convene for their latest meeting. Despite possibilities for a rate hike, Jerome Powell, the chairman of the U.S. Federal Reserve, is expected to keep rates steady at 5%-5.25%. Yet, markets are predicting with approximately 70% probability that the Fed will raise rates at least once between this date and the next meeting in July.

CMBS Markets Near Tipping Point

This anticipated action is becoming a growing concern for those in the commercial mortgage-backed securities (CMBS) market, as well as other debt markets with significant commercial real estate (CRE) exposure. Notably, it could spell trouble for office property exposure, pushing the sector towards a near-tipping point that could potentially land lenders with heavily discounted collateral and necessitate public workouts.

Further Hikes Seen As Adding Stress

The CMBS market, wherein commercial mortgages are pooled, securitized, and sold to investors, has been under a cloud since the onset of the COVID-19 pandemic in 2020. The potential interest rate hikes further intensify the stress, as rising rates increase borrowing costs, making it more difficult for borrowers to refinance their loans, but bringing inflation to heel as per Federal Reserve mandate.

Moreover, the economic slowdown is leading to lower occupancy rates and rent growth in some commercial real estate sectors, especially offices, placing additional unwelcome pressure on the sector. As the banking system undergoes its own stresses, expectations are rising for banks to pull back lending in commercial real estate, exacerbating the situation, and forcing the need for alternative sources of funding and workouts.

Investors Demanding Greater Compensation For CMBS Risk

The delinquency rate on CMBS loans has been increasing and is now at its highest level since June 2020, hinting at the financial strain borrowers are under. Additionally, the widening spread between CMBS yields and Treasuries indicates investors are demanding a higher risk premium for holding CMBS, reflecting the market`s perceived risk.

In spite of the challenges, opportunities for investors persist in the CMBS market. Certain sectors, such as multifamily housing, may provide attractive yields, offering a silver lining in an otherwise uncertain environment. However, the potential for further interest rate hikes could dampen these opportunities. Many investors in today`s market have not experienced a rate environment not characterized by historically-low interest rates, which could compound investor confusion in the coming months as rates rise further and potentially remain higher for longer than anticipated.

Most CMBS Loans Have Issues

According to Moody`s, 84% of maturing CMBS office loans are facing refinancing challenges in 2023. If rates rise as expected, this percentage may increase, accelerating the stress on both lenders and borrowers. Moreover, with the borrowing costs for CMBS loans having doubled from their pandemic lows to 7%, it`s clear that the borrowing environment is becoming more difficult.

Slowly Then Suddenly

Given these circumstances, we could witness an inflection point in the CMBS market, a moment when lenders might end up owning significantly discounted collateral. These lenders may then need to seek public workouts, a scenario that could bring about even more change in the CMBS and larger CRE markets, perhaps along the lines of S&L bailouts from the 90`s.

The future of the CMBS market is uncertain. The decisions made by the Federal Reserve, coupled with the ongoing effects of the pandemic and macroeconomic pressures, will shape the landscape of this crucial sector in the commercial real estate market. In such an environment, it`s more important than ever for investors, borrowers, and lenders alike to remain vigilant, adaptable, and prepared for potential future volatility.

In Summary

The June 2023 FOMC meeting, and the potential for interest rate hikes in the months that follow, serves as a reminder of the interconnectedness of macroeconomic policies and financial markets, knitted together with over a quadrillion in notional derivatives. The ripple effects of such decisions can be felt across sectors, and for the CMBS market, these effects could bring significant challenges in the near future.