CMBS loans set to mature in the remainder of 2022 and 2023 are facing bigger refinancing challenges in the higher interest rate environment.
A recently published CMBS report by Moody’s Investors Service shows that 73.5 percent of maturing conduit loans refinanced in second quarter, compared with 84.7 percent of maturing loans in first quarter that refinanced. “It is concerning to see that drop. The only other time there was a similar drop was during COVID, which was understandable at that point,” says Darrell Wheeler, vice president and senior credit officer at Moody’s Investors Service.
That decline in refinancing of loan maturities is attention-grabbing for a few reasons. It could be a leading indicator that there are liquidity issues building in the commercial real estate sector. Some borrowers are going to have to scramble to find more capital or alternative financing if the CMBS spigots are turned down. And, in some cases, it might push some stressed CMBS conduit loans over the edge and force liquidations or defaults. These are all possible scenarios, and how the story unfolds over the next few months will depend on if these maturities are able to refinance or not, notes Wheeler.
Although CMBS loan delinquency rates that spiked during the pandemic have been improving, higher interest rates could stall or reverse that trend. It also remains to be seen how higher interest rates might affect property values and underlying credit performance. “For maturing conduit loans averaging a 4 percent to 5 percent coupon rate, analyses have shown a good portion of them being able to maintain acceptable DSCR and obtain refinancing at 6 percent to 7 percent. At higher levels, we may see more expensive additional layers of debt come in or dispositions,” says Joseph Cioffi, a partner and chair of the insolvency and finance practice group at Davis+Gilbert LLP in New York City.
Across sectors, there will be refi challenges for properties with already low NOI relative to existing debt. Not only are they maturing into a higher rate environment, but costs are rising as well, including interest rate cap insurance, adds Cioffi. (Interest rate cap insurance are policies paid to third parties to protect borrowers with floating rate debt if rates in the market go above a cap set in the policy.)
Pressure on debt service coverage
Borrowers are dealing with a significant change in capital costs with the Fed poised to raise rates again this week. Most market observers are anticipating another 75-basis-point rise although some have suggested the hike could even be 100 basis points. Relatively speaking, the move in rising interest rates has been the largest in 20 years as the Fed tries to stave off inflation that is at a 40-year high, notes Rob Jordan, head of CMBS product at Trepp. “It is likely that some owners will struggle to make up the difference between the higher refinance rates while contesting with higher operating costs if inflation in expenses outpaces rent growth,” he says.
Lenders also are likely to require higher levels of debt service coverage due to the upward pressure they now face around their own financing costs, which will likely lower proceeds they are willing to offer borrowers, adds Jordan. It’s hard to say exactly which loans will face the biggest problems due to higher rates alone. “If you look at underlying fundamentals, most see office as a sector with the biggest challenges post pandemic due to the trend of work-from-home catching on with many employers and employees,” he says.
A recession would create another hurdle for property owners trying to hold onto assets. “Aside from higher interest rates, valuations can shift in a recession, dropping NOI below desired or viable levels for refi,” notes Cioffi. In addition, remote and hybrid work and slow return-to-office plans will impact whether refi or extension is available for a given property. This creates added valuation uncertainty. In addition, potential changes in office use would exacerbate excess supply issues generally and disproportionately impact older buildings, which could find it even more challenging to refi, he adds.
Hospitality properties could also show distress, especially if a recession were to result in a pullback in leisure and business travel. The canary in the coal mine could be seen first in the hotel sector, adds Wheeler. Although hotel NOIs are seeing a strong recovery, Moody’s data suggests that this segment is worth watching as the sector represents a significant portion – 39 percent—of the low DSCR loans maturing before 2024.
Distress could be contained
Although the drop in the percentage of loans that refinanced in second quarter is a metric that bears watching, it also is important to note that the volume of maturities that may have difficulty refinancing are a small sliver of the overall CMBS market.
According to Moody’s, the volume of performing non-defeased conduit loans that were scheduled to mature in the second half of 2022 or in 2023 totaled $29 billion. Although not inconsequential, it represents a fraction of the $386 billion CMBS conduit market. Moody’s analysis focused on that portion of loans that face higher refi risk. Specifically, 14.0 percent of 2022 maturities and 14.6 percent of 2023 maturities would have trouble maintaining a 1.4x DSCR with an interest-only mortgage rate at a 6 percent rate. Refinancing risk would rise to more than one-third if the mortgage coupon were to increase to 8 percent.
Refi challenges doesn’t necessarily mean borrowers will have to liquidate or hand the keys back to a lender. “Typically, loans do not default in this situation, it’s more that the borrower will scramble to find capital,” says Wheeler. Going back to 2019, for example, 85 percent of loans coming due refinanced ahead of their maturity dates. Of those that didn’t, 9.5 percent eventually have gone on to refinance, while the balance of loans were either liquidated, extended, defaulted or became delinquent, according to Moody’s.
There also are some notable differences that exist in the current market as compared to the Great Financial Crisis. In 2007 and 2008 there were a lot of delinquencies that ended up being handed over to the servicers and liquidated. That was largely because properties were underwater with values that dropped below the current loan balance. Right now, in most cases, these borrowers believe their properties are worth more than the loan balance. So, they’re doing whatever they have to do to refinance, notes Wheeler. “That 73.5 percent number caught our attention because it could be an indication that liquidity conditions are changing, and we will be following that number in future quarters to see where it goes,” he says.