Like many sectors, the commercial real estate market came under tremendous strain due to the global health pandemic. As businesses were shut down and travel came to a halt, many commercial property types began to show signs of stress. Landlords and tenants have sought financial relief in the wake of the unprecedented economic closure this past spring. While delinquency rates initially spiked, many borrowers have requested relief and are expected to receive forbearance agreements and modifications, limiting future potential losses.
This week’s chart highlights the actual historical commercial mortgage-backed securities (CMBS) loss experience, along with projected losses and the average credit enhancement by rating category. To understand concerns about potential future collateral losses on commercial mortgages, it is useful to look at the history. Prior to the great financial crisis, the worst year for commercial real estate was 1986, which saw a default rate of 20% — an average loss severity of 40% and cumulative losses of 8% on original loan balances. In 2008, the CMBS market experienced a cumulative loss rate of 13.9% with an average severity of nearly 50%.
CMBS securitizations are split into different classes of bonds, which provide investors with varying levels of credit support per rating category. The most senior bonds rated AAA typically have a 30% credit enhancement, providing protection from cumulative losses within the mortgage pool of up to 30% of the original pool balance before incurring their first dollar of loss. The senior investors are first in line to be paid interest and principal, while the most junior investors are paid interest and principal last and are the first to absorb potential losses. This creates a cushion for senior bondholders in the form of credit enhancement.
Although property values have historically been relatively stable, commercial real estate investments are not immune to the volatility a significant economic downturn brings. Commercial mortgage losses are primarily driven by the deterioration in collateral performance measured by income cash flows and capital values. One of the most significant risk management challenges today for market participants is making realistic future projections about the performance of commercial real estate loans during these unprecedented times.
The markets saw a significant sell-off in credit spreads at the beginning of the pandemic. However, spreads have largely recovered from the lows and the pace of acceleration in delinquency rates is slowing. That is not to imply we are out of the woods; rather, future projected losses have come down from early spring expectations. While excessive lending and loose underwriting standards led to the great financial crisis, the commercial real estate market was on solid footing before the pandemic.
As the country steadily reopens, there is still much uncertainty around unemployment and future gross domestic product, presenting challenges for commercial real estate. While future projected losses are difficult to predict in these uncertain times, historical CMBS losses have been relatively low. Market dislocations may present opportunities for investors, and CMBS securitizations offer structural protection in the form of credit enhancement. In addition, typical pools are diversified by property type, geography, tenants and borrowers. I have been biased to remain up in quality where credit support is sufficient to protect against potential future losses.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
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