New year, new mood as ABS supply ramps up
In recent years commercial real estate (CRE) has attracted capital from a range of investors, including traditional pension funds and retail investors but increasingly vast private equity (PE) funds. This trend didn’t come as a surprise, since occupancy levels were increasing and while there was plenty of development, supply couldn’t keep up as the economy recovered from the global financial crisis, a helpful environment for property prices. With valuations being further boosted by central bank easing, for many this was an attractive asset class to own, as were CRE loans, either directly for banking books or as underlying collateral for CMBS transactions.
Regardless whether we’re talking about offices, retail units, hotels or ever more popular logistics properties, valuations are a function of operating income and rates. In a possible recession we would expect to generally see tenants being less willing and able to take on more space, with demand perhaps suffering in general as some companies would be forced to downsize. However, a recession would hit differently depending on the jurisdiction and the industry you’re looking at. Tech hubs for example are already seeing companies such as Microsoft announcing large cuts in staff, but we continue to see strong demand for big box distribution centres as the transition from physical to online shopping continues.
While it is impossible to generalise in the European (or indeed the global) CRE market, valuations look very high and they have been fuelled by low interest rates. With rates increasing, valuations should drop accordingly. This will naturally take some time as the number of transactions tends to be extremely low, but if we listen to some of the CRE research companies then we are currently in a buyer’s market and valuations look to be 10-30% too high in certain areas. We would question whether a drop of that magnitude will actually materialise, but we do know there are quite a few properties that will need to be sold or refinanced in the coming years (especially in 2023 as the industry feels the pressure of peak rates).
Markets tend to forget the lessons of the past in favour of the tempting thought that This Time is Different, but investors would do well to remember that most of the European ABS losses post-2008 (though these were very low and vanishingly small compared to the US) came from the CMBS sector as commercial properties were sold at extreme discounts to their valuations. Today, green properties in good locations with high and diverse income from long leases will be much easier to refinance, and PE and distressed funds will be ready to pick up the pieces from those that can’t refinance.
In the UK there is another dynamic at play in the CRE market, which is that UK pension funds have only just started rebalancing (including sales from PE funds) after the dramatic sell-off that followed the previous government’s disastrous ‘mini-Budget’, and on top of this we’ve seen retail investors pulling out of the sector as well. We have also seen a number of large open-ended CRE funds being gated in recent months (some from asset managers that are big sponsors in CMBS), which is a reminder that it can take time to sell properties in a downturn. A buyer’s market also means that execution might not be as good as sellers would like it to be, which could fuel a larger drop in valuations for the UK.
For CRE loans (and thus CMBS), lower valuations aren’t necessarily a problem; if rental yields increase and sponsors are willing to put some equity on the table then refinancing is certainly possible. Loan-to-value (LTV) and debt-yield covenants have traditionally proven to be very efficient, but some of the large sponsors have been able to borrow without many or any maintenance triggers. It is clear to us that some will struggle and that some loans will have to be extended (a negative for CMBS bondholders), which means CRE loan and CMBS investors will want to be extremely diligent in what they finance going forward. Yields should reflect this, and be mindful of the delayed data that CMBS investors get on new or expiring leases and valuations.
We have been wary of CMBS exposure for some time, which doesn’t mean we don’t like the asset class in general but it does mean we want to pick our spots. We continue to like western European BREAAM-certified offices since we see tenants (and owners) preferring green properties, while we’re cautious of retail and hotels. And while we don’t dislike logistics properties, we think valuations here are too high currently and bondholders are not being compensated for their risk. There is an argument for some of the CRE ABS funding trades from specialist lenders that focus on small properties, high rental income, low LTVs and strong covenants, where we think arrears are likely to pick up but bondholders benefit from good diversification and there’s a lot more fat in those transactions.
Overall then our view on CRE is to watch this space, since the sector is in for some major challenges but given the potential impact on valuations it could also turn up some interesting opportunities.