CMBS shows ongoing challenges for commercial real estate

Securitisation made its latest appearance in the mainstream financial press this week with the news that the European commercial mortgage-backed security (CMBS) market is set to experience its first losses on AAA bonds since the global financial crisis.

AAA bondholders in Elizabeth Finance 2018 DAC, which is backed by a loan financing three regional shopping centres in the UK, are set to suffer a principal loss of around 6% after the deal’s special servicer announced it had accepted a bid of around £35m for the properties – not enough to repay bondholders in full after transaction costs and fees. Last month, the US CMBS market also witnessed its first post-crisis AAA losses on a transaction backed by a single office building in New York.

While both markets have seen occasional defaults in lower rated bonds in recent years, losses on the most senior CMBS notes are an indication of the commercial real estate (CRE) sector’s continued struggles.

Pandemic-boosted trends toward greater digitalisation and remote work have led to falling rents and increased vacancy rates, while at the same time higher interest rates have tightened financing conditions materially for borrowers. Prime CRE valuations have decreased by approximately 20%-30% on average since 2022, according to CBRE, though it varies by sector. These valuations have been hard to determine thanks to limited actual selling of properties, but distressed sales such as those on the Elizabeth Finance properties are now confirming the anecdotal evidence. Add in the fact that many CRE mortgage loans are coming to maturity and must be refinanced in what is such a challenging environment for borrowers, and it is no surprise to see negative headlines on this sector.

As investors in CMBS it is certainly disappointing to see such outcomes, though we have been bearish on the market in general for some time given its clear fundamental challenges and we have actively decreased over exposure by 75% versus 12 months ago. Of the 148 rating actions in European CMBS names in 2023, downgrades outnumbered upgrades three-to-one.

Looking at the Elizabeth Finance deal specifically (which we gave a wide berth when it was issued) there were several red flags. It was a concentrated portfolio with a high (over 65%) loan-to-value ratio and assets in non-prime locations. In addition, the deal’s small size (less than £100m) suggested a potential lack of liquidity in secondary markets. The biggest structural weakness of the deal was a pro-rata feature that meant proceeds from assets disposals or loan repayments would be distributed across all tranches (leaving leverage high at all times). Instead of benefitting from gradual de-risking, then, the senior notes would remain outstanding and exposed to tail risk, which is exactly what has happened here.

All that said, it is worth highlighting some positives for the European CMBS market. Though primary issuance has been subdued in the past 18 months, a few transactions have been successfully priced. These deals featured granular portfolios, high quality assets and low leverage – all aspects we favour when assessing credit risk.

Of the 18 loans that were due to mature in 2023, eight were repaid and nine were extended. Three loans due to mature in 2024 and 2025 were also prepaid last year. So far this year we have seen one restructuring and a couple of other loan maturities being extended. In most cases we have seen sponsors behaving in the right way, supporting their deals by injecting equity and engaging with investors.

Despite these positives, the outlook for European CMBS as a whole remains challenged in the short term. Caution on deal selection is essential, as is looking through ratings and relying on your own due diligence.