By Huxley Somerville
The rate of U.S. CMBS financing has been ascending slowly over the last three years. Assuming the macro environment is stable, Fitch expects more of the same in 2013.
CMBS issuance increased strongly, to roughly $50 billion at the end of 2012 (from just over $33 billion in 2011). Fitch does not expect such a large increase in 2013 and believes the CMBS industry will be the stronger for it. That said, $60 billion of new CMBS issuance is not out of the realm of possibility before the year is out.
The growth of new issuance in 2012 and slated for 2013 inevitably raises the decades-old question of where we are at with respect to CMBS underwriting?
The short answer sounds quite similar to the beginning of 2012: less stringent than a year ago, but still relatively strong. Standards have declined slowly over the last year. That said, they are nowhere near the lax underwriting that characterized deals that came to market between 2006 and 2008.
Fitch steadfastly maintains that it will continue to increase credit enhancement levels if underwriting standards for CMBS continue to decline this year.
The reality remains that the continued stabilization of commercial real estate fundamentals is very dependent on a liquid financing market to which CMBS is a big contributor. If negative macro forces come to the fore (be it fiscal cliff-induced or otherwise), that coupled with an extended illiquid financing market places property fundamentals would be at risk.
Absent significantly macro shocks, the outlook for CMBS as a whole figures to be stable in 2013, with performance among specific property types yielding more of a mixed bag.
For instance, multifamily CMBS have recovered well and will continue its positive momentum 2013. According to REIS, apartment vacancies fell to 4.6% as of third-quarter 2012, down from 5.2% at the end of 2011. Vacancies continue to be lowest in the Northeast and West with levels below 4% in both regions. Improvement, however, has been seen in all regions with rent growth across the U.S. exceeding 2% since year end 2011, per REIS.
Fitch does not expect to see inventory expand greatly through new construction. On an aggregate level, multifamily revenues are approaching peaks seen in 2007 and Fitch will be monitoring this closely in 2013 to ensure that revenues are sustainable on properties subject to new CMBS loans. Demographics, however, remain positive, despite some uncertainty on how the single family housing market recovery will affect multifamily demand over the next couple of years,. As such, Fitch does not expect revenues to soften in the coming year. Fitch expects delinquencies will continue in multifamily legacy CMBS deals, since they are exposed to poorer performing properties and areas, such as Texas, Florida and Georgia.
Consumer confidence has shown improvement and consumer spending has been increasing which bodes well for retail CMBS despite the still high level of unemployment. The National Retail Federation recently released national sales figures for October that were 3.9% higher than the same period last year. The organization also forecasts that November 2012 and December 2012 holiday sales will increase 4.1% from last year. The International Council of Shopping Centers reported that the August back-to-school season shopping was strong with a 6.0% increase in comparable retail sales.
Meanwhile, the Thomson Reuters/University of Michigan index of consumer sentiment in November was at 82.7%. This represents an astounding increase of 29.8% from last Novembers rate of 63.7%. Retail supply, however, is a mixed story.
According to REIS, mall vacancy was 8.7% at the end of third quarter-2012. This was lower than 8.9% at the end of second quarter-2012 and down significantly from a year ago (9.4%). However, vacancy in neighborhood/community centers remains flat at 10.8% compared to 11% as of third-quarter 2011 and still close to the all-time high of 11.1% in 1990. Second- and third-tier malls will continue to be closely watched, as they have shown potential for significant losses if they deteriorate too far.
Hotel CMBS quickly turned positive as the economic recovery took place in late 2010. Fitch anticipates that hotels in 2013 will not see the level of growth seen in the past two years and that it will come mostly from rate rises rather than occupancy gains. Smith Travel Research forecasts 4.9% growth in revenue per available room (RevPAR) in 2013.
Luxury and upscale hotels have led the recovery although 2012 saw strengthening in the budget arena too. In 2013, aggregate revenues may reach 2007 peak levels and Fitch will be monitoring individual hotel revenues in new issue CMBS to ensure that recent revenue levels are sustainable over the life of the loan.
Office CMBS is expected to show continued signs of a mixed recovery as major metropolitan office markets continue to outperform secondary and suburban markets. The sector as a whole should be more stable in 2013 than it has been in recent years although vacancy will continue to remain relatively high as tenants try to reduce space requirements and utilize greater open plan designs.
According to Reis, vacancies have dropped to their lowest levels in three years and are currently at an average of 17.1% compared to 17.4% a year ago. Washington, D.C., is the best-performing office market. But its vacancy rate of 9.5% is weaker than it was last year, when it was 9%, due mostly to weaker government employment. Rents have begun to increase with asking rents averaging $28.23, up from $27.84 a year ago per Reis.
Cities such as Atlanta, Detroit, and Phoenix, which suffered severe economic losses due to the recession, are likely to continue to show negative signs and take longer to recover. As leases roll in these markets, as well as in the secondary and suburban markets, it is likely that space will be rolled to lower market rents, with higher concessions and leasing costs. The performance of these properties will be based on varying attributes, including the diversity of tenants and concentrations in lease roll. Many highly leveraged loans from the 2006 and 2007 vintages will continue to perform below their original targeted underwriting. Pressure will continue due to persistent unemployment and leases continuing to roll to lower market rents.
Huxley Somerville is a managing director and head of the U.S. CMBS group at Fitch Ratings.