The signs of increasing commercial real estate troubles in the US and US mount.
Calculated Risk has been predicting a US CRE slump for some time. Their latest post reproduces a graph showing the lagged relationship between residential investment and investment in non-residential property. The resilience of the latter helped to support the US in the second half of last year, but there are now signs that the credit crunch is starting to impact commercial projects. CR also notes in a previous post that the CMBX, a credit default index of commercial backed securities, is setting new record, indicating rising delinquencies in the sector.
Right on cue, Fitch Wednesday put 188 tranches from 18 transactions of US CMBS on negative watch, totalling $8.4bn, and tweaked its methodology to incorporate its expectation of CMBS defaults “at least doubling in 2008.” Of that $3.2bn is in tranches currently rated AAA by Fitch.
The change means that Fitch is now assuming that the most junior CMBS bonds, the generally unrated first loss bonds which go into CRE CDO and ReREMIC vehicles (or B-piece re-securitisations), will experience “complete loss over time”, while sub-investment grade bonds will experience “substantial loss” in the event of default. Stand by for a batch of multiple notch downgrades.
But what about on this side of the pond?
There’s now movement from the raters here too. Fitch on Wednesday changed the outlook on five tranches of four UK CMBS deals from stable to negative. The move followed a review of 38 deals closed in the last two years, due to mature within the next four years – a segment seen as under pressure and at risk of a ratings downgrade.
The problem is aptly demonstrated by this chart, produced last year by Schroders using IPD data.
Rental growth, and income, may thus far have held up in the commercial property market, but for those deals maturing in the next few years, as the previous booming sector corrects sharply, the value of the property underlying these securities may not be sufficient to finance principal repayments.
Those most at risk of downgrade, says Moody’s, are those closed in 2006 and 2007, when values were at their highest, as the weight of demand for property assets from buyers backed with cheap debt pushed yields ever lower.
Since then yields on commercial property have blown out, with further falls in capital values expected in the coming months meaning sales or refinancing to meet payments at maturity will get tougher.
Schroders were in December arguing that the correction would be short and sharp, with property yields rising a further 100 basis points by mid-2008. While the market, conceded head of property William Hill, was likely to overshoot somewhat on the return to fair value, there had not been the type of “building boom” witnessed in the early 1990s, and a repeat of that crash seemed unlikely. The exception arguably is the City, with a glut of space under construction which could lead to pressure in the occupier market.
A weakening in demand from tenants as a result of economic or financial market woes, would increase downward pressure on property values, notes Fitch, and could leave some loans struggle to service repayments as rents fell. More bad news for CMBS.
The rater seems at pains to down play its move, pointing out that the four deals placed on negative watch represent only 10.5 per cent of those analysed, while the tranches affected are the most junior and total just 2.2 per cent of the 230 analysed.
Despite their greater reliance on asset values, CMBS transactions have inherent mitigating factors.
Fitch cites the long-term nature of CMBS deals generally in the UK; long term leases meaning security of cash flow; fixed rate CRE mortgage loans meaning interest rate fluctuations have less impact on default rates; and stable rental markets.
But the agency doth protest too much. Fitch’s UK move may not be huge in itself, certainly not compared to events in the US, but it could be a sign of things to come. CMBS were key to financing property’s bull run in the UK and have now dried up. Their downgrade could be the next helping of property misery on its way.