Measures of commercial mortgage quality, which have remained relatively conservative despite the growth in loan volume and capital flows into the industry, will be tested in 2022 by rising interest rates.
Commercial property values and loan origination volumes are reaching all-time peaks as investors flock to the sector. The Mortgage Bankers Association forecasts that commercial and multifamily borrowing will break $1 trillion for the first time in 2022, up 13% from estimated 2021 volume of $900 billion.
Meanwhile, CBRE’s lending index of debt market conditions rose 10.3% in the fourth quarter and is 42% above pre-pandemic levels, a sign that lending activity and liquidity are strong and credit spreads are tight. At the same time, CBRE reported that metrics that gauge loan quality such as the average loan-to-value (LTV) and debt-service coverage ratio (DSCR) were roughly the same as they were in 2018.
CBRE found that the average LTV of loans originated in 4Q21 was 63.4%, down slightly from 64.0% in 4Q20 and 65.3% in 4Q18. The average DSCR was 1.48 in 4Q21, which means that net property income was almost 50% more than the average loan payment. The 4Q21 DSCR was up slightly from 1.47 in 4Q20 and 1.42 in 4Q18.
Loan quality is boosted in part because of market conditions such as low interest rates and thinning yields, or capitalization rates, that investors are willing to accept to own properties. The average cap rate in CBRE’s loan universe was 5.1% in 4Q21, down 4 basis points from the year-earlier period and 77 basis points below cap rates in 4Q18. Lower cap rates increase property values and reduce borrower LTVs.
Meanwhile, low interest rates in recent years and tighter credit spreads have contributed to historically low loan coupons, which means borrowers can take out more debt with lower monthly payments than they could in the past. The average coupon in CBRE’s loan universe dropped to 3.3% in 4Q21, unchanged from 4Q20 but well below the 4.7% average in 4Q18.
Just over one-quarter (26%) of loans originated in 4Q21 had coupons of less than 3.0%, and 70% had coupons between 3.0% and 4.0%. Larger loans—usually with better-capitalized borrowers—were more likely to have lower rates.
CBRE’s index highlighted the increasing market share of alternate lenders—including debt funds, pension funds and credit companies—which originated 37% of non-agency loans in the fourth quarter of 2021, more than any other category of lender. Banks had a 29.0% market share, followed by CMBS (18.5%) and life companies (14.8%).
Surviving Rising Rates
Heady capital conditions reflect the commercial property market’s strong fundamentals performance, high returns relative to fixed-income products, and reputation as an inflation hedge. Rents in some property sectors—such as multifamily, industrial and self-storage—rose in 2021 at decades-long highs. Meanwhile, commercial real estate has traditionally produced competitive returns during periods of high inflation at a time when rising prices are a main economic concern.
“Commercial real estate lending volumes are closely tied to the values of the underlying properties. In 2021 those values rose by more than 20%, and those increases will fuel further demand for mortgage debt in the coming years,” said Jamie Woodwell, MBA’s vice president for commercial real estate research.
There are looming issues, though, that should concern the market. The Federal Reserve is expected to increase policy rates between 100 and 200 basis points over the next 12 to 18 months, which likely will push the 10-year Treasury rate up significantly. The 10-year-Treasury yield topped 2% last week for the first time since July 2019 and is expected to keep rising.
Since loans and properties are priced off the Treasury risk-free rate, cap rates could rise over the next 12 to 24 months. Although there is not a one-to-one correlation between Treasury yields and cap rates, a sharp increase in interest rates would put pressure on property prices and increase the cost of borrowing. Rising loan coupons will especially hurt when today’s low-coupon loans mature and must be refinanced.
Moody’s Analytics Chief Economist Mark Zandi said last week during a webinar sponsored by the Counselors of Real Estate trade group that commercial real estate prices would flatten as interest rates rise, while some property segments such as gateway offices face “game-changer” complications such as work-from-home that could reduce occupier demand. “Commercial real estate is a good hedge, but there is no way to get away from the reality of work-from-home and higher cap rates,” he said.
The good news is that loans underwritten in the current cycle are much better prepared to handle stressed market conditions than was the case before the global financial crisis. One loan analyst noted that when loans originated in the 2005-07 period were analyzed using stressed scenarios (such as higher interest rates and an economic recession), more than a quarter had stressed LTVs of more than 100%, and nearly half had stressed LTVs of at least 90%. Using the same stressed standards, much fewer loans originated in recent years fail the tests.
“What matters in all this is a loan’s ability to refinance under stressed scenarios,” the analyst said. “There is more risk in a rising rate environment, more debt per square foot is a concern, but (conditions) haven’t deteriorated to pre-financial crisis levels.”
Said Woodwell: “Continued increases in property incomes, and stability in the ways investors value those incomes, should also support solid demand for mortgage capital, even in the face of modest increases in interest rates.”