This is S&P Global Ratings' third quarterly update on U.S. commercial mortgage-backed securities (CMBS) conduit transactions published in the midst of the COVID-19 pandemic. We continue to closely monitor the COVID-19 pandemic's impact on U.S. commercial real estate fundamentals and our ratings on U.S. CMBS, particularly in the lodging and retail sectors. In our recent article, "U.S. And European CMBS COVID-19 Impact: Retail And Lodging Are The Hardest Hit," published, Sept. 28, 2020, we summarize the most recent rating actions taken on single-asset/single-borrower (SASB), large loan, and conduit transactions.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

The COVID-19 Pandemic's Evolving Impact

Servicers continue to work through a surge in requests for relief from borrowers, primarily related to lodging and retail properties. While initial forbearance agreements have generally been confined to three months and involved accessing reserve funds to meet debt service obligations, we are noticing an uptick in longer duration forbearance agreements, including one as long as 12 months. We believe it is reasonable to assume that this trend will continue until a vaccine or effective treatment becomes widely available.

It terms of performance, the overall delinquency (DQ) rate for U.S. CMBS transactions decreased by 16 basis points (bps) month-over-month to 8.1% in September 2020. However, the overall share of loans that are delinquent 60-plus days (i.e., seriously delinquent) is elevated, at 84%. Over 80% of this population is in the lodging and retail sectors.

We have also been tracking the increase of watch list (WL) loans due to the increasing number of loans in forbearance or currently requesting forbearance relief; the forbearance rate is 7.4% as of September. That rate has fallen somewhat since peaking above 8.0% a few months earlier. Similar to the delinquent loan population, over 80% of these loans also come from retail and lodging.

New Issue Credit Metrics Mixed but Generally Weaker Overall in Third-Quarter

The loan metrics for U.S. CMBS conduit new issuance transactions were mixed in third quarter, but generally weaker as a whole. These included the following:

• Leverage rose by nearly two percentage points quarter over quarter.
• Debt service coverage (DSC) ratios rose by about 0.15x, and remain at a high level. We note that historically low rates and high interest-only (IO) loan percentages are clearly contributing to elevated DSC ratios.
• IO percentages rose somewhat quarter over quarter for both the full-term and partial-term components. The combined total represents a CMBS 2.0 peak.
• Our average cash flow and value variance to issuer values both increased.
• Effective loan counts (as measured by Herfindahl-Hirschman Index score) were slightly lower, while average actual loan counts and deal sizes were up modestly.

Our Credit Enhancement Levels Are Above The Market Average

Our 'AAA' credit enhancement level was nearly five percentage points above the market average in third-quarter 2020, at 25.8% versus 21.1%. Meanwhile, our 'BBB-' credit enhancement level was 13.6%, compared to the market average of about 7.4%. We continue to believe these 'BBB-' rated classes could prove relatively more vulnerable to event risk—especially with more concentrated pools--until the ultimate economic impact of the COVID-19 pandemic on CMBS performance becomes clearer. As a result, we have not rated many of these classes in recent vintages.

Our average cash flow and value variance to issuer underwritten values increased 270 bps and 320 bps to 17.7% and 41.9%, respectively.

Of the six U.S. CMBS conduit transactions that priced in third-quarter 2020, we reviewed five and rated two (see table 1). The six offerings had an average of 41 loans, with top 10 loan concentration averaging over 60.0% for the second straight quarter, a full 10 points higher than the first quarter's average. The average effective loan count declined modestly to 21.3, well below the first quarter's average near 28:

Table 1

The conduit deals priced during third-quarter 2020 had higher loan-to-value (LTV) ratios and higher DSCs on a quarterly basis. The average LTV was 94.8%--a 170 bps increase quarter over quarter. Average DSC rose 0.15x to 2.48x in the third quarter, maintaining an elevated level. This likely reflects two factors: lower interest rates and a lot of full-term IO loans. For the purposes of our DSC analysis regarding partial IO periods, we utilize the figure after the IO period ends; but partial IO percentages remain somewhat low.

IO as an overall percentage of the collateral pools rose to nearly 92% in the third quarter from about 89% in the second quarter (a new CMBS 2.0 high). Full-term IO loans make up 72.1% of the collateral pools, a 50 bps increase quarter over quarter, while partial term IO exposures rose 270 bps to 19.9%.

In our review, we made negative adjustments to our loan-level recovery assumptions for all IO loans. In some conduit transactions, we made additional pool-level adjustments when we saw very high IO loan concentrations or when an IO loan bucket has no discernible difference in LTV versus the average (i.e., it is not "pre-amortized"). The average LTV for the full-term IO loans issued in the second-quarter 2020 was 92.9%, about 200 bps below the overall average.

Effective loan counts, or Herfindahl-Hirschman Index scores, which measure concentration or diversification by loan size, dropped 60 bps to 21.3. We consider this level to be somewhat diversified, but it's significantly below the recent range-–2018/2019 vintage averages were about 28, similar to first-quarter 2020. The average deal size increased by about $40 million to $775 million in the third-quarter 2020, while the average number of loans rose to 41, from 39 in second quarter.

Property Type Exposures Shift Within Conduits

Unsurprisingly, the last two quarters have featured a shift in property type exposures within conduits.

Industrial exposure jumped to 12% in third quarter, from 5% in second-quarter, marking a CMBS 2.0 peak. Retail exposure rose slightly to 9% in the third quarter from 8% in the second quarter, after it fell from 21% in 2019 and first-quarter 2020. Lodging rebounded a bit to 8% in the third quarter, up from 2% in second quarter. However, this remains below the recent vintage averages, which were in the low-to-mid teens. Office fell off a bit in third quarter to 39% (although mixed-use was up a bit) but remains high, up about 10% compared to 2019 and first-quarter 2020 levels. Meanwhile, multifamily exposure dropped 6% to 16%, similar to levels in the lead up to the COVID-19 era, and self-storage fell to 6% from 11% (a CMBS 2.0 high).

Chart 1

We discuss recent trends for the major underlying commercial real estate (CRE) property types below.

Office

The office sector is in the midst of an uncertain period regarding the future space needs of tenants, i.e., the demand side of the equation. Most markets, with a few notable exceptions (i.e., New York City), have seen restraint on the supply side in recent years. Currently, many office buildings are sparsely occupied, and we've seen examples in our new issue analysis of a gap between effective and net rents to renew leases or attract new tenants. The Green Street CPPI has offices down about 10% in value versus the pre-COVID period, which is in line with the decline in their aggregate "all property" index.

The question, of course, is whether the current state of most offices will become the "norm" going forward. Detractors cite some combination of a population shift away from larger, denser cities, work-from-home arrangements, and corporate cost-cutting strategies favoring a shrinking real estate footprint, leading to reduced demand, especially in central business districts. This, in turn, would impact vacancy rates (higher), rents (lower), and values (lower). On the other side of the debate, market participants stress the positive aspects of collaboration, the need to train junior employees, social distancing measures that are being implemented, momentum in the sense that office culture has been in place for a long time, the (future) availability of an effective vaccine, and the temporary nature of the current pandemic.

To date, there isn't much hard data available to conclude if a significant percentage of rolling office leases are, or are not, being renewed, whether corporations are exploring alternative spaces in suburban locations and/or perhaps subleasing current office spaces, and so on. We expect this picture to develop over the coming quarters, with more clarity likely in 2021.

It is also important to note that office leases are typically for longer terms, on the order of 10 years or more, so any potential distress would likely take place gradually, over an extended period of time. As a consequence of the pandemic, there is a trend for tenants to negotiate for shorter terms.

According to NAREIT surveys, office rent collections have remained steady and high-–well above 90.0%--through July.

Retail and lodging

In a recent report, we provide a detailed discussion of the current retail and lodging sectors. See "U.S. And European CMBS COVID-19 Impact: Retail And Lodging Are The Hardest Hit," published Sept. 28, 2020.

Our analysis found that retail malls have been facing significant challenges and deteriorating revenues for the past several years due to factors including the proliferation of retailer bankruptcies and store closures as consumer shopping preferences shifted to e-commerce from brick-and-mortar stores. We expect retail mall performance deterioration to continue and/or accelerate in the U.S. over the next year. Meanwhile, grocery-anchored retail, home improvement stores, and some larger big-box retailers are generally outperforming the traditional retail stores.

For the lodging sector, government travel restrictions, state-mandated closures, and fear of travel have resulted in significant declines in corporate, leisure, and group lodging demand. There has also been a dramatic decline in airline passenger miles for both international and domestic travel. These actions resulted in U.S. revenue per available room (RevPAR) declining 80%, 71%, 61%, 52%, and 47% in April, May, June, July, and August, respectively, reflecting historic U.S. lodging industry performance declines. And since August, the lodging sector has seen a worsening trend, with RevPAR declines back over 50.0% year over year as leisure travel wanes post-summer. Given these figures, it is perhaps unsurprising that many U.S. lodging properties had minimal or negative net cash flow during this period.

We expect a choppy recovery in the U.S. lodging sector, depending on both hotel type and location. Luxury and upper upscale hotels in dense urban/infill locations and those dependent on corporate, group, and international demand are the most negatively affected. These hotels will take the longest to recover because corporate and group meeting needs and travel protocols may evolve significantly going forward, and international demand will likely take some time to return to previous levels. On the other hand, economy and midscale hotels, particularly in smaller towns, highway locations, and suburban markets have fared better and have largely remained open. Extended stay hotels within the lower chain scales have also demonstrated stable performance.

Industrial

In the U.S., the e-commerce share of total sales increased 16.0% to $211.5 billion in the second quarter from 11.0% a year earlier, representing a 31.8% quarter-over-quarter and 44.5% year-over-year increase, according the U.S. Census Bureau's Quarterly Retail E-Commerce Sales report for second-quarter 2020. This trend has buoyed the performance of industrial properties, and their values have actually increased (up 2%) versus the pre-COVID-19 timeframe according to Green Street, which is only one of two CRE property types to do so (the other is manufactured housing). There appears little reason to believe that this property type will stumble in the near term, especially in so-called "last-mile" locations. Not surprisingly, CMBS conduits have experienced a considerable increase in exposure to industrial properties.

Multifamily

Despite some anecdotal evidence that multifamily rents have declined in certain large cities, like New York City, rent collections remain in the high 90.0% range through September, per NAREIT surveys. Similar in magnitude to offices, values have declined about 8.0% versus the pre-COVID-19 period, according to Green Street. Also, like the office property type, some risk of deterioration in property fundamentals/values exists due to a potential population shift away from denser city centers which could increase vacancies and drive down rents. There is some evidence of this supporting home values and rents in suburbs, exurbs, and smaller markets. Rents in downtown areas have fallen by more than 6.0% from the March 2020 peak, as per CoStar, and have been falling at a rate of about 1.0% per month since June. Concessions have also been increasing, especially at newer properties that are struggling to lease up to a stabilized level. However, rents in suburban markets are trending above pre-COVID-19 levels as demand increases. The trend is expected to continue as work-from-home options mean that employees don't need to be near offices and are seeking out larger spaces to accommodate a home office. The unemployment rate, which had risen to 14.7% in April, also affects the multifamily sector. Although this rate has fallen since April, it continues to remain elevated.

Self-storage

Self-storage property exposure in U.S. conduit CMBS was very steady from 2013-2019, accounting for 4% in all seven vintages. As noted above, self-storage properties have become more common over the past couple of quarters. These properties had seen considerable appreciation in value during this cycle, and despite a modest decline over the past year (down 2.0%), they still sit approximately 77.0% above their 2007 peak, per Green Street data. Through third-quarter 2020, performance has been strong, with minimal collateral losses. However, we believe some caution is warranted given the fact that vacancies had ticked up in certain markets prior to the pandemic. Though this is somewhat mitigated by substantial DSC ratio cushions at issuance, we believe that some degree of caution is also warranted because of the short-term nature of unit leases (often only month-to-month), combined with growing supply, in part, due to low barriers to entry.

Related Criteria

• CMBS Global Property Evaluation Methodology, Sept. 5, 2012
• Rating Methodology And Assumptions For U.S. And Canadian CMBS, Sept. 5, 2012

Related Research

• U.S. And European CMBS COVID-19 Impact: Retail And Lodging Are The Hardest Hit, Sept. 28, 2020
• U.S. CMBS Conduit Update Q2 2020: COVID-19 Impact Still Emerging; Questions Remain, July 16, 2020
• U.S. CMBS Conduit Update Q1 2020: The Magnitude Of COVID-19 Fallout Remains Uncertain, April 17, 2020