Overall Delinquency And Special Servicing Rates Rising Led By Office

As of the end of June 2023, the overall delinquency (DQ) rate for U.S. commercial mortgage-backed securities (CMBS) transactions was 3.4%, steadily rising throughout the quarter, led mainly by increasing office delinquencies. The retail and lodging sectors still maintain the highest 30-plus-day delinquency rates, at 6.2% and 5.0%, respectively, although they are well off their pandemic-era peaks above 20.0% and 15.0%, respectively. The office sector rate is now 4.4% and has risen in six consecutive months. Multifamily and industrial round out the major property types with 1.3% and 0.4% DQ rates, respectively.

The special servicing rate has also increased, up by approximately 80 basis points (bps) during the last quarter, to 5.6% in June. The rate for office, now at 6.9%, rose nearly two and a half percentage points over the past quarter alone. For more detail, see "Overall U.S. CMBS Delinquency Rate Rose 24 Bps To 3.4% In June 2023; The Highest Level Since December 2021," published June 30, 2023.

Refinancing Risk, Surveillance, and Rating Actions In Focus

The uncertainty about future office demand and the impact on fundamentals, valuations, and credit remains a focus of the commercial real estate and CMBS markets. Continued uncertainty with regard to interest rates and the relative dearth of transactions are making the future that much murkier. During the second quarter, we published a lengthy commentary on refinancing risk covering banks, non-bank financial institutions, life insurance companies, rated REITs, and CMBS (see "Stressful Conditions For U.S. Commercial Real Estate Are Raising Refinancing Risks," published June 5, 2023) as well as a scenario analysis laying out financing conditions for single borrower CMBS, titled "U.S. SASB CMBS Office Loan Refinancing Risk: Mind The Funding Gap," published June 7.

Not surprisingly, with the still elevated delinquency rates in retail and lodging and deterioration in office loan performance, rating actions largely turned negative over the 12 months ended June 30. Indeed, 218 CMBS ratings were downgraded, versus only six ratings upgraded (largely because of defeasance). The downgrades were primarily in single borrower/large loan and legacy conduit deals. While underperforming retail malls were the culprit behind most negative rating actions, underperforming office properties, particularly ones nearing loan maturity, have also started to drive downgrade activity.

Chart 1

For the rating actions in single asset single borrower (SASB) office deals, we have seen some variance deal to deal with regard to how far up the stack actions are taken. In general, a rating committee's view of temporary versus longer-term impairment, which depends on a number of factors (including the magnitude of changes in occupancy and the prospects for retenanting [recent market vacancy/subleasing trends], land value/location, lease rollover/maturity profile, and so on) may determine how far up the stack ratings actions will go. There have been three 'AAA' ratings from office-backed SASBs downgraded to the 'AA' category over the past nine months.

It is worth mentioning that we rate to timely interest and ultimate principal, and that the servicer advancing mechanism provides some support to timely interest in the speculative-grade and low investment-grade rating categories. Also (and we get this question frequently), a loan modification does not automatically trigger a downgrade (though loan modifications don't typically occur for positive reasons). Therefore, they may trigger a review, which can result in downgrades if we deem the risk profile to have changed since the last review or initial rating.

New Issuance Grew In The Second Quarter, But Remains Subdued; 2023 Forecast Lowered

There was about $11 billion in second-quarter 2023 private-label CMBS issuance, excluding commercial real estate collateralized loan obligations. This was nearly double the $6 billion in the first quarter, but still left the year-to-date figure of $17 billion down by about two-thirds compared to first half 2022. Aside from segments within the office sector, property cashflows overall have either rebounded to pre-pandemic levels or surpassed them, reinforcing the argument that the cost of capital is the primary headwind to issuance. The fact that long-term interest rates have risen recently suggests issuance may remain subdued for the time being. Our initial forecast of $60 billion for private label issuance now appears unlikely; something in the $30 billion to $40 billion range seems more appropriate.

A Larger Sample Size For Conduits

Challenges in collateral aggregation have been hampering conduit issuance, but there were eight second-quarter 2023 transactions, versus four in the first quarter. Here are a few observations (see table for details):

• Overall loan-to-value (LTV) ratios have been lower than recent history, down 310 bps to 80.9% in the latest quarter. Debt service coverage (DSC) ratio constraints are probably leading drivers for the lower leverage levels observed in the last few quarters.
• DSC ratios have been lower alongside the higher interest rates but were mainly stable quarter-over-quarter (q/q) at 1.56x in quarter two. Interest-only concentration percentages have remained high, and the full-term share reached a new post-financial crisis high of 82.4%. Even with the new high, the overall DSC ratio has fallen despite being less burdened with amortization.
• Deals have again become smaller and more concentrated. Average deal size fell to $751 million during the second quarter, down from $820 million in first-quarter 2023 and $849 million in fourth-quarter 2022. The top 10 percentages averaged 51% in 2021, 55% in 2022, 62% in the first four deals of 2023, and nearly 65% in the second quarter.

Of the eight conduit transactions that priced in second-quarter 2023, we rated five (see table 1). The eight offerings had an average of just 28 loans, with an average deal size of $751 million.

Table 1

Property Type Exposures Continue To Shift Within Conduits

Property-type compositions have been an interesting story in recent quarters.

The industrial property concentration level matched the record 18% from first-quarter 2023 in the second quarter, making it one of the strongest-performing sectors. The office sector has dwindled as investors are limiting exposure given the ongoing uncertainty. The second-quarter office exposure was about 23%, down 5% q/q. Retail, which has been performing better of late (absent the remaining challenges for lower-quality secondary/tertiary market malls to secure long-term financing), has seen its share rise year-over-year, despite dropping q/q to 28%. Lodging, following broad improvements in RevPAR following the pandemic, sits at low double digits, while apartment loans remain largely dominated by the government sponsored entities. The rise in the "other" category was mostly mixed-use properties. Self-storage increased throughout 2022 (7% of deals) but took a hiatus in 2023 (1% of deals), although we have seen some large single borrower deals backed by that niche sector.

Chart 2

Meanwhile, In Single-Borrower CMBS…

Six transactions worth about $3 billion in quarter one were followed by seven transactions worth a little over $4 billion in quarter two. This is down significantly from $33 billion across 38 transactions in the first half of 2022.

The property-type exposure for SASBs continues to evolve coming out of the pandemic. Taking the roughly $7 billion from the first half as a whole, we've seen about $2 billion each from lodging and self-storage, a little over a billion from data centers, and under a billion (each) in industrial, mixed-use, and retail.

Chart 3

Of the seven deals priced in the second quarter, we reviewed six and rated one. Of the six deals priced in the first quarter, we reviewed five and rated two.

Table 2

Elevated SASB leverage in recent vintages has been a concern, although the levels have come down in the limited sample sizes of 2023 driven by the same forces affecting leverage in conduit loans. When we decline to provide preliminary feedback on a deal (one instance apiece in the first and second quarters of 2023, two in the fourth quarter of 2022), it is generally due to high leverage. The share of fixed-rate SASBs has grown to levels not seen since well before the pandemic (albeit with a small sample size) suggesting for some that rates might remain higher for longer.

During the past two quarters, we've rated a deal backed by a hotel portfolio (LAQ 2023-LAQ), a transaction backed by a 42-property portfolio comprising mostly retail and industrial assets (OAKST 2022-NLP), and a data center deal (DATA 2023-CNTR).

Related Criteria

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