Overall Delinquency Up Moderately; The Focus Is On The Office Sector Rate

As of the end of September 2023, the overall delinquency (DQ) rate for U.S. commercial mortgage-backed securities (CMBS) transactions was 3.8%, up 40 basis points (bps) quarter-over-quarter. The office sector rate continues to increase for the ninth consecutive month, and stands at 5.6%, up a little over 400 bps so far this year. Retail still maintains the highest delinquency rate, at 6.4%, although it is well-below the COVID-19 pandemic-era peak above 17.0%. The lodging sector delinquency rate has now fallen below the office sector, at 4.7%, while the multifamily and industrial sectors round out the major property types with 1.4% and 0.3% rates, respectively.

The special servicing rate has also increased, up by approximately 40 bps during the last quarter, to 6.0% in September. The rate for office, now at 8.0%, rose 110 bps during the third quarter. For more detail, see "SF Credit Brief: Overall U.S. CMBS Delinquency Rate Increased 18 Bps To 3.8% In September; Office Loan Delinquency Rate Climbs For Ninth Consecutive Month," published Sept. 29, 2023.

Surveillance and Rating Actions In Focus

The uncertainty about future office demand and the impact on fundamentals, valuations, and credit remains the main focus of the commercial real estate and CMBS markets. On September 27, we updated our U.S. and Canadian capitalization rate assumptions for class-B office assets to better align with market fundamentals. While the current rising interest rate environment has led to correspondingly higher market capitalization rates for most property types, office assets' market capitalization rates have increased notably, suggesting a widening in the risk premium for the sector. Accordingly, we have raised our capitalization rates for class-B office assets by 100 bps. In addition, our capitalization rates for class-A and B office assets are now provided in prescribed ranges as opposed to spot assumptions. See "Guidance: CMBS Global Property Evaluation Methodology," published March 13, 2019 and "Guidance On Global CMBS Property Evaluation Methodology Updated," published Sept. 27, 2023. Following this revision, S&P Global Ratings placed its ratings on 47 classes from seven U.S. single-asset single-borrower (SASB) CMBS transactions and 13 classes from four U.S. conduit CMBS transactions on CreditWatch with negative implications. A list of the impacted transactions is available in "Sixty Ratings From 11 U.S. CMBS Deals Placed On CreditWatch Negative Following Revised Capitalization Rate Assumptions," published Oct. 12, 2023.

Indeed, deterioration at office properties backing SASB deals has been driving many recent rating actions. Over the 12-month period ended Sept. 30, 2023, 249 CMBS ratings have been downgraded, versus only one upgraded, due to a credit tenant lease transaction. For this quarter, we are introducing an appendix that provides line-by-line detail on the most recent quarters' actions, including deal/class names, CUSIPs, property type, deal type, rating to/rating from columns, and dates of actions. Further, we include affirmations in the interest of offering greater transparency.

Chart 1

For the rating actions in SASB office deals, we continue to see variations from deal-to-deal, which may depend on a number of factors. These include the magnitude of changes in occupancy and the prospects for retenanting (recent market vacancy/subleasing trends), land value/location, lease rollover/maturity profile, among other factors. There were a small number of 'AA' and 'AAA' classes downgraded during the third quarter (see the Appendix). In general, a rating committee's view of temporary versus longer-term impairment may determine how far up the stack ratings actions will go. It is also 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, a loan modification does not automatically trigger a downgrade but may trigger a review, which can result in downgrades if we deem the risk profile to have changed materially since the last review or initial rating.

New Issuance Remains Subdued; Conduits Gaining

There was about $10 billion in third-quarter 2023 private-label CMBS issuance, excluding commercial real estate collateralized loan obligations ($3 billion). This was more or less in-line with second quarter's $11 billion, and up from the $6 billion first-quarter total. Thus far year-to-date, the conduit side of the market has narrowly edged non-conduits, with $14 billion in issuance versus $13 billion. We believe conduits are gaining favor with borrowers, who are willing to accept five-year loan terms (versus typically 10-year terms), albeit with higher interest rates but with the added benefit of not having to obtain costly interest rate caps or loan extensions for floating-rate debt. The inherent diversification benefits of conduits conceivably also appeal to 'AAA' investors. SASB issuance had been heavily outpacing conduit issuance during 2021 and 2022.

A Larger Sample Size For Conduits

There were six third-quarter 2023 transactions, splitting the difference between eight in second quarter and four in first quarter. Here are a few observations (see table for details):

• Overall S&P Global Ratings' loan-to-value (LTV) ratios were up 270 bps quarter-over-quarter, and returned to roughly first quarter levels. They are still down significantly versus 2021 and 2022 figures. Debt service coverage (DSC) ratio constraints are probably the leading drivers for the lower leverage levels observed in the last few quarters.
• DSC ratios have been lower along with the higher interest rates, but were mainly stable quarter-over-quarter, at 1.52x for the latest reading. Interest-only percentages increased, and the full-term share easily posted a new financial crisis high, at 90.1%. The pressure on DSC ratios can be observed here. While the share of full-term interest-only loans has reached a new high, the overall DSC ratio has fallen, despite being less burdened with amortization. Conduit loans, in the current relatively lower leverage lending environment, are essentially becoming interest-only debt instruments.
• Deals remained smaller and more concentrated compared to 2021 and 2022 levels. The top 10 percentages averaged 51.0% in 2021, 55.0% in 2022, and 63.0% in 2023 through the third quarter. Lower pool Herfindahl-Hirschman Index (Herf) metrics have been a challenge for conduits in 2023 given rising interest rates and reduced acquisition financing opportunities. A key question is whether the risk of more concentrated pools will be outweighed in the long run by relatively lower leverage loans, especially as it relates to the credit enhancement of 'A' category rated bonds.

Pool diversity (Herf) has a greater impact on credit enhancement requirements for high investment-grade rated classes. This was a primary driver for the difference between 'AAA' credit enhancement levels for deals we reviewed versus market averages for much of 2023. Of the six conduit transactions that priced in third-quarter 2023, we rated three (see table 1). The six offerings had an average of 32 loans, and an average deal size of $759 million.

Table 1

Property Type Exposures Continue To Shift Within Conduits

Property-type compositions have been shifting in recent quarters.

Industrial properties fell to 10.0% in the most recent reading, which is still high from a historical standpoint, but less than the 18.0% from first- and second-quarter 2023. The office sector had been dwindling as investors are willing to accept less exposure given the ongoing uncertainty. However, the third-quarter share was about 27.0%, up 4.0% quarter-over-quarter. The retail sector, 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, and it rose two points quarter-over-quarter to 30.0%. The lodging sector, following broad improvements in revenue per available room following the COVID-19 pandemic, sits at low double digits, while apartment loans remain largely dominated by the GSEs (8.0% for third-quarter). The rise in the "other" category during second- and third-quarter 2023 was mostly mixed-use properties.

Chart 2

Meanwhile, in Single-Borrower CMBS…

Eight transactions worth $5 billion priced in third-quarter 2023, which is up modestly versus second-quarter 2023, but is only about half of the third-quarter 2022 volume of $10 billion.

The property-type exposure for SASBs continues to evolve coming out of the COVID-19 pandemic, although some trends are clear. Office deals have been few and far between. Industrial and self-storage have been steady contributors during the past five quarters, as has lodging. Retail has been more common in 2023, and we've also seen a fair bit with data centers, which is most of the "other" category.

Chart 3

Of the eight deals priced in third quarter, we reviewed all eight and rated two. We have been concerned about the elevated SASB leverage in recent vintages, 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 (three instances thus far in 2023, but none in third quarter), it is generally due to high leverage. The share of fixed-rate SASBs was elevated again (albeit with a small sample size), suggesting for some that rates might remain higher for longer.

Table 2

During the past three quarters, we've rated three deals backed by hotels (COAST Commercial Mortgage Trust 2023-2HTL, WSTN Trust 2023-MAUI, and LAQ 2023-LAQ Mortgage Trust), a transaction backed by a 42-property portfolio comprising mostly retail and industrial assets (OAKST Commercial Mortgage Trust 2023-NLP), and a data center deal (DATA 2023-CNTR Mortgage Trust).

Appendix

Related Criteria

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