How CMBSs work
Issuers, which include banks and lending institutions, package and sell commercial debt securities as bonds. The borrowers (issuers) use this debt to gain short-term liquidity, and debt buyers (investors) earn a return on the issued bonds (the bundled CMBSs) through principal and interest repayments.
CMBSs encompass three main types of securities, which include commercial real estate collateralized loan obligations (CRE CLOs), issuance for single-asset single-borrower (SASB), and conduit loans. Each type of CMBS offers different spreads and returns for the issuer and investor based on the package's credit rating, which is determined by the quality of the underlying securities and loan periods including short-term and longer-term investments.
Why the new surge in CMBSs?
General uncertainty of how long the commercial and consumer markets would take to recover made issuers hesitant in 2020 to originate and package new CMBSs. But as time revealed who the "winners and losers" of the commercial market were, numbers started to increase and trading activity started returning to more normalized levels.
With certain sectors falling behind when compared to others, there's a clear gap. The Trepp report found that office, industrial, and multifamily assets were the leading property concentrations for the trailing 12 months, with offices making up 40% of underlying assets with issuance. Retail and lodging continue to see deflated numbers because of the general volatility in these industries right now. Issuance for lodging is down 73%, and retail volumes are down 66%.
$60 billion in issuance is a significant jump from 2020's numbers and is largely due to the demand for short-term capital in the inflationary and volatile market we're seeing today. Issuers are able to use this liquidity to create more loans, which helps keep pace with inflation and a low interest rate environment to create more revenues and incomes for the company, or make improvements to their financials or underlying assets.
Move over conduits; there's a new leader in town
Conduit loans, which are similar types of loans packaged together and sold as a group according to rating or quality of the underlying asset and borrower, usually make up the majority of CMBSs issued each year. But as of June 2021, conduit loans were at $14 billion for the first half of the year, a stark contrast to the $45 billion on average conduit loan issuance achieved for the three years prior to the pandemic.
The highest issuance was for CRE CLOs, which hit $20 billion, a new full-year record, which was achieved after just six months. CRE CLOs are generally shorter loan terms and higher yields that offer more flexibility and financing for borrowers and issuers, something that's desirable for distressed institutions that may need additional capital to float operations temporarily and help them compete against rising inflation.
CMBS activity doesn't impact everyday investor activity -- at least not on the surface. The more fluid these markets are, the more likely issuers such as traditional banks and lending institutions are to create more loans. This directly translates into the ability for investors to get loans on new commercial assets.
Multifamily, industrial, and office properties are showing the strongest resilience in the markets today, but the delta variant could pose new challenges for certain sectors such as office. Issuance will probably continue to flourish as this industry continues to serve the needs of the marketplace.
Emphasis will continue to be placed on the quality of the underlying asset as it relates to cash flow, supply and demand, and debt service coverage ratios, in addition to new criteria such as the asset's ability to combat pandemic-related concerns, such as air filtration and the ability to social distance. This means investors should look to new developments that address the needs of the changing marketplace.