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Volatile Employment Recovery, but CRE Fundamentals are Still Moving in a Good Direction

April’s disappointing Non-Farm payroll number causes us to revisit our property and city employment to gross revenue regressions. We find that fully open markets are showing strong employment recoveries, suggesting the CRE recovery will be a function of further employment gains and how they translate into real estate demand. Cell phone traffic shows a spiked recovery pattern in markets that have reopened, but we expect sustainable employment support will be difficult to achieve. Thus, we focus on an 85% employment restoration base case and factor in lower utilization rates for office and retail properties. The results show very few property markets will suffer a gross revenue drop >10%. Exhibits 4 – 8 provide a selection of metropolitan rent expectations for each property type.

In anticipation of this strong performance, we adjust our COVID conduit base and upside scenarios to reflect a more robust hotel recovery and a somewhat better retail recovery. Exhibits 13 – 19 provide losses and default adjusted yields for each BBB- bond issued after 2014, with several individual bonds showing potentially attractive default adjusted yields for investors that can do the credit work.

Limited 2021 CMBS Conduit Issuance Feeds The Spread Rally

2021 is off to a slow start for CMBS conduit issuance. If we look at maturing loans in Exhibit 6 the pace may not pick up as we expect many maturing loans may need extensions, floating rate bridge loans, or subordinate debt to refinance. This lower issuance level is creating an ongoing 2021 positive value technical. Yes, recent LCF levels are rich relative to corporate bonds, and we expect that to hold while supply is low.

Agency CMBS issuance has not slowed, but has seen a similar 2021 spread rally as investors reach for Agency guaranteed paper in its many forms. Exhibits 10-12 update our ACMBS prepayments and delinquency data, expecting high prepayments while the 10-year Treasury is <2%. We continue to recommend Agency CMBS allocation for its prudent stability should the economy fall into a recession after a stimulus package is implemented. The last section of the report looks at RV. Investors expecting a lasting COVID recovery must look down CRE credit curves for spread; for example, B and C classes from ACMBS and CMBS offer a bit more spread with marginal additional downgrade risk. Investors seeking spread should also look at BBB- credit bonds, as our latest COVID default vectors suggest there can be excess default-adjusted spreads in specific credit bonds. We caution that selecting these requires a full loan-by-loan analysis, and a realization that the final economic impact on CRE properties is still difficult to estimate.

Post-COVID Commercial Real Estate Fundamentals

This article discusses Commercial Real Estate demand post COVID-19. Our analysis focuses on urban metropolises, creates city specific employment/revenue correlations for the five main property types, and considers potential employment recoveries. We find that market rents and occupancies have not kept pace with employment changes, showing a market anticipation of a vaccine driven recovery. This creates a potential for weakness if the vaccine rollout is slower than expected. This risk translates into a recommendation to focus on ACMBS and senior CMBS classes. See exhibits 2-6 for employment to revenue correlations for the 5 major property types.

CMBS Issuance Going Into Year End

September’s delinquency data showed that loans continue to transition to more severe delinquency buckets. Given the outsized impact to hotel and retail properties, we reviewed the remaining 2020 and 2021 loan maturities and calculate that only $9.4 billion can refinance, while another $18.2 billion may experience maturity defaults or require recapitalization using subordinate debt. These factors feed into our $22 to $30 billion conduit issuance forecast for 2021 (shown in exhibit 5).

The article finishes with a discussion of relative value: CMBS LCF spreads are rich to historical relationships with corporate bonds and swaps yield. Investors looking for more spread are buying SASB AAA spreads. We find the most value to remain in the senior “COVID exposed bonds” (hotel and retail SASB, or CRE CLOs) which offer outsized spreads at the AAA level.

CMBS Retail Exposure and How To Analyze it For COVID-19

This article focuses on CMBS relative exposure in regards to the growing list of retail bankruptcies (full list provided in exhibit 3). We re-underwrite every CMBS retail loan with potential NOI decreases with cap rate increases. This caused us to change our COVID scenarios to increase near term defaults and loss severity, while decreasing our extension loss expectations.

COVID-19 Will Cause SASB Borrower Defaults– Investors Need To Re-Underwrite Future Potential Performance

This article provides a deeper analysis of the SASB market. To help investors sort through the universe of SASB properties, we created a COVID-19 SASB underwriting methodology. We find that some SASB transactions may require short/medium term support, while some may not avoid mezzanine foreclosures and even trust losses. We expect 9.5% of our SASB sample will have mezzanine lenders becoming owners, while 14% of our sample could show bond losses. Our analysis suggests that SASB AAA bonds are likely money good, offering varying levels of DM depending on property type exposure and default expectations. Overall, our analysis suggests that some of these larger SASB loans could become multi-year workouts well beyond the anticipated extensions.

COVID-19 Impact on CMBS: BBB Credit Runs

In the attached article we adjust our CMBS credit runs for potential COVID-19 defaults. These new scenarios usually hit the BBB bond class, but still show attractive returns at recent price levels. Exhibits 5 through 10 provide a reference resource with CMBS BBB results by vintage. We also stress that in many cases investors now need to toughen their specific loan assumptions, as loans that were troubled are now more likely to default.

COVID-19 CMBS Credit Results

Because there are no models to project how COVID-19 will affect borrowers or their decisions to default, we have made some heavy-handed adjustments to our CMBS credit analysis. This article adjusts our approach to allow for servicers liquidating some low loss loan situations early, which improves potential D class BBB returns. Investors should consider this with last weeks COVID-19 vector which delays loan resolutions. Exhibits 5-10 provide a reference resource with CMBS BBB results by vintage.

Subordinate Debt Guide
Subordinate debt has helped keep CMBS leverage low. This emerging trend is supported by international, institutional, and fund investors who see subordinate debt yields as attractive relative to property yields and appreciate the optionality of stepping into borrower equity at a lower basis. In this paper we outline the various forms of subordinate debt, and how investors should review potential subordinate investments. We focus on the inter-creditor agreement, the risks it creates for senior CMBS investors, and the terms subordinate investors should know. Given the number of mezzanine loans on recent CMBS transactions, we hope you will find the guide helpful.
CMBS History Evolution Guide
This history starts in 1984 with the first single-asset, large loan transaction; then covers how the Resolutions Trust used credit-enhanced mortgage pools, which created ongoing market demand for commercial mortgage pool CMBS. The discussion looks at how servicing issues during the 2007 recession caused CMBS 1.0 to evolve into CMBS 2.0. Exhibit 12 provides a comparison of CMBS 1.0 to CMBS 2.0. Going forward, we expect CMBS will continue to evolve in order to improve the borrower/investor experience. We hope that some of that evolution will see a new IRP that incorporates loan data distribution via blockchain.
Credit Classification Approach for CMBS
This article provides a CMBS credit methodology to help screen credit CUSIPs. The approach would classify CMBS 2.0 pools based upon NOI DSCR along with debt yield, from which we create two scenarios: 1. A Moderate Recession and 2. An Extreme 2007-2010 Recession. Applying these consistent scenarios allows us to quickly triage credit lists with a universal approach. After applying this type of methodology investors can focus in on the troubled loan categories and hand underwrite specific credit issues. The report creates summaries of 2014, 2015, and 2016 conduit issuance in Exhibits 5, 6 and 7. The second half of the report discusses relative value and how CMBS have now moved to fair value.

Agency CMBS

Freddie K CMBS Guide

This guide outlines how Freddie Mac’s timely interest and ultimate principal guarantee on senior multifamily bonds have created a stable bond benchmark for investors and low cost funding for borrowers. As home prices continue to climb the demand for affordable multifamily housing options continues to increase. To meet this demand Freddie has been altering their K bond series to include (among many others) fixed, floating, small balance, tax exempt, and even multiple ESG oriented bonds, available at 5, 7, 10, and 15 year terms. Selling these loans in a CMBS hybrid format which guarantees senior bonds and establishes a market clearing price for the first credit loss class provides efficient funding while creating bonds that will be well insulated from economic slowdown or market volatility. During COVID-19 these bond spreads have rallied, indicating why these bonds should be a base component of any structured finance portfolio and how these bonds will likely perform in the face of further market uncertainty.

Freddie Mac Multifamily Conference Highlights

Participants in Freddie Mac’s 3 day OPTIGO multifamily conference described how Freddie is helping workplace housing and has recently begun using their K program to encourage borrowers to invest in tenants via the sustainable SG program. In forbearance, 76% of forborne borrowers have started to repay, with another 7% having entered the forbearance 2.0 program (offering 15-18 months to repay). Exhibit 3 shows how forbearance has reduced K delinquency since June. We also discuss how low rates have been driving prepayment. These fast prepayment speeds push us to conclude with a relative value comment on the various Agency CMBS products. Given ongoing COVID-19 uncertainty, we see the products as volatility havens, with Exhibit 9 showing a range of spreads available depending upon investors’ need of WAL certainty.

COVID-19 Potential Impact on ACMBS with a Focus on Freddie K Credit

Unemployment among multifamily tenants has left multifamily borrowers struggling to pay their mortgages. To help, the FHFA has mandated GSE servicers provide up to 3 months of forbearance. These actions will provide some relief to tenants, borrowers and even the servicers, but some level of forborne mortgages will eventually experience COVID-19 defaults. Accordingly, we have created some potential ACMBS default vectors.

Freddie PC Primer

This article delves into Freddie Participate Certificates and Fannie DUS, which allow investors to add guaranteed multifamily exposure without having to originate or service individual loans. This report describes how these products are created and how investors can bid them. The analysis highlights how building a portfolio of both PC and DUS can diversify away single vintage exposure and create a steady yield. We conclude with an exhibit of ACMBS spreads to show how they may outperform in a crisis or economic slowdown.

Freddie Mac Seasoned Multifamily Q Primer

This article discusses Freddie Mac’s Q multifamily program that provides liquidity to financial institutions by securitizing their portfolios of seasoned small balance multifamily loans. Thus far, the Q program has converted 11 seasoned multifamily loan pools which we summarize in Exhibit 3. Going forward, we expect that the Freddie Q program may focus more on affordable housing loans or loans supported by government housing programs.

The article is intended to help investors understand the Q bonds which trade in line with other Freddie K CMBS, but spreads vary based upon the prepayment risk. However, potential issuers may also find it helpful to understand how the Q product could be used to convert loans to senior guaranteed bond classes. Loan sellers can keep the related guaranteed certificates which have a zero-capital charge, but also frequently sell the resulting senior guaranteed certificates at Agency CMBS-like spreads.

Green ACMBS Guide

The Agency green multifamily lending programs have had positive impact on American rental housing conservation. This guide describes how borrowers qualify for FHA/Fannie/Freddie Green multifamily loans to obtain pricing benefits and discusses how these bonds need to attract more ESG investors to be commercially viable in the longer term.

In this guide we describe how Freddie Mac’s Small Balance multifamily financing program “FRESB” offers 5, 7 and 10 year fixed and hybrid ARM mortgages for smaller multifamily properties. FRESB transactions contain bond classes supported by each loan type; allowing investors to select specific WAL bonds. Limited historical default and prepayment experience means these guaranteed bonds price at a conservative 5% CPB, a market convention that somewhat understates potential prepayments and disregards extension benefits that may increase spread for the shorter hybrid ARM directed bonds. In Exhibit 6 we conclude by comparing our FRESB prepayment adjusted spreads to other Agency CMBS products and find these guaranteed bond classes provide fairly short stable cash flows that offer a nice spread pickup to most other Agency CMBS alternatives.


This guide explains why we like the current strong multi-family fundamentals and reviews the Fannie DUS structure. Exhibit 11 provides a default sensitivity analysis that demonstrates the stability of DUS A1 and A2 bonds. Exhibit 12 shows how Fannie spreads have remained relatively stable in the early 2016 crisis, the last time fixed income sold off. This stability analysis suggests that after the recent Agency CMBS spread widening, the DUS bonds are attractively priced relative to CMBS and other fixed income alternatives.

Freddie KF Speed Guide

Our Freddie KF Speed Guide reviews Freddie Mac floating rate program and analyzes realistic prepayment speeds for the underlying collateral. These borrowers frequently opt for 10-year floating-rate loans in order to obtain a 60-month IO period with the intent to prepay before the loan starts amortizing in month 61. Applying realized historical speeds to these pools creates only a 3.2 year average life, but when we consider how those speeds could change in a recession that may extend to create a 5 to 6-year guaranteed bond. Given our 3 to 6-year WAL expectation the recent LIBOR plus 39 to 41bp coupon offers a nice floating-rate carry regardless of potential economic outcomes.

Ginnie Mae Project Loan CMBS Guide

This Ginnie Mae primer reviews Ginnie Mae’s Project Loan CMBS structure. Project loan bonds initially price at 15% CPJ and the report discusses the market may be overcompensating when adjusting from that initial speed. We look at various WAL life bonds and suggest different speed analysis ranges for short, medium and long-term bonds. If market recession concerns become reality, then Ginnie’s guarantee should convert loan defaults to early bond prepayments, highlighting how these discount bonds could provide some level of recession credit hedge.

General Securitized Products

First Half Structured Finance: Credit Stabilizes, Feeding Record Spreads and Issuance – So What Now?

Demand for floating-rate paper has seen AAA structured finance spreads periodically test record tight levels. Given these tight spreads for AAA paper we recommend FFELP and CLOs (currently some of the wider spreads). For investors anticipating COVID reflation we recommend credit and prepayment risk from CMBS, CLOs, and RMBS along with esoteric ABS (railcar, containers, whole business, and time share). Exhibit 4 divides current SF spread options into safety and recovery plays.

June delinquency and forbearance for Freddie K showed huge improvement, but RMBS and CMBS are trailing that movement. Forbearance has allowed many senior spreads to rally, but the market must monitor whether the various forborne or modified loans can eventually re-perform. For instance, our COVID CMBS conduit analysis suggests many BBB bonds could take losses and have tight default adjusted spreads (see Exhibit 13).

Each product section provides the sector’s delinquency and prepayment rates along with commentary on how these may change throughout 2021. A common theme among products has been fast prepayment speeds driving prepay or call pricing assumptions, causing us to discuss how delinquency and market inefficiency can provide extra carry and returns. Thus, for most products we continue to recommend that investors evaluate a range of speeds as there should be incremental value in the extension trade.

Whole Business Securitization: Isolated Business Revenue Structures Poised for a COVID Recovery

One sector that is poised to recover from COVID-19 is Whole Business Securitizations “WBS”, which isolate corporate revenue generating assets into a special purpose entity issuance vehicle. These products use a number of structured finance tools to support their bonds, including cash trap reserve accounts and rapid amortization events, both of which are typically triggered by a set DSCR level. As such, WBS represent a senior claim on business revenues.

Anyone who has to decide between chicken, burgers, and pizza for lunch already has 60% of skills needed to evaluate WBS. Our check list on page 11 adds to that evaluation with franchise experience and bond structure. Investors willing to take on some re-opening risk should look to the casual dining sector, where an extra 80+ bps of spread can be picked up for some of the more sit-down concepts which have still maintained solid DSCR levels well above their cash trapping threshold throughout the pandemic. The fast-food sector has proven even more resilient due to the shift in consumer nature over the past 16 months, but still offers over 115+ bps of spread.

FFELP Student Loans – Attractive DM Relative To Their Potential WAL Variability

Recent rate and spread conditions, combined with an uncertain economic outlook highlight the extra recession-resistant value available in guaranteed FFELP floating rate spreads (currently the widest federally guaranteed spread available in the market). This report discusses FFELP loan collateral and how the servicer offers the borrowers flexibility along with how the loans are securitized as bonds. For FFELP bonds this repayment flexibility creates uncertainty; forgiveness shortens potential bond life, while COVID-driven deferrals and income repayment programs delay repayment. To consider these factors we describe how the programs affect loan payments and create a vector to show the potential for expected WAL and a second worst case extension scenario. Thus we can consider the range of potential WALs versus the expected DMs. Exhibit 8 shows our expected vector that includes a $10,000 paydown from potential loan forgiveness. That expected vector offers attractive DMs given the average lives, while our extended scenario (shown in Exhibit 9) drops a few DMs to 20bp but still offers attractive levels, given their Federal loan guarantee.

Fall Securitized Market Update

Most AAA spreads have recovered to or within 10bps of pre-COVID levels. Our discussion of relative value and issuance highlights how limited supply could support further AAA tightening. We also highlight how ACMBS still provides a haven for investors concerned with COVID economic risk. Investors searching for excess returns now must reach for prepayment or COVID related credit risks, and we discuss how COVID related loan losses may translate into default-adjusted returns. We expect that structured finance issuance will accelerate into year end while remaining muted by relative standards, creating a positive technical for investors looking to securitized products for extra spread.

TALF Could Help Counter the COVID-19 Impact On CMBS/RMBS

We explain the Federal Reserve’s new TALF program in addition to discussing the TALF lending parameters that were set up for CMBS in 2009. It is possible the Federal Reserve is still evaluating CMBS TALF, and our results that show no senior bond losses may be helpful in demonstrating that the senior classes can safely be financed. Given that the CMBS and RMBS markets are currently frozen, we expect that financing of their senior classes would let other credit participants look at the remainder of the credit stack which could be key in restarting these mortgage markets.

Non-QM RMBS Primer

This report provides a history of how the Non-QM mortgage market has developed. We find that post-crisis rules and underwriting processes are creating high quality Non-QM collateral that prepays quickly as borrowers improve their circumstances. Rating Agencies evaluate these loans using the 2007-2011 housing recession experience, creating relatively high credit enhancement (CE). To consider Non-QM RMBS credit risk, we ran crisis-like sensitivity analyses, but found prepayment speeds outweighed default risks. The bond structure and short expected lives makes the AAA spreads attractive, but a relatively flat credit curve suggests investors are betting on prepayments and upgrades.

CLOs – Diverse Managed Leveraged Loan Portfolios Structured To Withstand Crisis
Leveraged loans have funded significant business growth, in turn generating a greater number of lower rated loans with weaker covenants. In a recession, those leverage levels and weaker covenants could create defaults and losses exceeding historical experience. To consider that greater risk, this paper discusses recent leveraged loan trends and in Exhibit 11 explains how the CLO structure may contain this risk. We further stress several recent CLOs using a very severe recession stress and find the CLO structure quickly redirects excess coupon, limiting potential losses to the CLO equity and in the most severe case to some of the lower bond classes. Our severe sensitivity analysis demonstrates that subordinate CLO credit bonds likely face more downgrade risk than loss risk in an economic downturn. This paper helps investors understand how the CLO structure can absorb loan defaults and provide stable credit performance in an uncertain economy.
CRE CLOs = Less Stable Collateral than CMBS, But Structure Provides Stability and Value
This paper reviews current CRE CLO structures, market conditions, and finds that the senior A classes are well protected for most any economic downturn. Exhibit 2 provides a visual summary of how the CRE CLO structure works to limit senior class credit risk. Nonetheless, the transitional nature of the loan collateral suggests that an economic slowdown could cause loans to struggle to fulfill their improvement plans at a time when loan refinancing liquidity would be reduced. This creates economic extension and loss risk in the mezzanine investment grade classes.

In reviewing CRE CLO pricing spreads we find the senior class has fairly consistent basis to floating-rate AAA CMBS SASB spreads. In contrast, subordinate BBB class spreads can vary significantly based upon perceived credit risks. This paper is intended to provide a broad description of the sector for investors and concludes that careful credit evaluation is required to purchase junior investment grade classes.