US Commercial Real Estate Outlook:Seeking Calmer Waters in Quality
The COVID-19 pandemic upended the way we live and work by creating secular changes and accelerating trends that were already afoot. For investors in commercial real estate, the results have been mixed.
The pandemic hurt small retailers by hastening the transition to digital commerce and emptied office buildings by turning living rooms into workspace. But it also fueled a warehouse building boom and unleashed a torrent of pent-up travel-and-leisure spending when economies reopened, underscoring the diversity of commercial real estate.
Recent turmoil in the banking industry has renewed concerns that the crosswinds buffeting commercial real estate could turn into headwinds. Of particular concern are midsized and regional banks, which purchase commercial mortgage-backed securities (CMBS) and are active commercial real estate lenders. A pullback in lending by regional banks could create a credit crunch that would have a negative impact on real estate valuations.
There’s no doubting the many challenges facing commercial real estate, but we believe the issues afflicting banks are largely idiosyncratic, rather than systemic. Moreover, the commercial mortgage market is too diverse to be painted with the same brush—fundamentals vary widely by property type, location and quality. For investors, conducting thoughtful due diligence and picking the right spots has never been more important.
With Credit Tightening, Quality Matters
Mortgage-backed securities are an important component of commercial real estate lending, comprising more than 13% of commercial and multifamily mortgage debt outstanding. CMBS are made up of mortgages that finance the purchase of hotels, office buildings, apartment buildings and other commercial property.
To create CMBS, individual mortgage loans are pooled and securitized into rated securities and then divided into tranches according to credit quality. At the high end are securities rated AAA with relatively low credit risk. These upper tranches often feature credit enhancements that cushion investors from potential losses, while saddling investors farther down the credit spectrum with the lion’s share of credit risk in exchange for higher yields (Display).