CWCapital Markets Update - First Quarter 2019

In This Issue

In this issue of the CWCapital Markets Update, we focus on the fundamentals and trends affecting national commercial real estate debt markets. Our feature reviews the correlation between leverage and market fundamentals. We synthesize and present information gathered from various industry research, public resources, and our own research.

  • Feature – Leverage versus Employment Fundamentals
  • Economy: Continued positive employment and economic trends, but deficits growing at historic rates. Are trade war tariffs intended to fund the shortfall?
  • Cyclical highs in property prices, volatility, and negative fundamentals
  • Three trends we are watching


Leverage versus Fundamentals
This quarter, we feature a look at the correlation between leverage and market fundamentals. Most commercial real estate investors will agree that the economy and jobs are probably first among many important factors that influence the success of any property. From a lending point of view, we would, therefore, expect loans to be more conservatively underwritten in areas of high unemployment and volatility, along with more aggressive lending in areas of stability and low unemployment.

To test our theory, we gathered the past 4 years of employment information from for the top 388 Metropolitan Statistical Areas (MSAs) in the US, as well as information on over 4,600 CMBS conduit loans originated and securitized between 2017 and 2018. We rank the MSAs by most recent unemployment and volatility, match loans to each MSA, and then calculate
the average debt yield for each bucket. In a simplistic way, in regard to employment fundamentals, this analysis could help investors identify both over and under leveraged properties.

For the complete commentary, stats and graphs:

The Economy

  • The April jobs report noted that the economy continues to grow with 263,000 jobs created. Employment in the professional and business services category again led with 535,000 jobs created over the past year, leading both healthcare (404,000), and manufacturing (264,000) with retail continuing to decline as a source of jobs.
  • The unemployment rate declined to 3.6%, the lowest level since 1969. The participation rate declined slightly to 62.8%. Average hourly earnings rose 3.2% year over year. As of year-end 2018, El Centro CA, Yuma AZ, and Ocean City NJ have reported the highest unemployment with all three over 10%.
  • The 10-year US Treasury yield at 2.40% has tightened 28bps this year. Much of the tightening was related to overall concerns about global trade agreements, or the lack thereof, geopolitical issues, and other uncertainty. The 2/10 spread is 20bps, slightly higher than year-end, but continuing in its long-term flattening trend. Bloomberg news reports that the US posted a $544bn budget deficit for the first 5 months in February, the largest ever on record. Corporate and individual income taxes decline, as tariff revenue increased. Unless tariffs permanently make up the shortfall in taxes, we remain concerned about long term debt levels, rising rates and real estate price weakness on the horizon.

Property Markets

  • Effective Rent Growth – National average shows a 3.10% one-year growth rate, in line with the 5-year average. Multifamily rents grew 4.5% for the year, while retail growth continues to lag at 1.63%, continuing to slow.
  • Vacancy Rates – For the trailing 1-yr period, vacancy rates increased for all property types, (10 to 110bp). Although deliveries grew in all categories (except retail) over 2017’s pace, absorption for all asset classes was less than 1.0x. This is the first time that all categories were negative in the past 15 years. We expect continued vacancy increases across all categories as heavy construction pipelines in multi-family and warehouse property types are delivered.
  • National property prices for multi-family increased by 5.6% on a rolling 3-year basis, while retail properties have lost value per unit nearly every month for the past 2 years.

Debt Capital Markets

  • Credit spreads generally tighten in Q1 with CMBS BBB- coming in approximately 100bps. YTD19 CMBS conduit issuance of $10.8bn is off last year’s levels by over 17%, continuing the long-term decline in issuance. Competing products such as FHLMC ($16bn), SASB ($10bn), CRE-CLO ($5bn), and balance sheet lenders continue to take market share.
  • CMBS Risk Retention Pricing – Horizontal subordinates in the 14% area, L-shaped subordinates in the 16-17% area.
  • Conduit delinquency rates dropped to 1.76% this month, reflecting continued improvement.

Trends to Watch

  • Cyclical Highs in Property Prices – all property types experiencing price volatility at national level. Negative absorption and heavy delivery pipelines. Multifamily and industrial building on a very robust pace. Over-levered properties finding their way into rated securitizations.
  • Rising Interest Rates – absent panic flights to quality, we believe the growing deficit, tax policy, trade tensions and tariffs may balloon deficits, spike rates, impact values.
  • CMBS Conduit Deal Size – smaller deal sizes (now $830mm, a decline of over 8% vs 2018) may reflect both market share issues as well as less willingness for banks to hold loans on their books in current market.

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