CWCapital Markets Update - Second 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 risks associated with hotels as an asset class. We synthesize and present information gathered from various industry research, public resources, and our own research.

  • Feature – CMBS hotel exposure – cyclical, front, and center in a recession. And Houston has a problem
  • Economy: remains positive amid slowing in both growth and job creation
  • Concerns as yield curve inverts. Record budget deficits, trade wars, price volatility. Q2 2019 construction deliveries down 30% year over year
  • Three trends we are watching


CMBS hotel exposure – cyclical, front and center in a recession. And Houston has a problem.

Commercial real estate continues to hit cyclical highs, and the inverting curve recession warnings have been clear for months. So what are some of the first things to happen to commercial real estate during such periods?

Reviewing 15 years of national average price information can reveal some interesting clues. One should be obvious to investors though, and that is the volatility of hotel values.
On a fundamental basis, hotels have the shortest “lease” periods, reset their rates daily, require continuous capital investment, and are subject to intense competition in the form of newer construction. In addition to changing customer preferences, hotels can be quite cyclical and hit very hard when businesses and leisure travelers curtail travel during recessionary times.

Based on our review of over 2,300 hotels currently active in CMBS securitizations, price information (sourced from RCA) and other data, we have concerns about near to medium-term performance for this asset class.

Volatility: For context, national average hotel values declined by over 56% during the financial crisis, from 2006’s peak to the trough in late 2009. That was by far the largest drop with the average for other asset types closer to the mid 30% area.

  • Over a 15-yr period, hotel price volatility is nearly 2x that of office properties, and nearly 3x industrial and multi-family per unit volatility.

As a Leading Indicator: Entering into the financial crisis in 2007, hotel values began a steady and consistent year-over-year price decline almost 18 months before other property types began to turn sharply negative (year-over-year) in early 2009. Aside from the recent macro-trend decline in retail property prices, national average hotel prices have now declined for the 4th consecutive month on a year-over-year basis. Although other property types have experienced occasional declines, the hotel trend appears more consistent. National hotel per unit prices are now roughly equal to where they stood in 2006 prior to the crisis. Of all property types, hotel is also off its most recent peak values by nearly 30%.


  • Decelerating Demand – Slowing consumer spending, uncertainty around global trade, and the perception of approaching recession are several of the factors highlighted by PWC in its August 2019 outlook. Current expected ADR and RevPar are anticipated to increase by only 1% for the coming year. These levels are by far the lowest in the past 10 years, which averaged 5%.
  • Overbuilding – A recent publication by Lodging Econometrics indicates that the US has 5,530 hotel projects under construction (670,000 rooms). The current pipeline is only approximately 17% short of the historical peak in 2008. As of late 2018, ConstructionDrive News reported that major pipelines in New York, Dallas, Los Angeles, Houston, and Nashville combined with Miami, Detroit, Seattle, Denver, and Boston, all had building pipelines greater than 15% of current local inventory.
  • Performance – Existing performance issues across the top 25 MSAs are presented below. Houston leads the nation with 13 defaulted or previously defaulted hotels. That is nearly a 24% default rate, nearly 5x the national average. Correspondingly, it also has the highest cap rate of 10.2%. Oil price volatility, energy corridor relocation, distorted demand as a result of hurricane events, and corporate right-sizing all contribute to the problems. Notably, Houston also reports the nation’s 3rd largest construction pipeline with over 5,500 rooms under construction, 6,000 more scheduled to start within 12 months, and 5,000 in planning. That is an increase of nearly 20% of current inventory. While Houston may be more reflective of local economic sensitivities, an overall economic slowdown is likely to only add to the distress.

For the complete commentary, stats and graphs:

The Economy

  • The July jobs report noted that the economy continues to grow but at the slower pace of 164,000 jobs created. Employment in the professional and business services category again led with 300,000 jobs created year-over-year, which is down from over 500,000 jobs created in the April 2019 year-over-year time frame. Manufacturing and mining jobs remained relatively flat to slightly declining on a year-over-year basis.
  • The unemployment rate was unchanged at 3.7%, among the lowest levels since 1969. The participation rate was 63%. Average hourly earnings remained on a growth track of 3.2% year-over-year. As of July 2019, El Centro CA, Yuma AZ, has reported the highest unemployment in the nation with both over 20%. Portland ME and Burlington VT report the lowest with rates less than 2.0% each.
  • The 10-year US Treasury was 1.51% as of this writing, declining over 100bps from last year end. Much of the decline reflects overall concerns about global trade agreements, or the lack thereof, geopolitical issues, and other uncertainty. As we have warned for months, the 2/10 spread is now inverted at -1bp. Bloomberg News reports that the US posted a $738.6bn budget deficit for the first 8 months in May, the largest ever on record. The current deficit is nearly 40% larger than just a year ago. Corporate and individual income taxes decline, trade uncertainties abound. We remain concerned about long term debt levels, and real estate price weakness on the horizon.

Property Markets

    • Effective rent growth – National average shows a 2.88% one-year growth rate, slowing from over 3%. Multi-family rents grew 4.6% for the year, while retail growth continues to lag at 1.85%, continuing to slow.
    • Vacancy rates – For the trailing 1-yr period, vacancy rates improved in multi-family and retail properties, but declined in office and industrial properties. Deliveries slowed by 25%-30% across multifamily, office, retail, and industrial properties year over year as of July. Absorption was positively impacted, but we feel this is related more to slowing construction pipelines. We generally expect continued vacancy increases across all categories as heavy construction pipelines are completed.
    • National property prices for multi-family increased by 8.3% on a rolling 3-year basis, while hotel properties showed a 4th consecutive month of declines year-over-year. Continuing its macro-decline, retail has lost value per unit (3yr basis) nearly every month for the past 2 yrs.

Debt Capital Markets

  • Credit spreads generally tighten in 2019 with CMBS BBB- coming in approximately 128bps year to date. YTD19 CMBS conduit issuance of $26.5bn is slightly ahead of last year’s levels by $200m. This periodic increase reverses what has been a continuously declining year-over-year market share decline on the part of CMBS. Competing products such as FHLMC, SASB, CRE-CLO, and balance sheet lenders have taken market share.
  • CMBS risk retention pricing for horizontal subordinates is in the 14% range, L-shaped subordinates are in the 18-20% range.
  • Conduit delinquency rates dropped to 1.57% this month, reflecting continued improvement.

Trends to Watch

  • Cyclical highs in property prices – all property types experiencing price volatility at the national level. Multifamily, hotel, and industrial building at a very robust pace. Over-building a concern. Over-levered properties finding their way into rated securitizations.
  • Slowing construction deliveries – of note, property deliveries across asset classes appear to have finally started to slow in 1H 2019 relative to same period last year. Although this helps absorption figures, we remain concerned about the amount of inventory delivered across asset classes and in certain markets.
  • Economic uncertainty – global trade uncertainty, the impact of tariffs, ballooning deficits, and the potential for negative real interest rates (the current 10yr real rate is negative at -.08%) provides the basis for general concern over asset prices and performance across the CRE asset classes.

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