Interest rates

How Rising Interest Rates Affect CMBS – Commercial Property Executive

CMBS lending has been moderate this year. Interest rate hikes, soaring inflation, market volatility and erosion of confidence and other factors are to blame.

Increase interest rate have a particular impact on lending because higher rates put pressure on debt servicing, increasing costs for borrowers, said Constantine (“Tino”) Korologos, NYU assistant clinical professor and founding director of Leonidas Partners LLC. Additionally, higher debt charges may also combine with equity return expectations, raising capitalization rates.


Higher cap rates impact values ​​because the NOI and cap rate are indications of value. If the NOI does not increase, downward pressure on the value ensues. “Given the economic pressures on spending from inflation and concerns about recessionary conditions, it’s possible to see the numerator — income minus spending — drop,” said Korologos, co-author of the upcoming manual, Real estate capital markets; Evaluation, structure and participants. “That could amplify the effect of higher rates on value.”

Higher rates, uncertainty and market volatility could cause bond investors buying CMBS to seek higher yields on their bonds to capture high risk, he added. These factors introduce greater short-term sensitivity to market variations.

If there is a silver lining, it may be the secure nature of collateral, commercial real estate assets, Korologos added, noting that this sector has long been a haven of comfort and security for domestic and international investors. .

CMBS’s response to rising interest rates can be an economic indicator, said Joseph Cioffi, partner at law firm Davis + Gilbert LLP. Indeed, cash flows reflect the health of economic sectors, from retail to manufacturing.

So far, interest rate volatility has introduced additional uncertainty into an already changing post-pandemic economy and, by extension, into the secondary market. “Uncertainty for both lenders and borrowers is reflected in the sharp drop in new issuance in June and July, after a strong start to the year,” Cioffi added.

Advantages and disadvantages of CMBS

An attractive aspect of CMBS is that by design it is non-recourse to borrowers. If borrowers honor the lender’s agreement, they can always “return the keys” and avoid being held personally liable, Korologos said.

CMBS loans also typically come with fixed-rate coupons, which counteract the current rise in interest rates, said Rajul Sood, head of commercial lending solutions at research analytics and business intelligence provider Acuity Knowledge Partners. .

CMBS provides lenders with capital release and liquidity and offers real estate investors higher yields compared to government bonds. The attractiveness of CMBS for investors also results from its varied investment options, as well as its more flexible options for restructuring over an extended period, unlike conventional loans.

“The COVID-19 pandemic has established CMBS’ resilience to economic distress,” Sood said. In today’s environment, this type of security is more conservatively structured and benefits from stronger transaction fundamentals and underwriting standards.


But with inflation near a 40-year high and the pandemic creating volatility, CMBS funding is under pressure, Sood added. Rising interest rates, coupled with a generally higher loan-to-value ratio, can lower debt coverage ratios on floating loans, making these loans and investments riskier.

At a time when commercial real estate is struggling to recover to pre-COVID levels, investors remain spooked by the prospects of further variant surges, high energy costs and the negative impact of inflation on cap rates and occupancy levels in struggling retail, office and hospitality sectors. “This may result in high rollover risk for certain sectors witnessing double-digit erosion in property values, with an emphasis on LTVs,” Sood said.

Thirty Capital Financial CEO Kevin Swill said the only appealing aspect of CMBS today is the ability to lock in a rate for 10 years and sleep all night knowing that rate can be managed for the next 10 years. The downside is volatility and how quickly rising interest rates peak and begin to decline. “What is your threshold for accepting a tariff and being able to sleep at night? ” He asked.

Predict the future

Trepp’s CMBS delinquency rate rose in June for only the second time in nearly two years. The delinquency rate, however, has not been an impact or concern for originators, said Maverick Commercial Mortgage President and Founder Ben Kadish. “It’s the interest rates that are holding the market down,” he added.

A month after this rise, the Trepp CMBS delinquency rate fell 14 basis points month-over-month in July to 3.06%. That reinforced notions that the June numbers were inconclusive, Sood said. Although delinquency rates improved in July, inflation continues to drive revenue and spending, hurting overall revenue.

The tendency to delinquency rates should be watched over the coming months to fully understand the impact of current economic events on the CMBS market, she said.

Economic sentiment appears to bode moderate CMBS lending over the next few years, Sood added. A survey by the Urban Land Institute estimated the volume of commercial real estate transactions at $735 billion next year and $750 billion in 2024, both lower than the record high of $846 billion last year and expected to $800 billion this year.

“The widening of spreads and the weakening of the economy point to a drop in investor demand – already evident in this year’s volumes – effects that may linger well into 2023, given recession fears,” reported Sood. “Additionally, the CMBS loan maturity pipeline for 2023 is high at $70 billion, with the majority of office and hotel loans having lower metrics, [such as] high LTVs and lower yield on debt, leading to likely high rollover risks. »

Additionally, she said, the makeup of CMBS portfolios could expand beyond the typical five property types, gaining traction with potential investors.

In the short term, observed Cioffi, valuation should be a major concern for CMBS loans given the turbulence in the market, particularly in the office sector. If performance weakens and battles erupt over loss allocation, valuation disputes will likely be at the center of donnybrooks.

“Market uncertainty and losses can create fertile ground for disputes over projected net operating income and occupancy levels, and the role of valuation in defining key lending ratios such as debt service coverage or loan value,” he said.

Read the October 2022 issue of CPE.