A Recovering Office Market May Not Move the CMBS Office Credit Needle

CRE Finance World, Autumn 2012

A Recovering Office Market May Not Move the CMBS Office Credit Needle Director Research AssistantJason J. LamiLarry Kay Standard & Poor’s Ratings Services Standard & Poor’s Ratings Services D balance of rated CMBS, has been exhibiting the worst growth than those in the secondary and tertiary markets. And ifSecondary and tertiary markets, which account for approximatelytwo-thirds of CMBS office collateral, are experiencing the largestpercentages of loans with NOI declines. This follows rental patterns,as rents in primary markets have generally been exhibiting strongerespite a slowly healing U.S. office property market, thecommercial mortgage-backed securities (CMBS) officesector continues to struggle. Office collateral, whichaccounts for 30% of the total outstanding principal performance of the major property types. Office delinquencies not for the strength in several major markets, recent CMBS office accelerated in the first half of 2012, even as several large office loans credit metrics would have been much worse. The largest CMBS underwent modifications, which tend to mask or understate the office market, Manhattan, accounts for approximately 20% of total actual credit degradation. And although there are signs of recovery office principal outstanding, or $25 billion. According to Cushman in the office sector, office loan delinquencies are at record highs, and Wakefield, the Manhattan office market has recovered from and net operating income (NOI) declined for more than half of recessionary levels but is showing signs of slowing, both in terms CMBS fixed-rate office collateral that had servicer reported financial of rent growth and leasing activity in the second quarter of 2012. information for the 2010 and 2011 periods. Moreover, the payoff But with an office delinquency rate of just 1.16%, Manhattan has rate for maturing office loans hit a multiquarter low of 40% in the helped to soften the blow for the CMBS office sector. second quarter, and the loss severity rate, which measures the ratio of principal losses to the original principal balance, increased We believe office loan modifications will remain high in the foreseeable to 39% from 30% in the prior quarter. future, as refinancing the large, aggressively underwritten office loans originated at the peak of the market remains difficult. Between Office was the only major CMBS property type to experience a now and the end of 2012, approximately $1 billion of 2006 and year-over-year increase in the amount delinquent, and it’s also the 2007 vintage office loans mature. But even though loan modifications only property type for which the delinquency rate continues to reach don’t enter the delinquency calculations, they’ve done little to curb new highs. Delinquencies peaked for all other CMBS property types the CMBS office sector’s underperformance. With few new job either earlier this year or in 2011, and have subsequently retreated. creations, high vacancy rates, and peak-rent leases rolling to lower The amount of office delinquencies had climbed to $13.7 billion at market rates, we don’t expect any near-term improvement in CMBS the end of the second quarter from $11.1 billion a year earlier, and office credit metrics. As a result, the office delinquency rate will we expect them to continue trending higher (see chart 1). likely continue to move higher. Chart 1 Looking further out, office sector performance may continue to Amount Delinquent by Property Type struggle. We may not start to see any meaningful NOI growth until 2015, when leases signed at the market’s trough in 2010 start to benefit from rollover to higher rents. In addition, corporate “restacking” by making offices smaller and more efficient, along with reductions in square footage per office worker, could curb demand for space. Tepid Demand, “Shadow Space,” and Changing Demographics May Keep Vacancies High Job additions increased in July to 163,000 from 80,000 in June. The unemployment rate, however, unexpectedly rose, to 8.3% from 8.2% in June. The second quarter’s job increase of 225,000 was the weakest figure since 2010 (see chart 2). Temporary employment has also been on the rise, as employers appear to be reluctant to commit in light of recent economic uncertainty. Approximately 29% of the job additions in the second quarter of 2012 were temporary, up from 11% in the first quarter. Standard & © Standard & Poor’s 2012 Poor’s Ratings Services economists expect the U.S. unemployment rate to remain north of 8% through most of next year. A publication of Autumn issue 2012 sponsored by CRE Finance World Autumn 2012 17


CRE Finance World, Autumn 2012
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