Update: Commercial & Residential Real Estate, MSRs

New York | Earlier in the week, we wrote to our clients and colleagues in the secondary mortgage market about the growing dichotomy between urban and suburban commercial real estate exposures, and similar residential housing assets. We noted an important article in National Geographic that clearly lays out the long-term situation faced with COVID. Basically, we are years or even decades away from a solution that will restore full function to urban real estate assets:

“As COVID-19 continues to run its course, the likeliest long-term outcome is that the virus SARS-CoV-2 becomes endemic in large swaths of the world, constantly circulating among the human population but causing fewer cases of severe disease. Eventually—years or even decades in the future—COVID-19 could transition into a mild childhood illness, like the four endemic human coronaviruses that contribute to the common cold.”

In our view, there are two takeaways from the growing body of scientific opinion regarding COVID and the long-term nature of this global health challenge:

Commercial Real Estate

At year end, delinquency levels across most commercial real estate (CRE) exposures improved, with the number of properties reported in special servicing actually declining. As we noted in our comment on bank earnings, the fact of COVID forbearance such as the Cares Act and state moratoria are understating default and delinquency rates.

Overall delinquency rates remain elevated, 10x pre-COVID levels, and the rate of loans rolling into delinquency also remains high. New issue levels for commercial mortgage-backed securities (CMBS) remain below 2019 levels, but the pace is accelerating. Most of the mortgage-related series is residential, but also includes CMBS. Note that the new issue market for asset backed securities in 2020 remained well-below levels of 2019, as the chart below from SIFMA suggests.

Source: SIFMA

While there has been short-term improvement in CMBS delinquency rates, it is important for readers to remember that commercial real estate is a chopped salad; all of the assets, locations and financing structures are different. Unlike residential 1-4s, you cannot generalize about commercial real estate or CMBS vintages. And since much of the world of office buildings and hotels is privately owned and financed, the restructuring process is also obscured from view until a major loss event occurs.

Suffice to say that despite the huge rally in stocks since last April, commercial REITs were still down 15% over the past year as the markets closed last week, according to KBW. The book value multiple for commercial REITs was averaging just one times book equity. Names like KKR Real Estate Finance (NASDAQ:KREF) at 1x and Starwood Property Trust (NASDAQ:STWD) at 1.2x book are typical.

TCW noted recently that single family rental (SFR) bonds actually jumped to 2.58% delinquency in December after never have seen significant delinquency previous to COVID. They also report a growing tide of CRE, SFR and multifamily loans that have received appraisal reductions. For us, 2021 will be a year of revelation and reappraisal in commercial real estate.

We expect accelerating repricing and restructuring of CRE assets, particularly those located in major urban areas that have seen cap rates blown out. Yet again, remember the chopped salad metaphor because not all properties are distressed. TCW notes, for example, that hotel financials have skewed the average loan-to-value (LTV) in CMBS to 139% compared to the median of 42% for all loans sold into ABS.

Likewise, Fitch Ratings found that the U.S. CMBS delinquency rate fell four bps to 4.69% in December 2020 from 4.73% in November due to strong new issuance volume. This is the second consecutive month of decline, but it is important to note that the CMBS delinquency rate was just 1.45% at the end of 2019.

Although US banks were able to release loan loss reserves from consumer loan portfolios in Q4 2020, C&I loans continue to see a reserve build. The credit dynamic at work here is illustrated by the fact the delinquency in real-estate-owned (REO) in CMBS conduits was 0.5% in January of 2020 but rose to 4.5% in December.

Perhaps more important, despite the high rates of delinquency, annualized default rates in CMBS and bank CRE portfolios remain very low by historical standards. Whether and to what extent more delinquencies migrate to default will be a key issue in 2021 and beyond. But the fact of a wall of money looking for assets is likely to be depressing reported default rates.

New York City

Spending the past year in New York City, we watched the collapse of the local, street-level economy in areas that are dependent upon business, commuters, tourism, entertainment and hospitality. Most of midtown Manhattan’s offices and other structures are unused. Commuter volumes are 10% of pre-COVID levels. We estimate that the overall utilization rate for commercial assets located between 34th Street and 59th Street is perhaps 10-15%.

Manhattan streets are empty at night and there is little local pedestrian or vehicle traffic. By day, once busy areas such as Central Park South are quiet with no tourists or a large number of former residents. Open spaces provide refuge for the few remaining residents who cannot gather indoors. By evening, the midtown area is largely empty and increasingly dangerous as the streets are left to the homeless and bands of young people on motorcycles.

Residential neighborhoods in NYC have fared far better, but the business ecosystem that made the city possible is now gone. In its place we have a survival economy, where prices for goods and services have doubled or trebled. Manhattan restaurants, for example, now erect huts in the street because of the ban on indoor dining and raised prices to absurd levels.

Quality Meats on 58th Street

We see older cities such as NYC facing a particularly difficult and protracted adjustment. The pricing of all real estate in the five boroughs was built upon a level of utilization and services that is unlikely to be restored anytime soon. Offices, theaters, restaurants and other public venues from the smallest building to Lincoln Center are predicated on a level of utilization and density that may never be restored. This suggests that much of the Manhattan real estate market needs to be repriced downward and perhaps even redeveloped for other uses.

While many of the commercial and residential assets in New York are owned privately, by REITs and in CMBS, the direct and indirect economic impact of this adjustment will be substantial. In the near term, the value of both commercial and residential assets in urban areas may be significantly reduced to make financing a reality. And as the new valuation for commercial and multifamily assets in NYC is reached, the City and State of New York will see adjustments in revenues for sales, property and other taxes.

Residential Real Estate

In contrast with the generally negative situation with respect to urban commercial and residential assets, in the wider world of single-family and multifamily residential properties the outlook remains quite upbeat. Indeed, thanks to the continued purchases of MBS by the FOMC, home prices rose at nearly a 10% annualized rate in December.

The fact of rising average loan amounts in 1-4s suggests that a large asset bubble is in formation. We suspect that this situation will persist so long as the FOMC is buying $100 billion plus per month in Treasury debt and agency MBS. Federal Reserve Board Chairman Jerome Powell stressed that a QE taper is not anywhere close. Of note, former New York Fed President William Dudley warns that the longer QE continues, the more difficult will be the taper. Ditto.

The FOMC statement confirmed that the central bank will continue to increase its holdings of “agency mortgage‑backed securities by at least $40 billion per month until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”

But a big effect of QE is asset price inflation and the positive impact on loss-given default. Rising asset prices are largely eliminating credit risk for the secured residential mortgage asset class, a situation we expect to persist until 2024 or 2025. The chart below shows loss given default for bank-owned 1-4s including jumbos and non-QM loans held in portfolio.

Source: FDIC/WGA LLC

In addition, the fact that the large banks led by JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC) have once again started to buy third-party production in the jumbo market for 1-4s suggests that the damage done in April of last year is being somewhat reversed. Issuers such as Redwood Trust (NYSE:RWT) and New Residential (NYSE:NRZ) also have resumed originating non-QM loans for sale into private MBS, of note.

The good news is that we expect to see at least $3.5 trillion in new 1-4 family mortgages originated in 2021, a bull market volume indicator. As a large portion of the borrowers that were on some type of forbearance programs cure and then refinance, we expect to see delinquency rates fall. This is not to suggest that the industry does not face a problem with delinquency, but the positive environment for home prices is likely to continue due to a shortage of supply in existing homes.

There continues to be a strong pipeline for IPOs by independent mortgage banks (IMBs), but our view is that the window is continuing to close along with secondary mortgage spreads. The fact that strong issuers such as Amerihome, Caliber and loanDepot, for example, were reportedly forced to delay or downsize offerings illustrates the difficulty in obtaining support from investors. The chart below shows the MBA numbers for net profitability for IMBs (H/T to Joe Garrett).

Source: MBA

While 2020 will clearly be a record year in terms of IMB profits (commercial banks are generally missing this opportunity), we expect to see the secondary market spreads continue to shrink under the weight of competition and a dwindling supply of refinance opportunities. Notice the swing in profits from 2018, when much of the industry was losing money, to 2020. Another measure of IMB profits is gain on sale, which is shown in the table below from the MBA.

Source: MBA

In addition to MBS, another area that is also being distorted by the FOMC's QE open market purchases is mortgage servicing rights (MSRs), a naturally occurring negative duration asset that is presently changing hands near decade lows in terms of pricing. Many investors are rightly shy of buying MSRs given high rates of prepayments, but when fear rules is when negative duration assets like MSRs are cheap.

We note, however, that capitalization rates on conventional 3% coupons were rising last month, according to SitusAMC. Capitalization rates were up for the third month in a row in fact as the Fed of New York focused QE purchases on 2.5s and 2s for the most part. Ponder that.

As and when prepayment rates start to slow, in part because of the industry burning through the easy loans, we believe that MSRs and also MBS could outperform other fixed income assets. Residential MBS is currently offering investors negative returns due to early loan payoffs, but could see an increase in value as prepayments slow. Any "taper" by the FOMC will only accelerate that process.

Looking at the valuation multiples for new production conventional 4% MBS rising since September, which is roughly when the Fed stopped buying those coupons as part of QE, certainly makes us wonder about the unremarked optionality embedded within MSRs as well as agency MBS.