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In its recent look at U.S. capital trends, using the most recent data through 2023, MSCI look at what it called debt snapshots — a handful of considerations that help explain how troublesome CRE debt markets are at the moment.

The first was the spread between corporate debt and CRE debt and how it has risen to a high at least when looking at figures from the last 24 years. It was more relatively costly to finance a commercial property through a direct mortgage.

“The spread between commercial mortgage rates and corporate bonds widened to an average of 121 basis points over the last six months of 2023,” MSCI wrote. “Looking back to 2000, mortgage rates were at a comparable high relative to the cost of corporate debt only in the worst parts of the GFC. And even then, the spread was only at high levels for three months.”

After the Great Financial Crisis, the gap between corporate and CRE mortgage debt averaged only about 9 basis points between Moody’s Baa corporate bond yield and 7-year and 10-year commercial mortgage rates.

Connected to the cost is the perception of risk. According to Moody’s, the definition of Baa credit is, “Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.” The added spread for CRE mortgage rates suggests that commercial mortgages are even riskier. Given market jitters and concerns about default, that shouldn’t be surprising.

Higher interest rates do put a sting into transactions and refinancing, but investment funds are feeling the pinch, MSCI said. “On the performance side, it has also had an impact on investor returns,” they wrote. “The MSCI/PREA U.S. ACOE Quarterly Property Fund Index ended 2023 with an annual net total return of -12.6%, and a pure leverage impact of -396 basis points (bps). The mark-to-market on outstanding debt contributed a positive 13 bps but this gain only slightly offset the pure leverage impact and means the total impact of debt was -383 bps.”

And when interest rates are higher than returns on investments, debt becomes dilutive. MSCI estimates that interest rates on outstanding debt went from 3.4% in June 2022 to 4.5% by December 2023. Property returns for the year were -8.3%.

“As a core fund index, leverage levels in the index are relatively low, with debt representing 25.7% of gross asset value as of the end of 2023, though this is up from 20.9% in March 2022, largely due to asset value declines. For funds outside the core space that carry higher debt loads, the dilutive impact of debt would likely have been felt even more acutely.”

So far, bank loan delinquency rates have been “rising, not surging.” However, as has separately reported, there have been questions of whether lenders have been indulging in “extend and pretend.” Stretching renewal dates means not having to take immediate hits on balance sheets. That can work for a while, but only so long.


Source:  GlobeSt.