Beyond Office Spaces: The Untapped Potential in Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS) are now seen as a losing bet.

Or are they an opportunity? Thanks to the carnage in one segment, the majority of CMBS as a whole are now being punished. This could provide a huge opportunity for investors looking for high yields and the potential for capital gains.

The pandemic really threw real estate for a loop. As people quarantined and enacted work-from-home protocols, offices, shopping malls and other buildings began to empty out. Firms reevaluated how much space they needed and leases were not renewed.

At the same time, the post-pandemic snapback has played havoc on real estate loans. Thanks to the rise in interest rates, many property owners looking to roll over their maturing debt faced higher borrowing costs. These higher borrowing costs have also impacted the sales and construction of new properties. Owners looking to sell have been faced with a lack of buyers, while would-be buyers have been stopped by higher mortgage rates.

The result is that commercial real estate is having a rough go – and so are the bonds tied to these properties.

First created in 1994, commercial mortgage-backed securities (CMBS) are essentially packages of various mortgages bundled together and sold to investors. Banks and other lenders pool these loans based on creditworthiness and then remove the loans from their books. This keeps the flow of money for new loans growing.

However, with the post-pandemic issues, CMBS are starting to take it on the chin. Thanks to cash flow issues, default rates are beginning to rise. According to real-estate data provider CRED iQ, only 26% of the $35.8 billion of office CMBS loans that matured in 2023 were actually paid off in full due to cash flow and property value issues. Today more than 1,000 office CMBS loans – worth about $14.8 billion – have been placed with a so-called special servicer: third parties who try to find the best outcome for the debt. This can include extensions, renegotiating the terms or even foreclosing on the property.

More recently, those issues hit AAA-rated CMBS with bonds backed by a loan for a key NYC property, which were only repaid at 74%. This was the first time since the financial crisis and Great Recession that top-rated CMBS bonds were hit.

With defaults rising, it’s easy to see how the CMBS industry has been avoided by a variety of investors. And now, analysts have postulated that the carnage may only be getting started. Overall CMBS delinquency has gone from 3.12% a year ago to 4.71% this past March.

However, one bad apple may be spoiling the whole barrel. In this case, it’s ’office properties.’

Office properties in key cities such as New York, Chicago, Boston and San Francisco could be to blame for the rise in CMBS defaults and cash issues. Office properties remain the hardest hit as work-from-home trends continue to play out nationwide. It’s these vacant spaces that have their way with CMBS bonds.

Removing them from the picture offers a glimpse of hope.

Just take a look at this chart from Fidelity. As you can see, occupancy rates for apartments, retail (including shopping malls) and industrial spaces have continued to rise. Secular trends for these properties – such as the rise of renter nation, onshoring and omnichannel retailing – have continued to support cash flows, rent growth and occupancy. The chart doesn’t take into account other property types such as data centers, which are nearing 100% occupancy as many are being constructed while already on contract.

Source: Fidelity Institutional

Looking at default and delinquency rates for these properties paints a different picture. In many segments of the property market outside offices, defaults are now back to pre-pandemic lows.

Market participants seem to be getting back on board with commercial mortgages as well. The recent carnage in the office industry has boosted confidence in the asset class. The Commercial Real Estate Finance Council Board of Governors Sentiment Index, which tracks senior industry analysts’ ‘feelings’ about market conditions, rose by 33% at the end of 2023. This was the largest quarterly increase since the survey began in 2017. Looking into this year, the Index has continued to trend higher as surveyed members remain bullish about CMBS loans made to other property types outside of offices. ¹

This has been coupled with the low issuance of commercial mortgage activity. The pool of CMBS loans has continued to shrink as worried banks have stopped lending – a positive sign for future rate cuts. Investors will be drawn to the industry’s higher yields and cash flows.

For investors, it creates an interesting, albeit risky, proposition. Debt tied to offices makes up only about 26% of the CMBS market. This means there are other bonds out there that are still providing steady cash flows, high occupancy rates and strong fundamentals. Those bonds, by the way, are yielding close to 6%. Thanks to the office property meltdown, these other bonds are nothing close to paying near-junk-bond yields.

With that, there seems to be an interesting risk/reward proposition for the asset class. Like many bonds, buying an individual CMBS is pretty much off the table for most investors making using an ETF or mutual fund the only option. Investors may want to go active with their choice as well. Active managers can avoid problem property types like offices in their holdings, whereas an index is forced to own them all.

These ETFs were selected based on their low-cost exposure to the mortgage-backed securities market, including CMBS bonds. They are sorted by their YTD total return, which ranges from -2.9% to 2.5%. They have expense ratios between 0.04% to 0.39% and assets under management between $59M to $28B. They are currently yielding between 3.4% and 5.4%.

Commercial real estate has been hit hard since the pandemic, and that has impacted CMBS bonds. However, it could be an opportunity for investors. Much of the carnage in the industry is squarely in the office segment. With defaults low and cash flows high elsewhere, investors looking for high yields have an opportunity to score some value.

¹ Fidelity (April 2024). Emerging opportunities in real estate debt