by Richard Hill, Executive Director of Research, Morgan Stanley

What follows below are key findings elaborated upon in Morgan Stanley’s September 26, 2014, research report “The State of the Credit Cycle”.

CRE Prices Rise to Pre-Crisis Levels

The Commercial Property Price Index (CPPI) has increased 64.9% since its January 2010 trough and now stands only 2.0% below its December 2007 peak. This represents a recovery of 95% of peak-to-trough losses, which is roughly twice the amount the Case-Shiller has recovered, 47%.

However, the recovery is inconsistent across markets, with major markets having recovered 120.9% of their peak-to-trough losses, while non-major markets have regained only 75% of theirs. Out of the main property types, apartment prices have recovered the most since the crisis, recouping 141.5% of peak-to-trough losses, while hotel, retail, and industrial have recouped the least (42.1%, 61.9%, and 70.8%, respectively).

Prices Diverge Higher From Four Fundamental Factors

The CPPI has diverged higher from four CRE fundamental indicators (cap rates, NOI, investment, and loan origination) and the current differential is as large as it has been since 2001. These fundamental factors will need to improve to support the continued rise in prices over the longer term, in our view.

Cap rates: Cap rates have been trending around 6.3% since the end of 2011, while the CPPI index grew from 133.34 to 177.65, an increase of 33.2%. Prior to 2011, the last time cap rates were around 6.3% (2008), the CPPI was at 150.

NOI Index: PPR’s weighted average NOI index is currently at 96.75. The last time it was around this level (in 2009), the CPPI was roughly 109.

CRE Investment: CRE investment peaked at 1.39% of GDP in 2008, which corresponds with a CPPI peak of 182. Investment is now roughly only 0.73%, but the CPPI is almost back to 180.

Loan Originations: MBA’s CRE loan origination index is currently at 164, which is about 53% below its peak in 2007. In contrast, the CPPI is only 2.4% below its peak.

Market Share Rising as Issuance Increases

Commercial mortgage originations have increased significantly since the end of the financial crisis and are now on par with what was observed in 1Q05. Life insurance companies (and the government agencies earlier in the recovery) have been the primary drivers of the rise in commercial mortgage originations since the end of the financial crisis. However, commercial bank lending has recently accelerated and CMBS issuance is increasing.

Private label CMBS issuance, specifically, is on track to reach as high as $95B in 2014, which would be a 15% increase over the year prior and marks the fourth consecutive year of growth since the market reopened in 2010. CMBS market share as a percentage of total origination volumes has correspondingly risen to 25% as of 1H14 compared to 18% in 2010, but it is well below the 50% market share that drove issuance to nearly $250B prior to the financial crisis. We expect that CMBS market share will increase to greater than 30% in the coming years as issuance increases to above $100B.

Underwriting Standards Have Loosened…

Credit quality has declined as CMBS originators have loosened underwriting standards to win market share. Consider that weighted average loan-to-values have increased to 65% in 2014 from 58% in 2010 while weighted average debt yields declined to 10.7% from 13.7% in 2010.

…But Still More Conservative Than Pre-Crisis

That being said, our analysis shows that current underwriting standards remain more conservative than those of legacy CMBS loans. We do note an increase in the percentage of loans secured by properties located in secondary and tertiary markets, which is a fundamental difference compared to legacy CMBS deals and a potential reason for concern.

Loan-to-Values Higher But Below Pre-Crisis Peak

Weighted average LTVs have trended higher over the past several years, from 53% as of 3Q10 to 66% as of 3Q14. However, they remain well below the levels observed prior to the financial crisis when they peaked at 71% as of 2Q07.

Debt Yields Decline to Below 10%, but Spread to 10-Year Treasury Rate Remains Stable

Weighted average debt yields, on the other hand, are at the lowest levels since the beginning of 2005, after declining to 9.6% as of 3Q14 – the first time debt yields have trended below 10%. That being said, the debt yield spread to the 10-year Treasury rate remains above 7%, which is 200 bps higher than the pre-crisis tight of 5.12% in 2Q06.

Pro Forma Underwriting on the Rise But Below Pre-Crisis

Pro forma underwriting is on the rise in recent CMBS 2.0 deals, but it remains well below where it was pre-crisis. For instance, as of 3Q14, the most recent NOI was a weighted average of 6% below the underwritten NOI compared to a pre-crisis peak of -13.5% in 4Q07.

The prevalence of pro forma underwriting in legacy CMBS deals may also indicate that legacy CMBS LTVs and debt yields were artificially low since, in many cases, the underwritten NOIs never materialized. This suggests that the difference in underwriting standards between CMBS 2.0 deals and legacy CMBS deals may be even more pronounced.

We measure pro forma underwriting by comparing the delta between the most recent report NOI at the time of securitization and the underwritten NOI (MR NOI / UW NOI – 100%). A negative percentage reflects that the U/W NOI was higher than the most recent NOI.

A Growing Percentage of Loans Are Secured by Properties in Secondary and Tertiary Markets

The percentage of loans secured by properties located outside the top 25 MSAs has increased towards 40% as of 3Q14 compared to a pre-crisis low of less than 30% as of 3Q07. This is one of the biggest fundamental differences compared to legacy CMBS and an increasing source of debate among investors: would one prefer Class A properties in primary markets with too much debt or Class B properties located in secondary / tertiary markets with more conservative leverage?

This isn’t surprising as our analysis finds that CMBS owned a 22% market share in major markets in 1H14, compared to a 23% market share in secondary markets and a 45% market share in tertiary markets. CMBS originators will need to increase market share towards 30% for issuance to exceed $100B in the coming years, which may be driven by continued growth of secondary and tertiary market share.

Underwriting Standards Likely to Continue to Loosen; It’s Just a Matter of How Far and Fast

We believe underwriting standards will need to continue to loosen given the forthcoming wall of maturities. An average of $350B of loans is scheduled to mature across all lender types over each of the next 3 years.

Many of these loans will be difficult to refinance upon their maturity date without recapitalization by the borrower and/or looser underwriting standards.  For instance, our analysis of the universe of CMBS loans finds that only 37% of the loans scheduled to mature in 2017 have debt yields greater than 10%, and 65% have debt yields greater than 8%. By comparison, our analysis of 2014-vintage loans shows that 64% had greater than a 10% debt yield and nearly 85% had a debt yield greater than 8%.

The historical refinancing rate across vintages of around 80% may therefore be higher than what can be expected for the loans maturing over the next 3 years without looser underwriting standards.

Risk Retention and Credit Quality

Regulators adopted the long-awaited final rules regarding credit risk retention mandated under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) on October 22, 2014. In the CMBS sector, the final rules include limited changes over the previous re-proposal, with the notable exception of eliminating the cash flow trigger test. The rules will go into effect in late 2016, just prior to the wave of 2007 vintage loans starting to mature.

In our view, CMBS may become more expensive to issue, resulting in the cost of financing widening, which would in turn make CMBS originations less competitive to alternative lenders such as REITs, life insurance companies and banks. This may incentivize CMBS lenders to originate lower-quality loans at wider spreads in order to maintain market share, but they could face pushback from a smaller group of b-piece buyers who have the capability and the desire to hold bonds for a minimum of five years. New structural alternatives may emerge to satisfy risk retention. We think the winner may be CREL CDOs since the issuers typically retain greater than 5% of the market value of the deal given that they serve as financing vehicles (see The Evolution of CREL CDOs, April 7, 2014, for further detail).

Over the near term, we expect b-piece buying to accelerate as deals issued between now and when the rules are adopted in two years will be grandfathered. Therefore, b-piece buyers will retain the right to opportunistically sell their bonds in the secondary market to enhance their ‘base case’ yield and shorten the investment payback through interest proceeds alone (assuming no bond interest shortfalls). Please see our May 7, 2014, report Analyzing B-Piece BWIC Volumes for further detail.