The Impact of Tenant Departures
While the office sector remains relatively steady after the Great Recession, single-tenant exposure in CMBS 2.0/3.0 can present challenges.
A unique feature of a commercial mortgage-backed security (CMBS) is its ability to provide borrowers with long-term capital at attractive financing rates while simultaneously offering securities to investors with different risk appetites and investment horizon profiles. A staple subset of lending within the CMBS origination market involves single or large tenant-leased office assets. Such loans with long-term leases are often considered low risk at origination due to the high credit quality of the tenant. While the economy will go through different cycles during a typical 10-year loan term, the tenant is assumed to honor its lease obligations, implying stable property cashflows.
As seen in CMBS 1.0 deals, those before the Great Recession, large or single-tenant departures prior to loan maturity pose added risks. It's difficult to predict future performance of such loans because the outcome of an asset is binary in nature (term/maturity default risk) and has a significant impact on the property valuation.
Table 1 features a few examples of distressed assets from CMBS 1.0 in which a single or large tenant either vacated or announced a departure on or before the lease expiration. The capital expenditure required to re-tenant these properties was significant because the properties became obsolete over time, which led to higher loss severities.
These loans share a few common characteristics:
- Tenants honored their leases, but vacated or subleased space on or before the lease expiration date.
- Lease expiration dates coincided within one or two years of loan maturity date.
- Tenants were credit tenants with operations spread across the nation at loan origination, but they consolidated operations during the economic downturn.
- Tenants decided to move to a nearby location with better amenities and lower lease rates.
- Most loans had insufficient cash reserves, representing less than 5 percent of loan balance.
Impact on Bond Valuation
As shown in Table 1, the One AT&T Center loan located in St. Louis, has a cut-off balance of roughly $107 million and is currently 100 percent vacant after the tenant vacated the property upon lease expiration in September 2017. The borrower has struggled to re-tenant this property despite its downtown location due to its large size (1 million sf), higher amount of similar available space, and heavy capital expenditure requirements. Using appraisal reduction estimates ($92.4 million) as a proxy for implied losses on this loan as of January 2020, we expect tranches B, C, and D to realize full principal loss and the tranche AJ to lose almost 8 percent of its principal upon liquidation. If losses stay below $79.8 million, the tranche AJ will not realize any principal loss. On the other hand, based on the most recent appraisal of $17.6 million reported in January 2020 and accounting for all expected liquidation expenses, losses can be as high as $107 million, implying that the tranche AJ can lose up to 17 percent of its principal balance.
Thus, the impact of losses stemming from such large loans in the deal could have a meaningful impact on bond valuations depending on the magnitude of losses, available credit support, and tranche sizes (i.e., the percent of the deal).
CMBS 2.0/3.0: Single-Tenant Tail Risk
CMBS 2.0 and 3.0, CMBS transactions issued after the financial crisis of 2007, have shrunk from $4 or 5 billion to roughly $1 billion, meaning pools have become more concentrated. Exposure to single tenants has grown and requires in-depth analysis for any potential unforeseen issues.
Table 2 shows similar trends from sample loans in CMBS 2.0/3.0 deals. In the first three cases, tenants related to the energy sector (Newport Mining Corp and Conoco Philips) continue to struggle as oil prices remain low and tenants vacated at lease expiration dates. In the Broadcom example, the tenant departed because of ongoing consolidation in the telecom/technology sector. The early termination option gave the company the flexibility to vacate before the lease expiration. While none of these loans has been resolved or recorded losses yet, exposure to a large tenant either announcing a departure or already vacating the property is notable. That doesn't mean all loans will default or will experience higher losses, as strong geographic asset characteristics, increased reserves, and other trigger mechanisms such as cash sweep events can mitigate losses. However, office properties located in heavily oversupplied markets or highly dependent on certain industry sectors may be of concern.
Anecdotal evidence suggests that a downturn or consolidation in a particular sector will lead to widespread downsizing in space. In addition, with the growth of coworking tenants, assessing single-tenant risk is not a straightforward exercise. Office properties located in major markets — namely New York, Washington, D.C., and San Francisco — tend to re-tenant space at stable or premium rents over time. However, in lower tier locations where submarket demographics are not favorable, office properties with significant space may not re-tenant at the same speed or frequency.
A downturn or consolidation in a particular sector will lead to widespread downsizing in space. In addition, with the growth of coworking tenants, assessing single-tenant risk is not a straightforward exercise.
CMBS 2.0 underwriting is relatively conservative when compared to legacy CMBS underwriting from both debt service coverage ratio and loan-to-value perspectives. However, CMBS 2.0 office loans with large tenants haven't experienced an economic downturn yet, and the macro environment remains supportive for the office market in the U.S. Furthermore, in-depth analysis has become more complex due to ongoing trends, such as shared space/smaller space per employee along with the volatile nature of predicted cashflows. These features were rather uncommon in CMBS 1.0 deals, but they present unique challenges and valuation opportunities in today's market.
For more on this topic, check out CCIM Institute's Guidance for Rent Relief Requests.