Report: Third of CMBS Showed Negative Leverage in Q3

A new report from Moody’s Analytics CRE signals an ominous inflection point for commercial real estate: nearly a third of new CMBS issuance was afflicted with negative leverage in the third quarter as interest rates surged.

According to Moody’s, about $5.5B of CMBS—equivalent to about 28% of the mortgage-backed securities that were issued in Q3—were symptomatic of negative leverage in which the cost of debt is exceeding projected returns on investment, including projected rent increases.

This represents a huge spike from the 8% of negative leverage in CMBS detected in the second quarter and a quantum leap from the Q3 2021 level of 2%, Moody’s reported.

Moody’s said it was seeing a spike in negative leverage across asset classes, with the largest jumps seen in the industrial (35.9%) and multifamily (30.8%) sectors.

“Negative leverage will most immediately translate to lower loan-to-value (LTX) ratios, a slowdown in lending and trading volume, and ultimately downward pressure on asset values, which hadn’t yet occurred during the COVID-19 downturn,” Moody’s analysts said.

Calling the spike in negative leverage a clear sign of a “transition phase” for CRE markets, the analysts added:

“We’ll have to wait for the dust to settle in 2023 [to see] if the broader economy can continue to grow at or near potential or continue propping up CRE demand and rent growth.”

The last time a spike of this magnitude was seen in the number of mortgages impacted by negative leverage was shortly before the global financial crisis in 2008, when the collapse of the housing bubble led to a wave of defaults.

Nobody is predicting a seismic shift like 2008, primarily because lending institutions are in much better shape than they were during the sub-prime crisis and large players are not over-leveraged.

Despite the Fed’s relentless campaign of 75 bps rate hikes—another hike is widely anticipated this month—the US economy thus far has resisted a slide into recession, notching third quarter GDP growth of 2.6%, up from a 0.6% slide in Q2 2022.

Cap rates, which in many sectors have been compressed in the past two years, have showed signs of increasing in the industrial, office and retail sectors in recent weeks.

“Ultimately, negative leverage will drive bid prices lower,” Kevin Fagin, head of commercial real estate economic analysis for Moody’s, told Bloomberg.

“You’re either not going to buy that investment, or if it comes to refinancing, you might have to hand the keys back. You might not be incentivized to save the property,” he said.

According to Moody’s, we’ll continue to see many negative leverage deals get done in the near future as equity markets react to rate increases.