Interest rates have increased significantly from the unprecedented low levels that prevailed in the decade after the Great Recession. This suggests that leverage in the commercial mortgage-backed securities (CMBS) sector might be too high to attain prudent debt service coverage on newly originated or refinanced loans. Yet in the past 18 months, many commercial mortgage loans backing CMBS--particularly on the single-borrower side--have been structured with DSCs close to or even below 1.0x. Borrowers have been trying to refinance debt at existing loan balances, with the expectation that rising net cash flow and declining interest rates will eventually increase DSC levels.

However, revenue growth projections for almost all property types have moderated from the robust rates of recent years. In addition, inflation remains at levels where expense growth could mirror or even outpace revenue growth in the near term. Given our view that net cash flow (NCF) growth could be finite in the near term and because coupons might not moderate to levels of the recent past, we examined legacy CMBS performance of loans where DSC fell below 1.0x during their term. Loans with a DSC below 1.0x have had significantly higher default rates--almost five times higher than those of loans with more robust coverage levels.

The Rise Of CMBS Conduit Coupons

From 1997-2024, average U.S. conduit CMBS loan coupons ranged between a low near 3.7% and a high of about 8.5%, with a long-term mean of about 6.0%. Some of the lowest market rates (approximately 3.7%-4.5%) were in 2019-2022 amid quantitative easing and the COVID-19 pandemic. However, conduit coupons have averaged closer to 7.0% for the last year and a half, which is closer to the 6.6% average for 1997-2008. While most market participants are expecting both short- and long-term interest rates to decrease over the next few years, they may remain elevated compared to recent history for a longer period. To wit, our U.S. chief economist currently forecasts that the 10-year Treasury yield will average 4.22% in 2024, 3.64% in 2025, 3.36% in 2026, and 3.47% in 2027 (with the fed funds rate averaging 5.31%, 4.60%, 3.27%, and 2.90%, respectively, for those same periods). Therefore, while lower than current levels, the 10-year Treasury yield forecasted levels remain well above the sub 2% (and even sub 1%) levels that prevailed for the second half of 2019 through early 2022.

Chart 1

Commercial Property Revenue Growth Is Moderating

Some third-party revenue projections for each of the major commercial property types generally indicate that revenue growth will be modest over the next four years. The industrial sector has projected revenue growth of over 4% in each of the next four years, but other sectors aren't expected to be as strong. Revenue for multifamily, lodging, and retail is projected to grow by about 3.5% or less each year through 2028. Moreover, office rental growth will likely continue its negative trajectory for some time. Nevertheless, there are certain cases where rents (and hence NCF) are likely to improve in the near term, such as a property with below-market rents and near-term rollover into a low-vacancy, high-rent environment or a newly constructed or significantly renovated property that is still stabilizing. In such cases, we wouldn't expect a low DSC to persist over the long term.

However, we're generally skeptical that average revenue growth will be enough to substantially improve many of the low starting DSCs we've seen on many mortgage loans over the last several months. Unfavorable trends in operating expenses--particularly for labor costs, property insurance, and property taxes--have simultaneously eroded cash flows across all property types and could offset a portion of any revenue gains.

Chart 2

Historical Performance Shows Increased Risk For Low-DSC Loans

An analysis of historical data of the CMBS conduit universe has shown that loan defaults increase sharply when DSC drops below 1.0x. In our analysis, we calculated the number of loans within our sample (which includes over 110,000 conduit loans from the 1997-2024 vintages) with a DSC that dropped below a 1.0x (distressed loans) at some point during their loan term. We found that of the loans whose DSC fell below 1.0x at some point during their term (about 37% of all loans), about 27% ultimately defaulted, which we define as having gone 60 or more days delinquent. This compares to only a 6% default rate for loans with DSC that remained above 1.0x during their term.

Loans secured by hotels have a higher propensity (62%) to fall below a 1.0x DSC than the other property types. However, a large number of these hotel loans (1,977 loans; 35% of the hotel loans that fell below 1.0x) fell below a 1.0x DSC between 2020 and 2022 due to the lack of travel during the pandemic. Nevertheless, of the lodging loans with a DSC that fell below 1.0x at some time during their loan term, 35% ultimately defaulted, the highest of the major property types.

The office sector had the next highest propensity to default subsequent to DSC falling below 1.0x, at 29%, but we expect that figure to increase given the headwinds facing the sector. Industrial and multifamily had the lowest default rates (21% and 24%, respectively) even though their percentage of low-DSC loans was comparable to that of the other property types (except hotels).

Favorably, on the conduit side at least, issuer DSCs for 2023 and 2024 transactions appear to be averaging in the 1.65x-1.75x range. While significantly below the over 2.0x DSCs for 2019-2022, these levels are generally much stronger than the DSCs we have seen for single-borrower loans.

Single-Borrower Deals Are Feeling The Impact Of Rising Rates

The impact of higher rates has been particularly acute in the single-borrower sector. Of the approximately 180 single-borrower transactions we rate, 20 (11% of rated deals) are currently flagged as either performing or non-performing matured balloons (maturity defaults). Many borrowers are simply unable to refinance in the current rate environment due to some combination of low DSC ratios (DSCRs) and high loan-to-value ratios, as loan coupons have spiked and commercial property values have come down across the board. Borrowers need to refinance, but DSCRs at the existing loan balances are no longer workable without a simultaneous borrower paydown. The office sector is clearly in the eye of this storm, but refinancing difficulties have manifested across all property types (the April 2024 delinquency rate was up to 4.7%). In addition, special servicers have had their hands full (the April special servicing rate was up to 7.2%) as they work with borrowers to resolve these problem loans.

On the new issue side, single-borrower deal activity has been robust, but many of the transactions that we've reviewed in 2023 and into 2024 have very low DSCRs. In many cases, the DSCR on the most recent NCF is at or below 1.0x. To achieve a minimum 1.0x-1.1x DSCR on the actual cash flow, the loans are relying on either an in-the-money SOFR interest rate cap for floating-rate deals or loan coupon buydowns for fixed-rate deals. While these financial instruments reduce default risk during the loan term, much of that risk is simply pushed to the loan's maturity date. If interest rates aren't meaningfully lower in the future, or if revenue growth hasn't meaningfully outpaced expense growth, these new transactions could have a very difficult time refinancing, particularly because they're all interest-only, with no principal amortization.

In certain cases, we've declined to provide preliminary rating feedback on single-borrower transactions when DSCRs are very low and prospects for significant NCF growth are limited, thus raising refinancing concerns. As noted in our most recent quarterly reports, in first-quarter 2024, we declined to provide preliminary ratings feedback on 10 of the 16 single-borrower transactions that priced in the quarter and on four of the 13 transactions that priced in fourth-quarter 2023. Our primary reason was either high leverage or debt service constraints based on our NCF and current rates. The analysis of a single-borrower deal is primarily recovery-based, and high investment-grade tranches should be mostly insulated. But as we've seen in our surveillance book, principal recovery and timely interest become increasingly more uncertain once a single-borrower deal backing a loan with a DSC below 1.0x defaults, new lower appraisals come in, and servicers decide whether and how much to advance to bondholders.