More commercial mortgage-backed securities loans now are issued with interest-only structures than in the past, and researchers at Trepp, a data, analytics and technology provider to the securities and investment-management industries, said that rise could be putting the CMBS market in a tough place when the market hits the next downturn.
In the third quarter of 2018, interest-only loan issuance reached $19.5 billion, which was six times more than fully amortizing loan issuance, according to Trepp’s “Interest-Only Issuance has Skyrocketed, but is it Time to Worry Yet?” report. To put things further into perspective: About 80 percent of all CMBS loans issued in 2006 and 2007 were either interest-only or partially interest-only.
So, why is the market seeing these types of loans again? That’s because values on commercial real estate are at all-time highs, interest rates are low and the economy’s future health appears strong, according to Trepp. Additionally, competition for loans on income-generating properties has grown. Researchers noted that these interest-only loans make sense because they offer lower debt service payments as well as free up cash flow. However, borrowers aren’t able to deleverage during the life of the loan. Also, partially interest-only loans hold shock value when payments change from interest-only to principal and interest.
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Here’s where there is cause for concern, according to Trepp: Before the 2008 recession, the CMBS market saw a comparable spike in this interest-only structure. By the second quarter of 2006, interest-only loans comprised almost 58 percent of new issuance, while fully amortizing loans made up about 39 percent. As the market neared the recession, the gap between those two loan types only widened further. By the first quarter of 2007, interest-only CMBS loans reached nearly 79 percent of new issuance.
Interest-only loans are more likely to fall into delinquency during economic turbulence, the analysts noted. And what’s more, once the economy shows signs of healing, fully amortizing loans see delinquency rates fall while delinquency for interest-only and partially interest-only loans continues to rise.
For example, in July 2012, delinquency for fully amortizing loans sat at just over 5 percent, and interest-only loans’ delinquency was just shy of 14.2 percent. Trepp noted that this rate for interest-only loans wasn’t astonishing because many of the 5-year and 7-year loans originated in the years before the recession and were then maturing. That caused many buyers to be unable to meet payments because property prices fell and loan balances had never amortized.
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That said, analysts can measure the likelihood of loan delinquency by calculating debt-service coverage ratio. Trepp found between 2010 and 2015 that the average DSCR for interest-only loans was high at 1.94x. Since 2016, the average DSCR for these loans has declined slightly. If that average continues to fall, Trepp noted that the risk to the CMBS market will become something to be worried about. In March 2019, the average DSCR for new interest-only loans was 1.61x. That figure is approximately 0.35x higher than the minimum recommended by the Commercial Real Estate Finance Council.
All of this could be a perfect storm for the CMBS market should the United States encounter another recession. However, Trepp researchers said that it’s OK to sit comfortably for now because interest-only performance has remained above the market standard. But it’s important to keep an eye on the trend because this larger volume could foreshadow a loosening in underwriting.