Late-Cycle Risks Tick Up for CMBS, CLOs

Broadly speaking, Fitch Ratings expects 2019 to be “another year of solid performance against a backdrop of supportive macro conditions” for structured finance. However, the ratings agency sees late-cycle risks on the rise for some asset classes, notably CMBS and CLOs.

For CMBS, the overall outlook remains stable, but with pockets of concern. Retail’s ongoing transformation—due to the advent of e-commerce as well as corporate bankruptcies such as Sears—is one such pressure on CMBS performance. The pace of construction versus the pace of rent growth in multifamily and office is another.

“We expect multifamily new supply to fall in 2019, helping to slow recent increases in vacancy,” according to Fitch’s structured finance outlook report. “However, effective rent growth is also projected to slow as recent new construction is absorbed and landlords offer more concessions.”

As for office, Fitch doesn’t expect new construction to taper until year-end 2019, “further contributing to rising vacancy, slower net absorption and minimal effective rent growth.”

And Fitch sees a few instances of late-cycle behavior in packaging the securitizations. Although new deal conduit credit metrics have been more favorable this year than they were in 2015, which marked the weakest vintage of so-called CMBS 2.0, “there continue to be individual loans in each deal with aggressive issuer assumptions.”

More generally, there are secular concerns with potential for impact across the CMBS spectrum. “Commercial real estate continues to face growing disruption driven by technology advancements, tenant demand shifts and demographics,” according to Fitch. That being said, Fitch expects new delinquencies to remain relatively stable next year.

While CMBS has recovered gradually from its post-2008 slump, when new issues fell to essentially zero, CLOs have taken on greater visibility more recently. TPG RE Finance Trust and KKR Real Estate Finance Trust closed on $1-billion CLOs on the same day late last month, for example. Here again, Fitch sees risks emerging from late=cycle lending behavior.

“Issuers of loans held by U.S. CLOs may stay highly-leveraged, fueled by loan demand, high enterprise valuations and regulatory easing,” according to Fitch. High initial leverage, coupled with weaker loan documentation such as provisions around incremental debt and collateral dilution, could start to usher in lower recoveries for future defaults.

Macroeconomic factors may give rise to headwinds for CLOs, too. “Global trade tensions and historically low U.S. unemployment rates may drive costs for underlying loan issuers dependent on imported inputs and hourly paid labor,” says Fitch.

Rising interest rates should be manageable for most leveraged loan issuers, according to Fitch. “However, it leaves less room for underperformance by more leveraged borrowers, especially if not amply hedged.”

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