Until now, UK house prices had benefited from nearly three decades of decline in the risk free real interest rate. A 2019 working paper from the Bank of England predicted that “a 1% increase in real interest rates that was persistent could move real house prices by just under 20% across many years”.
Shikha Gupta, Portfolio Manager
Until now, UK house prices had benefited from nearly three decades of decline in the risk free real interest rate.
A 2019 working paper from the Bank of England predicted that “a 1% increase in real interest rates that was persistent could move real house prices by just under 20% across many years”.
In this current environment, it will be challenging for some households to manage the projected rises in the cost of essentials alongside higher interest rates. Following the mini-Budget announcement in September by Liz Truss’s government, the UK mortgage market recorded peaks of 6.65% and 6.51% for two- and five-year fixed-rate deals respectively on October 20th.
The Bank of England’s financial policy committee recently announced that the proportion of households struggling to pay their mortgages could rise to levels not seen since the 2008 financial crisis, if interest rates and living costs continue to climb, it said.
Mortgage Spreads Widen
This is not the first time that rates have been so high. What makes this current situation unusual, however, is that uncertainty in the rates market has led to much higher mortgage spreads.
For investors, both residential and commercial mortgage-backed securities, which consist of tranches (the most secure being AAA-rated) of securitised loans, will present interesting opportunities.
There could be an interesting point to enter the RMBS market. While we don’t think mortgage rates will go back to 2% or less, we do think an equilibrium will be achieved lower than the current mortgage rate of 6%, once there is a bit more certainty as regards the Bank of England’s terminal rate.
In respect of commercial mortgages, specifically, most have been underwritten at a cap rate of 5% to 6%. Now, with the Bank of England rate itself being 3% and rising, the cap rate is likely more in the high single digits range, depending on various factors including the geography, property type and operating income of the property; retail will be higher, logistics would be lower. Eventually, cap rates may stabilise at a slightly lower long-term equilibrium rate with the prospect of enhanced value for these assets.
In the process, the entire loan pool of these securitisations will have to be re-underwritten at a higher discounting rate and some of the lower tranches of these CMBS will become worthless. This may provide opportunities for investors to underwrite risk and see if the market is being overly conservative on some of these mezzanine tranches. A detailed approach that involves analysing hundreds if not thousands of data points within loan data, will help identify mispriced risks in tranches that have enough cushion to absorb losses when the value breaks in these mortgage pools.
Ready for The Challenge
These stresses take time to materialise in the securitisation space. In 2023, when more home mortgages will come to the end of their teaser rates (typically locked in for 2-5 years) and commercial loans are handed to special servicers, more opportunities in commercial and residential securitisations will likely emerge.
With personal disposable income in the UK reduced to the COVID trough, high inflation and a looming recession, the affordability of UK households is probably going to get worse from here.
Delinquencies will increase, while consumers struggle to refinance at affordable mortgage rates.
However, given the sharp increase in house prices since March 2020, there is some buffer before the negative equity issue kicks in for the majority of seasoned mortgages and there will be room to extend and amend (loans up for reset in 2023 were taken out between 2018 and 2021).
Mezzanine bonds, both in the RMBS and CMBS space, are one particular area of interest.
In RMBS, mezzanine tranches of seasoned pre-crisis pools, with low LTV – to provide cushion for any house price declines – and low loan sizes with increased paydown potential might be lucrative. While all RMBS will be indiscriminately trading cheaper due to repricing of mortgage collateral, the 1.0 RMBS tranches will be the first ones to recover once market recovers.
Most of the UK mortgages remain on banks’ balance sheets. There will be sellers as stresses build in the market and delinquencies rise, leaving them with no choice but to clean up their balance sheets. Banks are already facing pressure with bounce back loans (e.g. Barclays is already foreclosing on some of these loans), and CIBIL loans that they issued to corporates and retailers during the Covid lockdown.
CMBS 1.0 versus 2.0
In CMBS, many pre-GFC issuances were underwritten at low cap rates and high projected income expectations.
These 1.0 CMBS structures broke down in 2014-16 when the loans came to maturity and couldn’t refinance at the same valuations and lending terms as before. Some of these CMBS properties were prime real estate in major European cities and were still robust but needed non-traditional lenders to re-underwrite risk to lend to them again.
While the process took some time and loans were in special servicing, the mezzanine bonds of these CMBS lost value as heavy discount were applied to uncertain recovery values.
Prices of some of these tranches went down to low teens, but upon stabilisation of the asset, the same tranches ended up recovering multiples of their original investments.
One such example was retail properties occupied by DIY chain OBI in Germany where the loan went into special servicing in 2014 and was in workout with various restructuring or asset disposal plans being considered. However, when the creditors & noteholders got involved, a year later, not only the CMBS whole loan but also the B-note on the property was eventually refinanced.
Similarly, in 2.0 CMBS, when underlying loans need refinancing in 2023 some loans will not be able to extend or refinance based on the old valuations and will move into special servicing for workouts.
With respect to 1.0 CMBS, the key will be to look for tranches that offer maximum upside to stabilized CRE recovery value after re-underwriting the loans using the stabilized operating income and cap rates.
For the time being, we remain patient as we wait for the right opportunities to emerge over the next year.