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Are Borrowers Over-Leveraged?

Analysts and the lenders who generate loans for inclusion in commercial mortgage-backed securities can't seem to agree on whether the current crop of CMBS loans is over-leveraged. One camp says the market is safely underwritten while the other insists lenders are setting themselves up for widespread defaults down the road.

Lenders say the typical CMBS loan equals about 75% of the underlying asset's value. By contrast, a loan-to-value metric utilized by Moody's Investors Service indicates loans originated in the first quarter of this year averaged 103.8% of asset values, the highest level on record.

The central question is whether the low capitalization rates generating today's high property values and loan amounts are temporary or will be around for at least the next decade, when those loans will roll over and require new financing, says Brian Lancaster, head of structured products research at Wachovia Securities.

“There's a profound difference in the way the rating agencies look at property values and cap rates and the way the market does,” Lancaster says. “It really is a fundamental question of whether you think lower interest rates in the U.S. are here to stay for the next 10 or 20 years.”

Theories of relativity

Commercial real estate investors have been willing to accept historically low cap rates — and therefore higher acquisition prices and loan amounts — because those caps still offer a better return than alternative investments.

Office cap rates fell below 7% in the first quarter, according to Real Capital Analytics, which tracks commercial real estate transactions of $5 million and higher. That still trumps the 10-year Treasury yield, which climbed above 5% in April.

Moody's calculates office property values by assuming the cash flow or cap rate is a constant 9% of total value. That rate reflects a period of relatively stable cap rates in the 1980s that Moody's has used as a benchmark for the past 10 years.

The benchmark enables investors to compare loans from different years and identify which loans are at greatest risk if property values fall, according to Tad Philipp, managing director of the CMBS group at Moody's. The calculation method also produces property values much lower than the prices many buyers are paying for commercial real estate today.

So, if cap rates increase to 9% and asset values decrease accordingly, the amount of the average loan issued in the first quarter this year will exceed the total value of the underlying asset.

“An underwriter might say something is 75% loan-to-value at a 6% cap, and we might call it 100% (loan to value),” Philipp says. “All we're saying is that if cap rates revert to historic norms, there's no intrinsic equity.”

Moody's tool is useful for comparisons across vintages, but investors need to understand that it is a relative measure rather than an absolute statement of loan-to-value, says Jamie Woodwell, senior director of commercial/multifamily research at the Mortgage Bankers Association. “It can make loan-to-value look exaggerated relative to current market values.”

High volume, low delinquencies

Analysts and lenders alike agree that CMBS loans and the securities they create are performing well. Domestic CMBS issuance is on a course to break last year's record volume of $169.2 billion, yet the delinquency rate is at a seven-year low of 0.58%, Standard & Poor's reports. “More telling, the actual amount delinquent fell substantially, by 38% in the first quarter,” says Eric Thompson, a director in S&P's CMBS Surveillance Group.

Falling delinquencies seem remarkable in light of accelerated CMBS volumes. Through April, CMBS issuance in the U.S. totaled $52.7 billion, 34% ahead of last year's volume of $39.2 billion during the same period, according to Commercial Mortgage Alert. Meanwhile, CMBS volume issuance outside the United States totaled $15.9 billion through April, down 34% from $24.1 billion a year ago.

The year-to-date drop in non-U.S. CMBS volume may just be a respite from unusually high volume last year and from a peak in the fourth quarter in particular, says Dottie Cunningham, CEO of the New York-based Commercial Mortgage Securities Association. Indeed, the $19.6 billion in non-U.S. CMBS issued in the fourth quarter contributed more than 28% to the year's total of $69.3 billion.

Entering uncharted territory

Despite strong CMBS loan performance, analysts worry that favorable market conditions and pressure to place capital are pushing CMBS borrowers into dangerous territory. Analysts say that if the economy were to wobble, borrowers would face an elevated risk of default.“Everything has performed the same because the environment has been good, but we think it is a good time for investors to start differentiating [credit quality] in advance of a downturn,” says Philipp of Moody's.

In Moody's first-quarter review of the CMBS market, the company points to high loan-to-value ratios, a proliferation of interest-only loans and dwindling debt-service coverage ratios as red flags of increasing risk in conduit lending.

Interest-only loans are one way lenders are trying to make financing attractive as long-term interest rates inch upward, according to Real Capital Analytics. The vast majority of conduit loans — which are originated for securitization — have interest-only periods ranging from 12 to 36 months, while 20% are interest-only through the entire term of the loan. “Only one-third of recent conduit loans have included amortization from the commencement of the loan,” says Bob White, president of Real Capital Analytics.

Limited amortization increases the balloon payment — and also the risk — at the end of the loan term because most of the original principal will require new financing when the loan term expires.

Debt-service coverage ratios also are decreasing. Until recently, commercial real estate assets produced a net operating income equal to about 1.45 times the amount of debt service on the property, according to Real Capital Analytics. Recent deals have averaged a debt-service coverage ratio just under 1.40.

In the first quarter of this year, 53% of underwritten debt-service coverage ratios were below 1.30, long considered a floor for wise underwriting, according to Moody's. The percentage of the ratios below 1.30 has never been higher.

Betting on the future

Both lenders and analysts are beginning to gravitate toward a middle-ground view in the debate over cap rates and asset values. Buyers' willingness to accept historically low cap rates is “beginning to unwind” as the gap between the rising 10-year Treasury yield and current real estate returns narrows, says Lancaster, the Wachovia researcher.

On the analyst side, Moody's researcher Philipp says improved financing structures and other changes in the capital markets may well stave off a radical increase in cap rates.

But with Treasury yields rising, Philipp doesn't believe cap rates will remain as low as they are today, either. If cap rates do climb significantly over the next decade, the market will take a less appreciative view of underlying asset values down the road. That could spell trouble when it comes time to refinance the largely unamortized loans originated this year.

“Going back 40 years, cap rates have never been lower,” Philipp says. “So relative to this cap-rate compression, are there implicit bets being made that it will last forever? Those aren't the kind of bets we want to make.”

Matt Hudgins is a writer based in Austin.

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