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Price Appreciation Clouds CMBS Risks

Aggressive underwriting will lead to increased defaults in the latest crop of loans earmarked for commercial mortgage-backed securities (CMBS), warns Fitch Ratings. The chief cause for concern is a reliance on continued property price appreciation to achieve positive cash flow.

“Experience has taught us that continuously upward-trending rents and real estate values aren't guaranteed,” says Zanda Lynn, managing director at Fitch Ratings. “In the overly optimistic view of the market, future corrections or economic fluctuations are not contemplated.”

Over the past decade, CMBS defaults have averaged 3.7% annually, according to Fitch, which defines default as a payment 60 days or more past due. The rating agency expects about 15% more defaults over the 10-year term of loans initiated in 2007, due to the combined effect of loans based on projected — rather than current — values, and aggressive underwriting that is enabling borrowers to take on total debt exceeding 100% of asset values. In some cases, debt service at the outset exceeds existing cash flow.

Fitch researchers contend that the fallout in the subprime market should alert investors to the dangers of mixing aggressive underwriting with reliance on continued price appreciation. Yet Fitch has reviewed underwriting where existing cash flow was adjusted to reflect continued market and rental growth.

In some cases, office leases that expire after the loan refinancing date are included in calculations as if they generated higher, market-rate rent; in others, vacant space is considered leased at market rates.

On the hospitality front, Fitch has reviewed cash flows that anticipate increased revenue based on market growth alone, without the continual capital investment that is a necessity for hotels to maintain their market position.

“Real estate professionals are structuring loans today with the expectation that cash flow will continue to rise in a commercial real estate market that has already experienced dramatic upward trends,” says Eric Rothfeld, senior director at Fitch. “Fitch is seeing the market financing the higher value prematurely based on the expectation that it will occur, but well before it does — or does not — come to exist.”

Market evidence argues both for and against Fitch's default projections, according to Mike Straneva, Americas director of transaction real estate at Ernst & Young. Because cap rates are already at historic lows, significant price growth through cap-rate compression is unlikely, says Straneva.

That could make refinancing difficult for highly leveraged assets and increase defaults, particularly if cap rates increase, Straneva says. “If your cap rate on an apartment portfolio was 6% when you bought it and now the cap rate is 7.5%, you just had a whole lot of value go out of your property,” he says.

Yet, commercial real estate fundamentals remain healthy nationwide and could support double-digit rent growth in some tight markets, such as Los Angeles' office market. That will create positive cash flow to help borrowers stay in the black.

“People aren't going to be bailed out by cap rates,” Straneva emphasizes. “On the flip side, there's going to be real rental growth in many property types, and that in turn will cause cash flow to improve and will lower loan-to-value ratios.”

Because some 70% of new CMBS loans are interest only (IO) or include an interest-only period, the bulk of defaults resulting from CMBS issuance in 2007 may not occur until the loans require refinancing in 2017, says Lisa Pendergast, managing director of CMBS research at RBS Greenwich Capital. Regular payments on IO loans are smaller and easier to manage because the borrower isn't paying on the principal.

“The irony is that while IO loans will keep term defaults lower, they will work in unison with the very real potential that rates will be higher and property valuations lower (in 2017) to create a higher balloon default rate,” says Pendergast.

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