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Joseph A. Furlong , VP
Capital Markets Group
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Delinquency and Special Servicing Impact
on CMBS and Commercial Mortgage Loans
Losses continue to pile up in the commercial loan market, while delinquent unpaid balances that can be counted in billions of dollars continue along their 32-month trend. With commercial mortgage back securities (CMBS) credit ratings in decline and the mounting difficulties with obtaining “take-out” financing, special servicers are playing an increasingly crucial role in maximizing returns on loan portfolios and obtaining extension modifications for borrowers.
DELINQUENCY RATES ON THE RISE
The delinquent unpaid balances for CMBS increased overall by 118% from the period of August 2009 through August 2010. Delinquent unpaid balances increased by $551.8 million in August 2010 alone. The distressed 90+ day, foreclosure and REO loans grew an aggregate of $4.05 billion, or 9%, from the previous month. This is the 31st straight month of similar increases.
Realpoint, Monthly Delinquency Report – Commentary, August 2010
Realpoint is projecting the potential for large-loan delinquent unpaid CMBS balance to continue along its current trend and potentially grow to between $80 and $90 billion by the end of the 2010 calendar year. Based on an updated trend analysis, they project the delinquency percentage to potentially grow to 11% from 12% under more heavily stressed scenarios through year-end 2010.
Fitch Ratings reported the cumulative default rate for domestic CMBS increased to 9.48 percent at the end of the second quarter of 2010 from 8.15 percent in the first quarter 2010. Fitch projects that it will reach 11 percent by the end of the year. The cumulative default rate for loans securitized in 2006, 2007 and 2008 could top 14 percent by the end of the year as predicted by Fitch. So far, loans securitized in 2006 have a 9.98 percent default rate; 2007 loans have a 10.48 percent rate, and those originated in 2008 have an 11.94 percent rate.
Many commercial loans originated in vintage 2003 through 2005 have a high maturity default risk where little to no amortization has taken place due to interest-only payment terms. These loans generally utilized aggressive pro-forma underwriting which included low debt service requirements (between 1.1 and 1.25) or overall lack of borrower capital. Many large floating rate loans, secured by un-stabilized or transitional properties, have either reached their final maturity extensions or cannot meet debt service requirements or cash flow covenants necessary to exercise in-place extension options. According to Fitch Ratings, 115 securitized loans with a balance of $1.3 billion matured in August 2010, of which two thirds were originated in 2005.
Collateral values have fallen due to a combination of rental rate pressure, increased vacancy, and an increase in cap rates. Cap rates, which correlate net operating income and market value, have trended up for class A, class B and class C properties. Class A properties have seen the largest movement in cap rates due to eroding market fundamentals and the lack of liquidity in the credit markets. Additionally, many properties are now over leveraged, due in part to the high loan-to-values and minimum debt service coverage ratio (DSCR) requirements of the CMBS days. These factors have tripped default clauses in the loan documents, flooding the market with foreclosed properties. Stabilized class B and class C properties are affected most by increased vacancies and falling rents, which is in part a result of the economic recession.
In addition to the current high underwriting standards credit market, all of the above factors played a crucial role in the borrowers’ inability to obtain take-out financing.
SPECIAL SERVICING IN THE SPOTLIGHT
The percentage of loans that are in special servicing grew to 11.79 percent in August from 11.33 percent in July. This exposure continues to rise on a monthly basis, increasing for the 28th straight month through August 2010. An average of nearly $4 billion of CMBS loans were transferred in each of the previous 12 months, which indicates that this is far from being out of hot water. Special Servicers will play a key role in the overall outcome of delinquent loans.
Realpoint, Monthly Delinquency Report – Commentary, August 2010
Special Servicers will experience additional pressures to maximize returns in today’s credit market. Significant effort will be required to achieve the level of results demanded by investors. There are many obstacles that the Special Servicers must overcome in order to reach these goals. Some of the issues include the lack of “take-out” credit available to borrowers, distressed collateral pricing, which results in higher than expected loss severities, and a prolonging of liquidation time frames.
The severity of losses on liquidating loans supporting US commercial mortgage-backed securities has exceeded their historical average in the third quarter of 2010. During this same time frame, the 342 additional loans liquidated for a loss had a weighted average loss severity of 42.8%, 740 basis points higher than the current 35.4% weighted average. Due to the increased loss severity of loans liquidated during the second quarter, the current historical weighted average overall loss severity rate rose to 35.4% from 34%. "We anticipate that the cumulative loss severity rate will continue to rise from 35.4% as more loans from the 2006-2008 vintages of CMBS are liquidated at relatively higher loss severities," says Moody's Vice President/Senior Analyst Keith Banhazl in a recent Moody’s report. "For loans from these vintages, lax underwriting standards, the absence of amortization and other loan structural features, historically low capitalization rates, current reduced market liquidity, and the general impact of the economic downturn will likely fuel higher loss severities."
With more commercial real estate headed toward foreclosure and bankruptcy, lenders and servicers are willing to work with borrowers who bring their own resources into the equation to achieve a "win-win" for everyone involved. Offers of 1- to 3-year extensions are not uncommon if the borrower can pay down their loans or are willing to pay extension fees. Freddie Mac, a portfolio lender, considers its commercial workout philosophy to be relationship-driven. Daryl Hall, vice president of asset management, Freddie Mac, had this to say on the topic at the MBA's Commercial/Multifamily Servicing and Technology Conference in New York: "Do not default to try and get our attention, because we will just foreclose on the asset. Talk to us and continue to make the payments while we talk. If you stop making payments, we will assume you have no interest left in the asset.” Borrowers must come to Freddie with a plan, "detailing a solution," and be ready to bring additional money to the table. "If there are fiscal needs, sometimes there needs to be a pay down. It's a shared gain concept. We expect people to recommit to get income from us." On the other hand, lenders are less willing to consider extensions if there is any chance of the borrower refinancing or selling the property at a price that clears the loans.
Lenders are now beginning to re-enter the market place, but the loan quality requirements are high. These loans generally require low leverage (50% to 60%), minimum debt service coverage ratio of at least 1.35 to 1.60, and strong sponsorship. Borrowers are often still having difficulties quickly refinancing their maturing loans. It is not uncommon for it to take two to three months for a new loan to close.
VALUING COMPROMISED PORTFOLIOS
While special servicing plays a crucial role in the potential recovery of delinquent loans, it carries a negative impact on the overall portfolio. These compromised portfolios can present a challenge in the valuation process. Proper analysis of all information available, whether through servicer reports or other market information is paramount in performing valuation analysis. Due to the unknown nature of loan work-outs or modification negotiations, it is mandatory to value the loans using a “worst case” scenario until all the details have been fully flushed out.
Very few of the junior-AAA bonds issued since 2004 have maintained their original ratings, according to a tally published by Bloomberg. Given the large volume of loans that are delinquent or in special servicing, both of which result in losses to CMBS trusts, few of those bonds have maintained their original subordination, or credit-support levels. It is important to understand how the current and the overall change in credit grades associated with each tranche affect the value of CMBS.
There is a continued trend of loans associated with CMBS that are transferring to special servicing. MIAC believes this trend will continue for the foreseeable future. MIAC implements cutting-edge technology and modeling best practices, combined with underwriting expertise necessary to effectively value these kinds of assets. We can assist you in navigating through your CMBS or commercial loan portfolio valuation issues.
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