Market-Peak CMBS Could See 30% Default

NEW YORK CITY-The years between 2006 and 2008 were the peak period for CMBS issuance, and by several metrics these years also represented the trough of underwriting. Given the still-sluggish recovery in commercial real estate fundamentals, it stands to reason that clouds loom over securitized loans from the market’s peak, with the potential for inclement weather sooner (in the case of loans with five-year maturities) or later (for 10-year debt coming due in 2016 and 2017). Already the most troubled vintages, ’06-’08 CMBS loans could see a cumulative default rate as high as 30%, Fitch Ratings said in a report last week.

And while they didn’t put specific numbers on the extent of the trouble they foresee, both of the other major rating agencies have pointed to continuing strife in boom-period CMBS. Standard & Poor’s notes that of the ’07-vintage CMBS maturities, $19 billion are five-year term loans, approximately 85% of which are scheduled to mature in the first half of 2012.

“The retrenchment in the capital markets and among other lenders in the third quarter of 2011, which has continued into the current quarter, dims the refinancing prospects” for loans maturing this year, according to a report S&P issued in December. As much as 60% of the five-year CMBS scheduled to mature in ’12 may fail to refinance, S&P says, noting that retail loans are at greatest risk.

Longer term, Moody’s Investors Service sees turbulence in 2016 and 2017. That’s when 10-year loans originated in ’06 and ’07 will come due. Given that most of the loans of these vintages come with debt service coverage ratios significantly below the 1.40x typically seen in 10-year loans that mature in the next couple of years, “a significant number of maturity defaults and loan extensions will occur in 2017,” according to Moody’s.

A decline in DSCR is among the factors Fitch cites in reporting that underwriting standards have eroded during the era of CMBS 2.0.  “The more CMBS underwriting standards  decline, the stingier Fitch will become with its assessment of these new deals,” Huxley Somerville, head of US CMBS at Fitch, says in a statement.

The average DSCR dropped to 1.25X in ’11 from 1.36 in 2010, although that’s still higher than the 1.05 seen in ’07. Similarly, current loan to value ratios, while higher at an average of 91.6 than the 85.5 level of 2004, are nonetheless lower than the 110.7 of five years ago, although both the LTV and DSCR numbers from ’10 were more in line with the conservative underwriting that prevailed in 2003. 

Yet average DSCRs may not tell the whole story over time. There’s a risk that a “barbelling” of DSCRs across transactions could diminish the relationship between the average DSCR and the potential performance of the average loan, says Fitch. The ratings agency adds that the year-over-year gap between coverage ratios in ’10 and ’11 was small enough that the average DSCR still represents “a viable indicator of overall loan quality.” Accordingly, Fitch says that one of the lessons taught by CMBS loans of ’06-’08 vintage is to assign a higher probability of default on loans with a DSCR of less than 0.95.

Another lesson, according to Fitch: “LTV is not everything, as there is a wide recovery range between best and worst in class.” On an even lower tier when it comes to rating CMBS are pro forma projections; in fact, according to Fitch, “There should be no reliance on pro forma income.” Should underwriting standards continue to slip this year, Fitch says it will increase its credit enhancement levels when rating loans.

For new CMBS issuance, Moody’s anticipates about $40 billion of originations this year, off slightly from the ‘11 tally of $43 billion, including Freddie Mac transactions. The ’11 total was originally projected to be much higher, but turmoil in the CMBS sector, including July’s cancellation of a $1.5-billion issue by Goldman Sachs and Citigroup, brought volume down considerably in the year’s second half.

More than one-third of the projected ’12 total, or $15 billion, will come from the guaranteed portion of Freddie-sponsored bonds collateralized solely by multifamily loans, according to Moody’s. About 70% of this year’s CMBS issuance will come from conduit originators, Moody’s says, with the remainder coming from large-loan, single-borrower or floating-rate transactions.

Diversity among asset types in CMBS loans is expected to remain low throughout ’12, a factor that Moody’s terms “a negative for credit.” Given the outlook for “modest issuance,” Moody’s anticipates that CMBS transactions will remain small, “with most falling between $0.5 billion and $1.5 billion.”