CMBS' Seven-Year Itch

NEW YORK CITY—The CMBS community might identify most strongly with one of the late Yogi Berra's best-known epigrams: “It's déjà vu all over again.” Seven years after the capital markets meltdown, as volume in the CMBS market begins increasing at a faster pace, Fitch Ratings wonders whether CMBS is experiencing a seven-year itch and sees some characteristics that marked securitization deals at the last market peak, namely “weakening loan characteristics, declining underwriting quality and concerns about originator, banker and rating agency competition.”

Fitch notes that there are reasons to believe that this time around will actually be different. “For instance, pro forma income is greatly discounted or ignored altogether and perhaps most importantly, credit enhancement levels are substantially higher,” according to a report from the ratings agency. “But market participants can ill afford to forget how quickly performance can change.”

Moreover, 2007 and 2015 aren't so far apart on a couple of key metrics. The average Fitch loan to value ratio year to date is 110.3%, while in '07 it was 110.7%. Also in '07, the average debt service coverage ratio across 40 fixed-rate conduit transactions rated by Fitch was 1.05x, compared to 1.18x so far this year. “But the difference is largely attributed to the current low interest rate environment,” according to Fitch. 

That being said, Fitch notes two key differences between '07 and '15. At the peak of the previous cycle, “loans were often originated based on an expectation that cash flow would continue to rise in a market that had already experienced dramatic upward trends.” Therefore, loan metrics in '07 were driven in part by “pro forma income that artificially provided numbers that were never actually achieved.” Furthermore, says Fitch, credit enhancement levels today are much higher, with AAAsf CE at 23.625% this year compared to 11.875% eight years ago.

“Therefore, it's unlikely that the next 12 months will bring the same level of misery that followed the September 2008 peak,” according to the Fitch report. “But we must remember that economic cycles are, by definition, cyclical. The current upturn commercial real estate has been enjoying since 2009 will eventually come to pass and the CMBS market can ill afford to forget the tough lessons learned in previous cycles.”

Seven years on from '08, “we're not saying that we're about to enter another real estate recession,” Huxley Somerville, managing director and head of US CMBS at Fitch, says in a video segment. “However, we are saying that the real estate cycle exists and we need to be aware of it.”

On the subject of epigrams, one often applied to commercial real estate is that it operates in “a 10-year cycle with seven-year memory.” Not only is there the potential for short memories in CRE generally, Fitch says, but some CMBS originators haven't been around long enough to experience a full cycle, much less multiple cycles. This can leave them lacking the perspective and tools necessary to conduct thorough analysis and respond appropriately to unanticipated stress.

“CMBS cannot afford to repeat the 2008-2009 experience,” says Somerville. “Seven years on from 2008, it's important for all of us in the CMBS community to remember this.”