Modeling CRE Losses for Commercial Mortgage REITs lthough we are optimistic about the outlook for real estate fundamentals and mortgage REITs have had solid performance metrics in recent years, the increasingly competitive lending environment could create risk of increased losses in future years. Based on the current profile of loans owned by commercial mortgage REITs, recent levels of financial leverage, and the potential for a decline in property values and property performance, we believe the sector is well-positioned relative to where it was before the last downturn, although concentration risks that could produce outsized losses if REITs do not maintain lending standards. Industry Outlook We remain optimistic on the investment outlook for commercial mortgage REITs. Our optimism is based on expectations for continued positive economic growth, modestly improving real estate fundamentals, the large pipeline of CRE debt maturities, and ongoing availability of attractive financing options (including current low rates and improving execution through securitization). However, increased competition is a growing concern, including from banks and insurance companies, CMBS conduits, and nonbank lenders. As a result, we believe capital availability is driving yield compression and loosening underwriting standards, including higher LTV ratios and increased deal mix with IO loans. As the lending environment becomes more aggressive, the potential for mispricing increases as lenders do riskier deals with increased leverage to maintain target returns. While we believe sector dividend yields of 7-8% remain attractive on a relative value basis and are in-line with historical average spreads over treasuries and high yield debt, the current environment has prompted investor questions on how we frame potential losses. Broadly speaking, average loan to value ratios of 68% and average debt-to-equity ratios of 2x (equivalent to 65% to debt-to-capital) remain low enough to suggest modest loss rates on loans made thus far in the cycle since theoretical loss severities remain within existing equity cushions while property prices continue to rise. On the other hand, we believe risk is increasing on new originations. We also believe an effect of increased competition and yield compression in the market for CRE loans is a likely increase in loan repayments, which for the commercial mortgage REIT sector have so far been modest on recent vintage loans. As a result, we believe portfolio risk is likely to increase going forward. Lastly, CRE lending has high concentration risk, so statistical averages may not fully capture idiosyncratic default risks. CRE Finance World Winter 2015 30 Historical Performance and Lending Profile Commercial mortgage REITs originate and acquire commercial real estate (CRE) debt. Pricing of the assets and liabilities is based on a credit spread over benchmark interest rates, which is sensitive to market dynamics including supply/demand, interest rates, and relative value. Assets tend to have concentrations in hotel, office, mixed-use, and multifamily with disproportionate geographic exposure to markets with strong origination and capital markets activity, including New York in particular. Through a real estate lending platform, companies typically originate, acquire, and manage commercial real estate loans and securities. Portfolio risk depends on credit underwriting, position in the capital structure, sector diversification, asset level performance, as well as macroeconomic trends. Since commercial mortgage loans tend to be large (averaging $25 million or 1.5% of loans for our coverage), portfolios are subject to concentration risk since an individual loan’s performance can have a material impact. Since loans may be transitional or higher yielding, durations tend to be relatively short (approximately 2-4 years), similar to credit facility terms including extensions as long as assets remain performing. Last-dollar loan-to-value (LTV) ratios average approximately 65- 70% but can reach 85%-90% or higher in the case of subordinate debt or preferred equity. Additionally, not all property types should be viewed equally since there may be considerable variance in how asset value is determined (whether on initial cost, projected construction cost, market value, or sell-out value) particularly on properties undergoing development and/or repositioning. Historical delinquencies in past downturns ranged from 5-9% in 2009-2010 and 10-12% in 1991-1992 while loss severities ranged from 14-29% in 1994-2011 and 25-50% in 2006-2013 according to data from the Federal Reserve, the American Council of Life Insurers (ACLI), Moody’s, and S&P. Property prices fell 25.8% in 2009 and 19.7% in 2008 (including 32.4% and 20.9% for Office) according to Moody’s CPPI and 11.2% in 1991 and 10.0% in 1992 according to the MIT TBI. Given an average LTV of 68% for the commercial mortgage REIT sector and debt/equity ratio of 2x (50% debt/capital), we believe the companies can withstand approximately 15-20% of losses at the property level before impacting equity and that loss severities of 25-35% would produce equity losses of 4-7% depending on asset mix and corporate leverage. Hypothetically, assuming a 5-9% default rate, 25-45% decline in property value, 7-20% in A Ryan Tomasello Associate Keefe, Bruyette & Woods, Inc. Jade J. Rahmani Director Keefe, Bruyette & Woods, Inc.
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