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CRE Finance World, Autumn 2013

U.S. Conduit CMBS Update: Credit Metrics Were Stable in Third-Quarter 2013, but Transactions Remain Riskier Year-Over-Year Borrowers and lenders have adjusted to rising interest rates so far Since reaching a low of 1.63% on May 2, the yield on the 10-year U.S. Treasury is up over 100 basis points. Rising interest rates may lead to higher capitalization rates, depending on the prevailing risk-premium (the yield spread between commercial real estate investments and the “risk-free” Treasury yield), potentially decreasing property valuations. A potential offset occurs when gradually rising interest rates result from stronger economic growth, causing increased demand for commercial real estate, which in turn leads to higher rental rates and property values. A rapid increase in rates can lead to lower CMBS loan origination volume, as we saw earlier this summer, as the uncertainty causes lenders to pull back (until rates show signs of stabilizing) and CMBS buyers to demand wider spreads. Borrowers and lenders appear to have adjusted fairly quickly this time, however, as market observers expect a number of conduit transactions to price in September. Cash-out refinancing combined with limited borrower recourse increases risk In our June update, we highlighted several cases where non-recourse carve-outs for certain “bad-boy” acts (such as fraud and voluntary bankruptcy filing) had decreased. However, in these cases (Irvine Core Office Trust 2013-IRV and Wells Fargo Commercial Mortgage Trust 2013-120B, both Standard & Poor’s-rated), there were mitigating factors: the borrowers generally owned and managed the properties for a long period of time, and the first mortgage debt exhibited a low LTV with limitations on additional debt, leaving significant remaining equity tied up in the asset values. Though long-term institutional ownership and low loan leverage might be considered to mitigate softer non-recourse carve-out guarantor provisions, we believe this growing trend should be scrutinized. For example, in some recent transactions, large private equity funds are taking a significant amount of cash equity out of a property as part of a refinancing and also limiting borrower recourse provisions. We believe these situations merit closer examination from investors and rating agencies. Loan cash management provisions have gradually weakened Loan cash management provisions continue to weaken as compared to 2011 and 2012 transactions. Ongoing reserves for real estate taxes, insurance, and capital expenditure items CRE Finance World Autumn 2013 54 are becoming less common in favor of DSC or debt yield-based reserve trap triggers. Moreover, some of these performance-based cash flow trigger thresholds may not necessarily be capturing all additional property net cash flow, which can prove to be a powerful incentive for borrowers to cooperate during a loan workout situation. Cash trap trigger thresholds also appear to be trending lower relative to a property’s in-place net cash flow, and sometimes don’t apply until DSC drops below 1.0x. Pari passu structures are likely here to stay To increase deal diversity, certain larger loans may continue to be divided among several deals using pari passu structures. A recent example is 11 West 42nd Street, an office building in midtown Manhattan, which was securitized in GSMS 2013-GC13 and GSMS 2013-GCJ14. In our opinion, pari passu loan structures may lead to more complex workouts in the event of default. The reemergence of pari passu structures for larger loans of at least $100 million has likely been driven by less investor demand for stand-alone transactions, but also general market acceptance of those loans being sliced up and included in multiple conduit/ fusion pools. Moreover, market values and rating agency LTVs have been increasing for some large assets, 11 West 42nd Street being such a case. Higher rating agency leverage typically makes these loans more ideal for conduit/fusion execution. Market liquidity and consistent deal flow have probably also eased issuers’ concern with holding pari passu pieces on their balance sheets longer than they would like. Overall Risks Are Lower Relative to Peak Years, but Some Loans Are Trending Down a Similar Path We believe conduit credit risk stabilized versus Q2 2013, but remains higher than in 2012. At this point, we are not seeing the same levels of overall risk in underwriting and borrower behavior that were prevalent in 2006-2007. Nevertheless, we believe some recent conduit transactions include some loans with characteristics prevalent in the 2006-2007 vintages. Therefore, we will continue to monitor the deals we rate for these continuing signs of declining loan and pool quality that could eventually lead to higher defaults and losses. Related Criteria and Research • Risks Increase In 2013 Vintage U.S. Conduit CMBS, June 10, 2013


CRE Finance World, Autumn 2013
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