CMBS Refinance Risk: Vintage Analysis across Multiple Economic Scenarios

CRE Finance World, Summer 2013

CMBS Refinance Risk: Vintage Analysis Across Multiple Economic Scenarios Xiaojing Li A publication of Summer issue 2013 sponsored by CRE Finance World Summer 2013 19 his real estate cycle introduced a significant credit risk element to the evaluation of CMBS bonds — the potential maturity risk1 of balloon financing, i.e., borrower’s ability to secure adequate refinancing proceeds. There is a common understanding within the industry, that refinance risks exist due to the overwhelming use of balloon structures, but the potential significance of material shifts in lending underwriting criteria was likely underestimated.2 Today’s standard credit analysis of CMBS bonds typically includes a relatively thorough review of balloon risk. As lending criteria responds to changes in the economic environment, balloon risk is highly correlated with vintage exposure.3 This paper analyzes potential maturity risk across the CMBS universe4 by vintage under multiple economic scenarios. Refinance Factors To reasonably estimate refinance risk, a number of factors must be projected: • Risk-free interest rates5 • Lending spreads6 • Lending underwriting parameters, principally LTV and DSC7 • Commercial real estate performance relative to economic conditions8 Naturally, properties are exposed to substantial idiosyncratic risk, and numerous other factors will potentially impact the likelihood of obtaining adequate refinancing proceeds at balloon. For purposes of this analysis, we focus on the four factors identified above. Modeling Framework While it is possible to model numerous scenarios, our framework utilizes three factors to narrow down the potential outcomes as follows: • Risk-free interest rates remain relatively low and benign, or risk-free interest rates move up dramatically and remain elevated. The 10 year Treasury forecast under the base case scenario is primarily driven by the forward rate curve.9 The rising rate scenario is based on the 10 year Treasury forecast under the 2013 Dodd- Frank Act Stress Test’s Supervisory Adverse Scenario, with an additional spike in rates beginning 3Q2016. Exhibit 1 Interest Rate Scenarios Source: Federal Reserve Board, Moody’s Analytics, Bloomberg • New loan underwriting gravitates to either more lenient parameters or to more conservative parameters, and associated lending spreads adjust accordingly (lower under the lenient scenario, higher under the conservative scenario).10 Exhibit 2 Modeled Refinance & Extension Parameters11 • Commercial property valuation, as measured by capitalization rates, either remains “sticky” (changes in capitalization rates are minimal12 in comparison to changes in the risk-free interest rate) or is reactionary (changes in capitalization rates are highly reflective13 in comparison to changes in the risk-free interest rate). T Senior Quantitative Analyst PPR Global Daniel Wijaya Senior Financial Analyst PPR Global Xiaozhi Zhao Quantitative Analyst PPR Global Stephen Miller Director, Capital Markets, Debt and Risk Management Research PPR Global


CRE Finance World, Summer 2013
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