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CRE Finance World, Summer 2013

A publication of Summer issue 2013 sponsored by CRE Finance World Summer 2013 23 Overall, even in a benign, low rate environment with high collateral valuation and accommodating servicers, the CMBS universe maturity losses at 2.4% are significant. Should any of the scenario factors (as modeled herein) play out, we expect universe maturity losses to exceed 3.7%.27 In a low yield environment where investors are stretching for incremental yield, the residual balloon risk of CMBS bonds should be accounted for. At the refinance loss levels projected here, bonds in the middle of the credit stack could be impacted. We don’t have a crystal ball in predicting how rates will move. Interest rates may stay low for an extended period of time, which, in turn, could result in more aggressive lending and more aggressive valuations in the continuing search for yield. Clearly, from the standpoint of CMBS balloon risk, such an environment will minimize potential credit loss. To the extent that there is sufficient possibility that rates will rise, it should be expected that CMBS balloon risk will be commensurately elevated. 1 In this article the terms refinance risk, balloon risk, and maturity risk are all used interchangeably. 2 By way of example, the accelerated repayment feature (known as “ARD”) that existed in early vintages was largely removed from later vintages as the CMBS market grew. 3 This is based upon the premise that most properties will perform in line with the overall market 4 The universe is based upon the current outstanding balance from ’04 to ’12 vintage conduit loans of approximately $495 billion as of 1Q2013. 5 For purposes of analysis in this paper, we use the 10-year U.S. Treasury note (as projected under alternate scenarios) as the metric for risk-free interest rates, without debating the definition of “risk-free” or the use of the 10-year Treasury note as the appropriate reference term. 6 The additional interest incorporated into the coupon rate of the loan above the risk-free interest rate. 7 LTV = Loan-to-Value; DSC = Debt Service Coverage 8 While performance includes both NOI and property value, in this analysis we primarily focus on the value impact resulting from potential marginal changes in capitalization rates in relation to interest rate movements. We note that relevant literature on this subject suggests that the pass through rate of interest rate movements to cap rates ranges from approximately 30% to 70%. 9 The base case interest rate scenario is based on Moody’s Analytics SO scenario published in March, 2013, and adjusted by the forward rate curve. 10 From a historic perspective, the “conservative” underwriting parameters are actually more on the aggressive side. This is primarily explained by historically low coupon and capitalization rates, which provide better DSC and LTV measures. Our “conservative” parameters would closely mirror current underwriting parameters except for lending spreads; under the conservative parameters spreads are roughly 10 to 50 basis points higher than current spreads, depending upon the property type. The 33 year amortization period for multi-family reflects permitted interest-only loan terms. 11 Later in this paper we explore the potential benefit of loan extension at maturity for loans that do not fully meet either the lenient or conservative refinancing criteria. The extension criteria are included in Exhibit 2. Extension parameters: Lenient = available refinancing proceeds => 85% of balloon balance (i.e., loan extension eligibility trigger of 15%), 2 year extension granted at current loan terms, Conservative = available refinancing proceeds => 95% of balloon balance (i.e., loan extension eligibility trigger of 5%), 1 year extension granted at current loan terms. 12 Under this scenario, each 100bp movement in the risk-free interest rate is simultaneously accompanied by a 25bp change (in the same direction) in capitalization rates. Please see footnote 7 for comparison. 13 Under this scenario, each 100bp movement in the risk-free interest rate is simultaneously accompanied by a 75bp change (in the same direction) in capitalization rates. Please see footnote 7 for comparison. 14 Property & Portfolio Research (PPR) models probability of default (“PD”), loss given default (“LGD”), and expected loss (“EL”) utilizing a proprietary credit default program known as Compass. CMBS Refinance Risk: Vintage Analysis Across Multiple Economic Scenarios “Conservative underwriting trumps rising interest rates, which in turn trump reactionary cap rates in terms of relative impact on probability of default.”


CRE Finance World, Summer 2013
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