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CRE Finance World, Winter 2013

CMBS — Party Like its 2007 and COMM 2007-FL14 (Glenborough). However, the additional debt The United States is experiencing the lowest interest rates in burden introduced by mezzanine debt unquestionably increases recent history. These low rates are allowing property owners to risk for the loan and can create unintended consequences. borrow funds for 10 years or more via CMBS at all-in rates often below 4%. As compelling as the credit metrics may be for these The Improving DSCR Fallacy loans, given current DSCR ratios and LTVs (driven by capitalization A mitigant of higher CMBS LTVs that is often cited is improved rates that are linked to Treasury rates), investors should ask how debt service coverage ratios (DSCRs). Indeed, on first blush, this these loans will perform at loan maturity (typically, in 10 years) statement appears to provide comfort. Underwritten DSCRs for under interest rates and capitalization rates that are closer to CMBS 2.0 conduit transactions have hovered around 1.65x as historical averages. compared to 2007 levels of approximately 1.25x. Cash flow is, after all, one of the most important determinants of value and 2007 Level Credit Spreads Achieved stability. However, in our view, this has more to do with historically While CMBS conduit credit spreads have recovered significantly low interest rates rather than improved underwriting. As a test, we since the financial crisis, generic legacy spreads (as demonstrated substituted mid-2007 10-year swap rates of 5.0% with current by the GG10) remain at historically wide levels, as noted below. swap rates of 1.7% for the CMBS conduit class of 2012; doing so More interesting, new-issue credit spreads have rallied significantly reduced the weighted average DSCR from 1.65x to below 1.0x. and reached new tights in November 2012 in the COMM 2012- CCRE4 transaction where the 10-year AAA priced at swaps+83 Exhibit 2 bps, a level not seen since November 2007. Historical 10-Year U.S. Treasury Yields Exhibit 4 GG10 A4 Spreads (CMBS “1.0”) & New Issue 10-Year AAA Spreads at Issuance Source: Bloomberg Exhibit 3 Source: Commercial Mortgage Alert, RBS, Bank of America Merrill Lynch CMBS 1.0 vs. CMBS 2.0 — Issuer Conduit DSCRs A governor that may dampen the continued spread rally is the absolute rate of return required by investors. With the 10-year US swap rate at below 1.7%, the total anticipated yield-to-maturity for investors, given current CMBS AAA spreads, is less than 2.6%. Nonetheless, the consensus of market participants seems to be that new-issue AAA credit spreads could continue to tighten to levels as low as swaps+ 60-65 bps in 2013. Source: Barclays Research, Commercial Mortgage Alert A publication of Winter issue 2013 sponsored by CRE Finance World Winter 2013 21


CRE Finance World, Winter 2013
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