Default Ruthlessness: Examining Borrower Default Behavior

CRE Finance World, Winter 2014

Default Ruthlessness: Examining Borrower Default Behavior LTV and DCR Are Not the Only Determining Factors for Defaults on Commercial Mortgages A publication of Winter issue 2014 sponsored by CRE Finance World Winter 2014 57 or simplicity, some models used by CMBS investors assume that the non-recourse borrower will default immediately if the DCR falls below 1.0 or LTV goes above 100 (percent). This is sometimes referred to as “ruthless default” behavior. In reality, however, borrowers do not choose to default just because DCR is below 1.0 or LTV is higher than 100. This article examines some historical data and attempts to look at various factors that have an impact on the borrower’s decision to default, and presents historical default rates for each category. Using different default rates for the different categories may be a better approach for scenario analysis for CMBS investors than trying to use fixed cutoff numbers for DCR and LTV to examine each loan to determine if it will default or not. An important underlying factor that motivates borrower behavior is the option value embedded in owning the real property. Also, borrower selection impacts ruthlessness. Market expertise helps borrowers measure the benefits of supporting an underperforming property based on potential future upside. Further, key to the decision to support the property is the borrower’s access to capital and overall liquidity – without which there is no ability to subsidize the property until the market improves. Introduction As part of their investment analysis, CMBS Investors run various scenarios of changes in economic conditions, cap rates, vacancies, NOIs, etc. The resulting DCR and LTV are used to decide if the loan will default in that scenario and what the loss severity will be in case of default. If DCR falls below 1.0, that clearly increases the likelihood of default during the loan term as borrowers are required to pay out-of-pocket to cover property expenses. When the property value is below the loan amount default is more likely and losses will be higher in case of default. Also, if the LTV is above 100 at maturity, the loan is not likely to not qualify for a new loan without putting more equity into the property, and hence there may be a maturity default. In practice borrowers do not choose to default just because DCR is below 1.0 or LTV is higher than 100. There is an option value to owning real property that impacts borrower behavior. The option value captures the possibility of upside in the future. Investors are aware of the option value. However, if 1.0 DCR and 100 LTV are not the cut off points, what are the levels that drive borrower behavior? Even more complex models must address this question as well. In this research we focus on the multifamily loans and look at the borrower default behavior in loans in both CMBS and Freddie Mac collateral. Default Ruthlessness of CMBS Multifamily Borrowers To examine the default behavior in CMBS, we analyze performance records of about 25,000 fixed-rate multifamily loans in CMBS deals from 1998 to 2013. We focus on two key factors: (1) debt service coverage ratio (DCR), and (2) mark-to-market loan-tovalue (LTV). We calculate the DCR using the latest reported net operating income (NOI) of the underlying property and the annual debt service. To calculate LTV, we use three methods to estimate property value: (1) property appraisals updated by mortgage servicers, (2) direct capitalization valuation, and (3) market index based valuation. When the updated appraisal was not available, we generally select the lower of the direct capitalization value and the index based value. The cap rates used were from Real Capital Analytics and the multifamily value index series used were those from National Council of Real Estate Investment Fiduciaries (NCREIF). In the direct cap valuation, we use the trailing 12-month NOI to better measure operating profitability of underlying properties. Although it may be a conservative approach, especially for any property that is temporarily distressed, this approach reduces the impact of any pro-forma underwriting used at origination. With derived LTV and DCR for each period, we then identify CMBS multifamily mortgages that ever went underwater, defined as either DCR<1 or LTV>100. We also identify all defaulted loans — defined as 60-day delinquency (or worse) in this analysis — and calculate the default rates that reflect how ruthless borrowers were on loans on properties that were distressed. Table 1 Default Ruthlessness in CMBS Source: Trepp and Freddie Mac In our analysis some loans defaulted even though the available data did not indicate that the property was underwater. This may be due to possible reporting issues in (1) incomes, (2) reported valuations, or (3) cash flows not reflecting the actual property F Yu Guan Analyst Freddie Mac Jun Li Director Freddie Mac Malay Bansal Senior Director Freddie Mac Steve Guggenmos Senior Director Freddie Mac


CRE Finance World, Winter 2014
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