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Real Estate Analysis Rating Through A Recession Real Estate And Loan Interaction And The Importance Of Refinance Risk Assessments Other Loan Level Issues We Consider Consistency, Despite Diversity Related Articles
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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions
Consequently, it is critical to analyze these cash flows during the life of the loan and through loan refinance. We make an assessment of cash flows available to meet debt service for each individual loan. This assessment takes into account a number of features of the property, including its location, likely demand from tenants to occupy the property over time, and the appeal of the property to the real estate investment market. This analysis is tailored to the individual asset and is not necessarily exactly the same for all properties within a specific asset class or location. A rigorous assessment of the quality of the real estate and its income-producing potential ultimately shapes our opinion of long-term value. It also determines whether we consider that the real estate has sufficient inherent value to support either a refinancing or a sale to a third party for a sum greater than the remaining outstanding principal balance of the loan before the maturity date of the rated notes that it backs. CMBS analysis is expressly not a CDO of contracted rents from the real estate on long-term leases. This is because although properties leased on long-term leases to investment-grade tenants are generally a positive factor for cash flow evaluation, contracted lease income typically accounts for less than 50% of the investment value of a property over a 10-year period and therefore, on a cumulative basis, is normally less than the total debt amount advanced. In any event, most commercial real estate loans do not provide for significant amortization so the ability to refinance or sell the asset to recover the remaining debt is essential. It is also important to consider that the credit quality of the occupying tenants may evolve over the loan term. It is the quality of the real estate, including its age, condition, configuration, functionality, and location that is often the more significant determinant of risk, rather than the line-up of tenants occupying the assets on Day 1.
Real Estate And Loan Interaction And The Importance Of Refinance Risk Assessments
Real estate loans are typically structured to address a series of risks to the debt and to maximize the probability that the loan will be repaid. Interest cover, interest rate hedging, amortization, reserves, and financial covenants, including LTV ratios, are all frequently used to enhance a plain vanilla loan structure.
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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions
Our analysis focuses on how the loan terms mitigate risks. We give credit for loan features that are credit positive, such as well structured and frequently tested LTV ratio covenants. We increase subordination requirements where we consider the absence of these mitigants could have a material impact on recoveries. The declining use of scheduled amortization during the loan term and rise of the five- or seven-year bullet loan has put additional pressure on refinance risk. In forming a view of interest rate risk, we take account of the prevailing interest rate environment and the implied interest rate environment shown by current swap rates as discussed last year in "European CMBS Refinance Risk Part I: Storing Up Trouble For The Future" (see "Related Articles"). An important conclusion that we reached was that investment-grade notes in over 50% of the 44 European CMBS transactions selected for the analysis would experience weak refinance strength and potential losses following a 200 bps upward movement in swap rates to 7.5% without a material rise in property level cash flows. The outcome would be similar in the event of an adverse shift in property yields of the same magnitude (see below). If the same analysis was re-run today using a more recent pool of transactions we think the results could show an even higher proportion of loans would be "at risk" to rising interest rates. This is a function of the continued trend of rising values, increasing overall indebtedness levels, and static underlying cash flows. Consequently, whole-loan exit yields on debt have been under sustained downward pressure and we see no signs of potential refinance issues subsiding. Considering the views of refinance lenders is a key part of the credit analysis of a loan. At refinance, the refinance lender looks at the cash flows over the life of the loan at that point, repeating the work that was done for the initial loan but for a different time period. For example, the initial lender on a seven year loan considers the first seven years and perhaps five years after loan maturity, while the lender at loan maturity looks at cash flows from year eight to year 20, perhaps. In tandem with refinance, a consideration of the then-current market value of the asset is also important. Ultimately, a loan bullet or balloon, as previously mentioned, will be repaid either by financing from another lender or an asset sale, either by the borrower or as a result of an enforcement process. Any analysis of this kind is extremely difficult as it involves judgment. However, there is reasonably good historical property yield data available to enable us to place current performance into a longer-term context. It is important to consider the influence that gilt yields, finance rates, and rental growth prospects could all have on property yields over the life of a loan. At a time of very low yields and correspondingly high capital values, this analysis is as important as ever.
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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions
Our cash flow assessments do not assume that a sponsor funds major capital expenditure at the properties, unless cash reserves have been put in place as part of the initial finance package For transactions where the borrower has material hard cash equity at risk, as opposed to a notional equity stake arising from a favorable revaluation of the real estate, we lower subordination requirements. Wherever appropriate, we expect to see confirmation of purchase price and, if this is lower than the reported property value, it almost certainly becomes our adopted benchmark for calculating the Day 1 LTV ratio as well as the borrower's equity in the transaction. Acquisition costs should not be confused with value as these amounts are always deducted by a potential purchaser when considering an offer. Net purchase price is the figure on which we therefore focus. In certain situations there may be no purchase price information available. Occasionally, however, the assets in question may have appeared more than once before in earlier securitizations, so it is possible to track the degree to which refinancing activity has enabled borrower's equity to have been replaced by debt over time. In limited circumstances, we give enhanced credit for the sponsor. This typically occurs in giving credit for sell-down portfolios, for example.
Enforcement regimes
We evaluate the likely enforcement routes of loans in CMBS transactions. Our CMBS ratings reflect loan probability of default and recoveries thereafter. Efficient enforcement routes require less subordination as the adverse impact on both the amount and timing of recoveries are minimized. The fundamental building block of security in a real estate loan is a first-ranking mortgage. These act as a disincentive for borrowers to fail to comply with the terms of the loans and, ultimately, provide a creditor-friendly path to enforcing security. In some transactions a "springing" mortgage is used. Its purpose is usually to put off significant mortgage registration duties. To avoid contingent perfection and a rating cap on the borrower, these arrangements need to ensure that a mortgage will be put in place when the borrower is solvent, allow for hardening periods, prefund the costs of registration, and allow for the registration of mortgages to be independent of the borrower. Our subordination levels for "springing" mortgage structures are higher than for those with mortgage security on Day 1. While share pledges over borrowers and their holdings companies may be of use in negotiations with a borrower at or around the time of default, these are legally ineffective if exercised over an insolvent entity in the overwhelming majority of European jurisdictions.
Loan flexibility
Where a loan allows substitution of assets, we assume a borrower takes full advantage of this flexibility. Our ratings reflect the weakest potential pool of assets that would be allowed by the terms of the substitution criteria. In particular, the potential to erode interest cover and overcollateralization through substitution have a direct effect on Day 1 subordination levels. Similarly, where borrowers are permitted to undertake development works we would expect, as a minimum, that a borrower can demonstrate before the works commence that they have funds in place equivalent to or, preferably, in excess of, the estimated costs of such works. If there is any concern that the borrower may find itself unable to
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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions
complete the works, we consider the detrimental impact this could have on an asset, its potential cash flow, and its value.
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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions
Earlier we stated that CMBS tranches take account of recoveries following any default and, therefore, the probability of default of the loans is generally higher than the probability of default of the lowest-rated tranche. However, this outcome presupposes a CMBS structure that facilitates timely payment of interest until, and repayment of debt upon, recovery with no additional shortfall over and above that which we anticipated during our loan level analysis. Class X notes typically extract all excess cash and, in some cases, continue to be paid without any deduction even after a loan event of default has occurred. The additional burden of special servicing fees and liquidity therefore affects the junior notes first and will increase overall losses. Appraisal reduction mechanisms which limit liquidity drawings in a default situation where it has been determined the LTV ratio has breached, say, 90%, also need to be carefully considered in the context of the more highly leveraged loans that we see. If the reduction mechanism is triggered, our ability to rate to timely payment of interest is impaired and the affected notes would be downgraded regardless of the likelihood of eventual recoveries. We also highlighted how a junior lender's purchase option that fails to deliver a "make whole" purchase price would lead to a downgrade of the ratings on the most junior class of notes. Unfortunately, these are all examples of where the credit analysis of the senior debt can be undermined by a structural defect that all too easily shorts what might otherwise be considered investment-grade notes. High prepayment rates in European multiborrower transactions, coupled with pro rata pay, can leave the most senior class of notes exposed to the credit risk of the last remaining loan in the pool. It's not possible to evaluate every prepayment scenario but we consider several possible scenarios and increase subordination levels to take account of many but not all prepayment outcomes. Available funds caps limit the interest coupon to a tranche to that which is available. Its main purpose is to avoid a ratings downgrade where, following prepayment, the margin on the remaining loans is not sufficient to meet the interest coupon on the notes. Available funds caps should only address prepayment risk.
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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions
Despite the necessary prominence of subjective, qualitative analysis, however, we ensure that the analytical approach adopted for each transaction is consistent.
Related Articles
"European CMBS Loan Level Guidelines" (published on Nov. 15, 2006). "European CMBS Refinance Risk Part I: Storing Up Trouble For The Future" (published on June 15, 2006). All related articles are available on RatingsDirect, the real-time Web-based source for our credit ratings, research, and risk analysis.
Additional Contact: Structured Finance Europe; StructuredFinanceEurope@standardandpoors.com
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