Fitch: Is U.S. CMBS Getting the Seven-Year Itch?
Weakening loan characteristics, declining underwriting quality and concerns about originator, banker and rating agency competition are not new items on investors' minds. And there are reasons to believe that this time around will be different. For instance, pro forma income is greatly discounted or ignored altogether and perhaps most importantly, credit enhancement levels are substantially higher. But market participants can ill afford to forget how quickly performance can change.
For commercial real estate, the bottom of the cycle occurred around third-quarter 2009, when the NCREIF* Property Index indicated total returns declined 23% for office, 15% for retail, 21% for industrial and 23% for multifamily compared with peak levels in 2007.
In 2007, the average Fitch debt service coverage ratio (DSCR) across 40 fixed-rate conduit transactions rated by Fitch was 1.05x compared to 1.18x in 2015 year to date. But the difference is largely attributed to the current low interest rate environment. The average Fitch loan to value (LTV) in 2007 was 110.7% right on top of the 110.3% thus far in 2015.
However, there are two major distinctions between 2007 and 2015 that cannot be overlooked:
--In 2007, loans were often originated based on an expectation that cash flow would continue to rise in a market that had already experienced dramatic upward trends. Thus, the above 2007 metrics were driven in part by pro forma income that artificially provided numbers than were never actually achieved;
-- Credit enhancement (CE) today is much higher. with 'AAAsf' CE at 23.625% in 2015 compared to 11.875% in 2007.
Therefore, it's unlikely that the next twelve months will bring the same level of misery that followed the September 2008 peak. But it is important to remember that economic cycles are, by definition, cyclical. The current upturn commercial real estate has been enjoying since 2009 will eventually come to pass and the CMBS market can ill afford to forget the tough lessons learned in previous cycles.
Not only is there the potential for short memories in the commercial real estate market in general, but some CMBS originators (and even some rating agencies) haven't been around long enough to experience a full cycle much less multiple cycles. This can leave them without the perspective and tools necessary to conduct thorough analysis and respond appropriately to unanticipated stress.
As a rating agency, Fitch endeavors to rate through the cycle. As such, Fitch's ratings aim to react to fundamental changes affecting the transaction profile and not temporary changes in condition. Fundamental changes include an issuer's performance falling above or below Fitch's original expectations, a move toward deeper, longer cycles for a given asset class or a change in the operating environment based on a fundamental increase or decrease in systemic risk. Whenever the downturn inevitably occurs and whatever its potency, Fitch rates CMBS bonds according to criteria that is applied consistently from one year to another regardless of how strong the current market may be.
If Fitch were to base its CMBS ratings on current economic conditions, without reference to conditions at other points in the cycle, there would be substantially more ratings volatility. In turn, this would reduce the ability of the ratings to communicate relative changes in creditworthiness among CMBS transactions, above and beyond cyclical developments affecting all issuers. That is why Fitch property cash flow adjustments are typically greater for loans originated during the peak of a real estate cycle than for those originated during the trough.
To illustrate, take the case of a typical Manhattan hotel. Since 2009, average occupancy has increased by about nine percentage points through the end of 2014. Average daily rates (ADRs) and Revenues Per Available Room (RevPARs) mirror this rise. However, there are signs of weakness in part due to the 23,803** rooms anticipated to open in Manhattan in 2015, 2016 and 2017. Fitch believes Manhattan hotels are close to their peak performance and therefore assumes more conservative room occupancies, ADRs and RevPARs based on the last few years, not just the past, record year. These adjustments provide what Fitch believes is a closer approximation to sustainable income over the life of the loan and take into account the experiences of 2007 and 2008 and 2000 and 2001, when average occupancy for Manhattan hotels dropped approximately 10 and 11 percentage points respectively.
Likewise, while a fixed-rate loan provides stability and certainty over the life of the loan, Fitch does not believe the current interest rate environment will be in effect when the loan refinances. Fitch therefore assumes refinance interest rates that reflect the long term rather than current levels. Whether interest rates are mean-reverting, or there has been a downward structural shift since the 1980's period of very high interest rates, is somewhat irrelevant as both theories imply a long-run forecast that is still higher than the current, extremely low, interest rate environment.
And while the correlation between interest rates and cap rates is perhaps tenuous***, there is no expectation that current cap rates are going to stay low forever. Cap rates are cyclical too and will rise at some point in the future. Fitch's cap rates used in rating CMBS bonds reflect levels higher than the current market.
In addition, Fitch has been much more proactive in publishing commentary on transactions deemed too aggressive in the past seven years. Fitch has become even more transparent in its analysis through enhanced presale reports, introduced earlier in the year. The enhanced presale reports, among other things, provide Fitch expected losses for the largest twenty loans. Fitch has also published reports highlighting differences amongst originators. And credit enhancement on Fitch rated deals continues to rise as underwriting declines.
Which brings us back to the cycle. There is nothing inherently dangerous about a real estate cycle. It only becomes dangerous when market participants forget there is one. CMBS cannot afford a repeat of the 2008-2009 experience. Seven years on from 2008 is a very good time for all CMBS market participants to remember that.
*NCREIF - National Council of Real Estate Investment Fiduciaries
** PwC Manhattan Lodging Index - Fourth Quarter 2014
*** The Connection Between Interest Rates and Capitalization Rates - Morgan Stanley January 23, 2015
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