Regulators could use lessons learned from defaulted legacy CMBS loans to create a set of criteria for future high quality real estate loans, including CMBS debt.
The suggestion is made by Bank of America Merrill Lynch’s European structured finance team after they analysed the historical performance of over 1,000 commercial property loans across 20 European countries totalling €157bn which were securitised in 184 European CMBS transactions between 2000 and 2013.
The findings of BAML research analyst Mark Nichol suggest that there are factors which contribute broadly to good credit performance which could be used to minimise the likelihood of future defaults. Applied to CMBS, they could be used to design CMBS product that could qualify for the ‘high quality securitisation’ type 1 label which regulators are developing.
Currently under Solvency II, all CMBS transactions are assigned to the ‘type 2’ group, which is more costly to hold than ‘type 1’ deals, and limits the investor pool.
BAML’s Historical drivers of CRE loan performance report found that all €3.5bn of the European CMBS losses to date were concentrated in 150 loans that were all made between 2005 to 2007, and suffered as a result of the increase in property values that occurred at the time and the scale of the subsequent correction. However, the report also says that weaker underwriting standards at the peak of the market may have contributed to the poorer performance of these vintages.
Unsurprisingly, in terms of capital value, it found both the default rate and loss severity of loans increased as the initial loan to value (LTV) ratio increased. Among the loans that had an initial LTV between 60% and 70%, 10.4% have experienced a loss. This increased to 20.2% and 25.6% for loans with an initial LTV of 70-80% and 80-90%, respectively.
In terms of debt service, the lower the initial interest cover ratio (ICR) the more likely loans were to default. Just 2 of the 68 loans that had an initial ICR of 2.5 or greater went on to experience a loss. At the other end of the spectrum, of the 26 loans with an initial ICR of between 1.0 and 1.1, almost half experienced a loss.
BAML said that although no two commercial properties or loans are alike, “Our findings suggest there are some factors that have contributed broadly to good credit performance, which could be superimposed on a case-by-case framework to minimise the likelihood of default and the severity of losses in commercial real estate lending in the future”.
For example, focusing on property types that exhibit rental income stability such as multifamily property and prime offices and shopping centres located in core markets whose rents are supported by predictable occupier demand for space.
If an LTV threshold were useful, BAML’s analysis “suggests 60%” as above that, the default rate increased sharply, while credit could also be given for scheduled amortisation. BAML also supports the idea of mitigating the volatility of property values by introducing ‘through the cycle’ property valuations, as promoted by the Real Estate Finance Group in last year’s ‘Vision for Real Estate Finance in the UK’ report.
“We think these lessons could be used by regulators and the industry to create a set of criteria for high quality CRE loans, which could be used to design a high quality CMBS product,” the research concludes.