Underwriting terms are laxer, but have yet to hit the lows of 2007, writes Alex Catalano
The US CMBS market is gathering speed. From near-death in 2009, new issuance has picked up and is on track to hit $100bn this year. But what is also evident is a slide in underwriting standards. “We hear from originators that they are adamant about holding strong their underwriting and say it is everybody else down the street that is caving in,” says Huxley Somerville, managing director and head of US CMBS at Fitch Ratings. “But everyone has the same argument, so I’m not sure you can put too much credence in what each one says.”
Liquidity has rushed back into the US lending market and competition is intense. “With quantitative easing, you have the longer end of the curve artificially low,” says Mark Gallagher, senior strategist, Americas research, at CBRE. “That entices asset managers into looking at more credit products. “There is also a steady belief that fundamentals are improving and there is more upside to the property market, so they’re willing to take real estate risk. They feel that the current vintage of loans will perform well, with a low default rate.”
There is no doubt that CMBS conduits are loosening their corsets. The various metrics used to assess the health of CMBS loan-to-value levels, debt service coverage ratios, the percentage of interest-only loan – are worsening. Rating agencies have started to put out warning signals; in a report last month, Moody’s CMBS analysts likened the deteriorating underwriting standards to the “boiling frog” syndrome: because the water heats up gradually, the frog doesn’t jump out, with unfortunate consequences. Looking at originators’ loan-to-value ratios, they are still lending at sensible LTV levels of 75% or less, although Moody’s predicts that one in four loans in Q1 2014 conduits will be at this level or higher.
LOAN-TO-VALUE RATIOS CREEP UP
By the rating agencies’ reckoning, LTV levels are more like 108%. Moody’s average LTV ratio for the conduit transactions it rated in Q1 2014 increased to 107.3%, from 103.5% in Q4 2013. Fitch, which analysed 2013 and Q1 2014 issues, calculated that LTV ratios ranged widely, from 95.3% to 108.5%, while originators’ own LTV levels stayed in a rather tight band, from 62.4% to 69.7%.
The gap between agencies’ and originators’ LTV levels is due to differences in the cap rates and cash flow used by each. For example, current market cap rates for class A multi-family housing investments have hit historic lows; according to JLL, in hot markets like Boston or Seattle they are now as low as 3.8%, while core central business district office cap rates are below 5-6% in US primary and rising secondary markets.
The rating agencies’ values, however, are based on long-term, sustainable cap rates: in Moody’s case, there is a now 323bps difference, one of the highest recorded, and this is “the key driver of the nearly 40-point difference” between its LTV levels and originators’. There has also been a steady rise in the percentage of conduit loans that include what rating agencies consider to be above-market or unsustainable income.
“For some properties, notably offices, we have noted instances of leases accounted for at pre-crisis peak rents, well above current market levels,” says Tad Philipp, director of commercial real estate research at Moody’s. “In our analysis, we mark these rents down to levels we deem sustainable.” The agency applied net cash flow haircuts of more than 10% to one-seventh of loans in the Q1 2014 conduits it rated.
While LTV ratios are an important metric, the debt service coverage ratio (DSCR) signals the probability of default. These, too, are falling, but have not yet reached the dangerous lows CMBS 1.0 issues reached in 2007, which is providing investors with some comfort. Moody’s puts the average DSCR at 1.44x for Q1 2014 conduits.
“DSCR has been propped up by low interest rates, so there’s been a disconnect between the interest rates on which DSCR is based and the cap rates on which value used in LTV ratios is based,” says Philipp. “Interest rates fell much more quickly than cap rates. So we have essentially 2006 LTV levels, but because of higher DSCR coverage and recovery fundamentals, overall credit quality is closer to late 2005.”
However, CMBS loans that are partially or fully interest-only are rising and now account for 50% of the conduit loan pools. Since they either are not amortising or amortising at a slower rate, they carry refinancing risk, especially if interest rates have risen in the meantime. “The percentage of interest-only loans is better now than at a similar stage of CMBS 1.0,” says Philipp. “At the pre-crisis peak, 90% or more of loans were interest-only for at least a portion of their term.”
DANGER IN INTEREST-ONLY LOANS
Nonetheless, originators do not seem to be going for lower LTV levels on interest-only loans and using lower leverage to offset the amortisation foregone. “Some loans are towards the high end of the LTV scale and are still interest-only, so they rely on income growth or something else positive happening to the property to ensure it can be refinanced at higher interest rates in 10 years’ time,” says Somerville.
Collateral quality is also an issue. As the larger, primary US markets have recovered, there has been a drift to smaller, secondary and tertiary ones. There is also some concern about the quality of assets: for example, weaker shopping malls or a higher-than-average concentration of hotels in small markets. A compensating factor for looser underwriting is that CMBS now offers more credit enhancement: that is, the AAA investment-grade tranches are given extra comfort because there is a cushion – usually 30% of the securitisation – of subordinated tranches that are the first to absorb any losses from the underlying loans.
The super-senior AAA usually has the full 30% cushion, while the junior AAA had around 20% for much of 2011 to 2013. The junior break point has been drifting upwards, to 24% on average, giving this tranche more protection. “If underwriting continues to decline you can expect credit enhancement to be in the 25-30% range by the end of the year,” says Somerville. “We’ve already seen deals where we expected credit enhancement to be 26-27% and are not rating those transactions.”
However, as a consequence of the rising credit enhancement for the junior tranche, the super-senior cushion is not as plump as it used to be. Investors are not yet actively agitating to move the super senior point to 35% or 40%, but some have suggested it might be time to think about this. “You can’t point to any one move that’s alarming, but the overall trend is,” says Philipp. “In the past three years we have gotten into a position that took perhaps 10 years to develop last time. “It’s because many of the same players are following the same playbook, just doing it more quickly. Last time the playbook had to be invented, but this time they can just open it up and go to a later chapter.”