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CMBS Underwriting Approaching 2006 Levels

Nomura: Loan-to-Value (LTV) and Debt Service Coverage Ratios (DSCR) Relatively Stronger Than Legacy Loan Vintages
July 29, 2013
The pace and volume of CMBS issuance has increased substantially in 2013, led by strong investor demand. Through the second quarter, issuers have placed $26.9 billion of conduit paper across 21 transactions, substantially higher than the $12.7 billion issued across 11 transactions over the same period in 2012.

Retail loans account for the majority of all securitizations, according to Lea Overby, head of CMBS research at Nomura Securities International. However, the concentration in retail has declined over the past two years as originations of multifamily properties and esoteric properties have increased.

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Notably, non-core property types such as manufactured housing communities and mixed-use facilities have garnered an increasing share of loan originations, reaching 24% through the second quarter of 2013, up 4%.

Similarly, collateral concentrated in primary and secondary locations are contributing a growing proportion to commercial mortgage-backed securitizations.

Conduit transactions are also becoming more diverse, as reflected in the higher number of loans per deal and a higher concentration of small balance loans.

“Following the restart of the conduit engine in 2010, over 4,000 loans have been originated and securitized. By examining the aggregate loan statistics each quarter, we can compare trends in,” Nomura Securities' Overby noted in a new report.

Comparing 2013 deals with prior years, Nomura found that deal-level loan-to-value (LTV) and debt service coverage ratios (DSCR) are relatively stronger than legacy vintages. Using rating agency data, deals issued in 2013 contain leverage consistent with levels last seen in 2006, while underwritten DSCR levels remain generally above prior legacy thresholds.

Overall trends in leverage generally follow property mix. Among the major property type classifications lodging and retail have seen a rise in leverage on average, while office and multifamily levels have declined. Leverage among office and lodging loans reported the largest change over the first half of this year, with average underwritten LTVs in lodging properties rising by 3.8% and office LTVs falling by nearly 3.5%.

The sharp decline in office LTV is largely attributed to a handful of low-levered loans. In the second quarter, six office loans were originated with LTVs less than 30%, all of which are located in New York City, including an office condominium carrying a 6% LTV ratio. Excluding this set, office LTV trends were in line with first quarter data, averaging 66%.

In addition, a growing proportion of loans with interest-only terms are increasingly originated without historical financials.

Approximately 71% of all office loans by balance carry interest-only terms for at least a portion of their loan term, compared to 56% for multifamily assets and 52% for retail assets. For the first half of 2013, the use of interest-only terms for loans within the multifamily sector has increased substantially, rising 20% to its current level, while growth in the office and retail sector was more muted at 7% and 5%, respectively (Figure 11).

However, amortization continues to be most common for lodging loans. The use of interest-only structures within the lodging sector continues to trend lower, declining to 11% in through the second quarter, down from 2% from the beginning of the year and 12% annually.

A new report from Moody’s Investors Service similarly found that loan leverage and the share of interest-only loans in conduit commercial mortgage backed securities set new “CMBS 2.0” highs in second-quarter 2013.

With DSCR coverage beginning to come down from historical highs, conduit loan underwriting quality is now similar to that of the 2005 vintage but declining rapidly towards that of the 2006 vintage, Moody’s noted.

“The credit lessons learned from the poorly underwritten loans in the peak CMBS 1.0 vintages had ‘terms’ of only five years or so,” said Tad Philipp, Moody’s director of commercial real estate research. “However, as conduit leverage and default risk have risen, so have our credit enhancement levels.”

Based on transactions Moody’s rated in the second quarter, conduit loan leverage rose nearly 5%, to 102.6%, based on Moody’s loan to value (MLTV), the agency’s primary measure of balloon refinancing risk, from 98% in first-quarter 2013.

“The increase in the second quarter was one of the sharpest in a single quarter, and we expect it to rise further still,” Philipp said.

Moody’s debt service coverage ratio (MDSCR) fell in the first quarter and is expected to continue to decline, although it should remain above the long-term average. (A higher DSCR lowers the risk of default during the loan term and increases the likelihood that amortization (for loans that have it) will take place as planned, which mitigates refinancing risk.)

Moody’s said it expects the share of multifamily loans in CMBS 2.0 conduits will increase because of regulator-mandated cutbacks in government sponsored enterprise (GSE) lending volume. Although the increase could be credit positive, the quality of multifamily collateral in CMBS in recent quarters has been among the lowest of the major asset classes.

“As the above average delinquency rate for CMBS multifamily attests, an otherwise strong asset class could perform badly if collateral underwriting and sponsor quality are poor,” Philipp said.

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