US CMBS 2.0/3.0 loan troubles scrutinised
The US$96.4m Ty Warner Hotels & Resorts Portfolio loan, securitised in MSC 2012-C4, has become the latest high-profile CMBS 2.0/3.0 loan to face difficulties (SCI 6 May). Such instances are being portrayed as idiosyncratic in nature (SCI 27 April), but they could herald a broader trend towards defaults.
Excluding the Ty Warner loan, Morgan Stanley CMBS strategists calculate that a total of 33 2.0/3.0 loans with a current balance of US$406m are specially serviced, of which US$198m are current (representing 16 loans) and US$208m are delinquent (17 loans). A further 12 loans totalling US$108m are delinquent, but not specially serviced. Meanwhile, newly watchlisted 2.0/3.0 loans posted volumes of US$2.1bn, US$1.9bn and just over US$1bn in February, March and April respectively (SCI 29 April).
Mary MacNeill, md in Fitch’s US CMBS group, expects idiosyncratic issues to remain isolated instances in CMBS 2.0/3.0, given that in-place cashflow generally appears to be sufficient in most transactions. “Idiosyncratic events leading to term defaults or transfers to special servicing are likely to continue, but the bigger risk in CMBS 2.0 is potential maturity defaults. Some loans originated in the current low interest rate environment that will have to refinance into higher interest rates could struggle,” she adds.
However, 1st Service Solutions founder and ceo Ann Hambly disagrees with the notion that the recent spate of CMBS 2.0/3.0 watchlistings and special servicing transfers is simply due to idiosyncratic events. She argues that it is a broader trend, which signals another period of prolonged defaults, should property values decline or there is another CRE market crash.
“Technically CMBS loans underwritten in the post-crisis period should perform well because there are a number of factors in the market’s favour from a credit perspective. But clearly some loans aren’t performing as expected,” Hambly observes.
Hambly adds that, as just one borrower advocate, her firm has received enquiries in connection with a handful of CMBS loans originated in 2012, a few originated in 2013 and one from 2014 that are already troubled. She attributes this directly to deteriorating loan underwriting standards, drawing parallels between the explosive growth in the share of CRE debt represented by CMBS both in 2005-2007 and 2013-2015, fuelled by aggressive underwriting.
“The main characteristic of troubled loans from 2005-2007 is that they were strapped: they typically had high LTV ratios, interest-only payments and limited, if any, reserves,” she explains. “If everything had gone as planned, they would have been fine. The same characteristics are emerging now: we’re seeing loans underwritten without a cushion that should be OK, providing no negative events occur.”
Hambly says that lease rollover risk – which has been flagged in many recent CMBS 2.0/3.0 watchlistings (see SCI’s CMBS loan events database) – is especially reflective of the stretched boundaries seen in post-crisis underwriting. Idiosyncratic credit events are brought into sharp relief against such a backdrop.
Retail and office properties account for the majority of watchlisted 2.0/3.0 loan exposures so far. “The preponderance of online shopping is leading to physical store closures, while the lead time for office space creates a gap between demand and supply. Office leases are typically for five to 10 years and aren’t flexible if a tenant needs to downsize. This contrasts with the hotel sector, for example, where supply/demand imbalances adjust fairly quickly,” Hambly observes.
Retail closures are expected to continue, with loans exposed to the sector likely to prove difficult to refinance. MacNeill says that Fitch is closely monitoring the retail sector, especially in relation to tenancy issues or loans with Sears and JC Penney exposure. Other property types on the agency’s radar are suburban office locations, as well as properties with high exposure to oil industry tenants or areas that have experienced a loss of industry.
MacNeill admits that there is concern among investors about the overall quality of CMBS loan underwriting and vacancy rates. However, she notes that Fitch is taking such issues into account in its ratings by introducing higher haircuts.
Senior CMBS investors have historically focused on the credit rather than the underlying real estate. But Hambly suggests that the sector should increasingly be approached as a CRE investment rather than simply as a triple-A rated bond because it can be greatly affected by real estate fundamentals and may not always return an investor’s principal in full.
“Investors need to participate in the CMBS market with their eyes open, but how many have the necessary experience of the underlying real estate? This is yet to be realised by the majority of investors,” she notes.
Looking ahead, MacNeill says that it’s difficult to predict servicer behaviour in terms of whether they will liquidate or modify a 2.0/3.0 loan. “If a property needs more to time to stabilise and/or increase in value, servicers are more likely to modify a loan. If the market is hit by a significant interest rate spike, for instance, they may be more likely to liquidate a loan when either the market is more liquid or when values are high,” she concludes.