The refinancing of commercial mortgage-backed securities (CMBS) will beone of the biggest threats to the global real estate market over the next few years. A question mark hangs over the future of loans that are nearing their maturity date, given the lower risk appetite of traditional property lenders and a lack of available credit.
Hypo Real Estate board member Bernd Knoblochcalledthe refinancing of CMBS loans a potential timebomb for the industry at a panel discussion on property lending at MIPIM, while David Henriques, director and head of real estate at Cairn Capital, described itas “the CMBS train wreck coming down the track” in EuroProperty’s sister publication, EG Capital. Further defaults in European CMBS are expected as the global economy weakens and credit market troubles continue.
In a report, Standard & Poor’s estimates that around 75% of all European CMBS loans are due for refinancing between 2011 and 2014. This year, 30 loans amounting to £2.9bn (€3.18bn) are due to mature across 23 transactions. The ratings agency says48 CMBS tranches were downgraded for credit reasons in 2008, compared with 14 in 2007.
“Lending to the commercial real estate sector is unlikely to resume before 2010. Balancesheet allocations to real estate may have to shrink as European banks seek to de-leverage,” S&P said in the report.
“New lending to commercial real estate is unlikely to be a top priority for governments at a time when they seek to influence bank lending to corporates, small and medium–sized enterprises, consumersand homeowners.”
The number of CMBS loans in default is rising in both the US and Europe and will increase in 2009 as property values continue to fall, debt remains limited and the letting markets weaken, with more companies downsizing and more tenants defaulting on their leases. As a result, there will be more loan covenant breaches, payment defaults and loans going into special servicing in the coming months.
“As most CMBS loans do not amortise greatly over their term, the largest current risk in global CMBS remains refinancing,” says Rodney Pelletier, head of EMEA structured finance performance analytics at Fitch.
The securitisation market has been closed for lending for more than 12 months, but traditional lenders such as commercial banks and insurance companies had been filling the void. This changed following the collapse of Lehman Brothers lastSeptember, with most lenders dramatically scaling back their exposure to commercial property.
Pelletier continues: “This risk is partly mitigated by the fact that only a small volume of CMBS loans will mature in 2009 and 2010. More maturities will occur from 2011 to 2013, but most will occur after 2015.”
Against this backdrop, upcoming maturities are significant. Some $22bn (€16.4bn) of US CMBS aredue for refinancing in 2009, according to Barclays Capital’s annual securitisation research. European CMBS loan maturities were relatively low in 2009 and 2010, totalling €6.5bn, before spiking sharply with €16.5bn in 2011 and €12.1bn in 2012. Therefore the effect of the current lack of available debt in the overall marketwill not fully hit most European CMBS for at least a couple of years. But there is not likely to be a quick recovery in property values so defaults are expected among those loans maturing in 2011.
“CMBS loans are defaulting in different regions for separate reasons. In the US most transactions are more granular, with a large number of loans backing each CMBS deal. This creates more diversification and means that CMBS rely on several borrowers making payments based on the rental income they receive,” says Andrew Currie, a managing director in Fitch’s CMBS team.
“European CMBS deals typically contain fewer loans, and each loan tends to be bigger. This means that the performance of the CMBS is reliant on one or two loans to make payments. If the loan gets into trouble there will be underperformance at the note level.”
Hans Vrensen, Barclays Capital head of securitisation research, adds: “Loan defaults are not contagious they are a by-product of local property market behaviour.”
In the US, CMBS loan defaults have been driven by tenant defaults. In Europe, the main driver has been value declines. For example, Plantation Place in the City of London is relatively safe because it is let to stable tenants, but the underlying loanis in defaultbecause property values have fallen.
The next wave of property value declines will come as a result of rental value change rather than yield movement. Traditionally yields have risen because income has fallen but this time value falls are ahead of declines in income.
Global CMBS experienced net negative ratings performance for the first time in 2008, with an upgrade-to-downgrade ratio of 0.7 to 1, according to Fitch Ratings. This year, downgrades are expected to significantly outweigh upgrades across all rating categories.
Economic fundamentals have deteriorated substantially in most countries, with house prices falling, GDP growth turning negative and unemployment rates increasing. In the US, these factors have already generated negative repercussions, with unemployment and house price declines resulting in increased mortgage loan defaults and property foreclosures, causing further declines in house prices. This negative spiral is perpetuated by the tightening of available bank credit. The magnitude of pending loan and bond maturities is also causing investors concern.
Similar cycles are expected to emerge in other countries, particularly Spain, the UK and Ireland. However, Fitch says it is unlikely that these markets will be able to break away from these negative trends without government intervention.
With UK values down by as much as30% over the past two years, and expected to decline 15-20% in 2009, many banks and servicers will be forced to accept loan maturity extensions, workout non-performing loans and deal with foreclosed loan properties. In the process, banks will have to make significant write-downs on their real estate loan portfolios.
Graham Emmett, a partner at Rankvale, and former head of European CMBS at Goldman Sachs, says: “Balance sheet banks are stuck with a lot of real estate exposure but they are not necessarily calling default on loans. They are talking to borrowers, extending maturities and hanging in there. If there is an interest cover ratio or debt servicing cover ratio, banks are showing their teeth. Otherwise they are sitting ontheir hands.“
Reduced demand from tenants for space coupled with new supply hitting the market will result in weakness in the letting markets, which is expected to bring rents down and increase voids across the board. Prime properties in core locations are expected to fare better, but tenant defaults will become a bigger focus as the economy comes under increasing pressure.
“I can see defaults in the pipeline on CMBS that is retail–based, therefore some banks will probably call in loans in two or three years if vacant space is not re-let or tenants go bust,” says Emmett.
Retailers have been at the forefront of tenant defaults over the past few months, although other corporates are expected to follow suit. As a result, more CMBS loans are likely to experience covenant breaches, have payment defaults and go into special servicing. This will trigger more rating actions.
A functioning primary CMBS market may return by 2011, but it might not be able to refinance all of the loans maturing in 2011-2012, notes Barclays Capital. Barring an unexpected recovery in capital values, this could lead to increased CMBS loan defaults at maturity and, ultimately, losses for bondholders.
The recapitalisation of banks will also be a key concern over the next three years. If banks reduce their exposure to commercial real estate as expected, some loans will be successful in attracting new debt financing but some will not. Banks will be more likely to lend to large, established borrowers on prime assets. Defaults and losses will be lower for CMBS backed by these type of loans but higher for deals with smaller borrowers or secondary properties.
In the US, Fitch expects that retail and hotel properties will experience greater stress, as performance of these assets is heavily dependent on consumer spending as well as business and leisure travel, all of which have fallen off sharply. Declining retail performance was chiefly responsible for a 13 basis point increase in delinquencies in February 2009, bringing the Fitch Ratings US CMBS loan delinquency index to 1.28%. Fitch expects US loan defaults to increase to at least 3% by the end of 2009.
In European and Asian commercial property markets, challenges in the retail and financial sectors in particular are expected to pressurise CMBS performance.
“It is clear in both the US and Europe that there has been an increase in the number of loan defaults. However, the volume is not incredibly high. In the US, defaulted loans might go up to 3% this year, driven by declining economic conditions. This is historically high, but relatively low. We are going through a period of unprecedented decline in real estate values,” says Pelletier.
There can be defaults on underlying mortgage loans and on the underlying bonds. However, defaults on the underlying loans are more commonbecause bonds typically have several loans backing them so it would take several defaults on the loans to trigger bond defaults.The US has seen more cases of bond impairment, but remains at a relatively low level. Unlike US CMBS, which aremore granular, European CMBS aremore concentrated and therefore subject to event risk.
“The good thing about Europe is that the leases tend to be longer term so we haven’t seen as many cashflow issues that have started to arise in the US. Tenant default issues there are more acute because there is more diversity so more tenants can go bust,” explains Fitch’s Currie.
