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CMBS 2.0 Underwriting Loosens

Multifamily share of CMBS rising

July 19, 2013

By Mortgage Daily staff

Conduit underwriting quality on commercial real estate loans is now at pre-crisis levels, according to a new ratings agency report. Another development is the rise of non-agency multifamily issuance.

Debt service coverage ratios in the second quarter were 1.68 times, falling from 1.82 times in the prior three-month period. A further decline is forecasted.

Lower DSCRs increase the risk of default and reduce the likelihood that amortization will take place as planned. Higher DSCRs mitigate the risk of refinance.

The findings were based on analysis of commercial mortgage-backed securities rated by Moody's Investors Service -- which discussed the findings in US CMBS Q2 Review: Ten-Year Loans, Five-Year Memories.

The New York-based firm noted that loan leverage and the share of interest-only loans set new "CMBS 2.0" highs in the latest quarter.

Conduit loan leverage jumped to 102.6 percent, based on loan-to-value, from the first quarter's 98.0 percent. Moody's said that leverage is its primary measure of balloon refinancing risk.

"Moody's loan to value is now at a level consistent with the early 2006 vintage, because debt service coverage, although declining, remains at historically high levels, and overall credit quality is closer to that of the 2005 vintage," Moody's Director of Commercial Real Estate Research Tad Philipp stated in the announcement. "However, the period of low term default risk based on Moody's debt service coverage ratio, in relation to balloon default risk based on Moody's loan to value, appears to be drawing to a close, with conduit loan coupons rising at a much faster pace than cap rates."

Philipp said that the second-quarter increase was the sharpest in a single quarter, and a further rise is expected.

The report said that conduit loan underwriting quality is now similar to that of the 2005 vintage and is rapidly declining towards that of the 2006 vintage.

"The credit lessons learned from the poorly underwritten loans in the peak CMBS 1.0 vintages had 'terms' of only five years or so," Philipp said. "However, as conduit leverage and default risk have risen, so have our credit enhancement levels."

The report said that the multifamily share of CMBS 2.0 conduits will increase as a result of regulator-mandated reductions in lending volume at Fannie Mae and Freddie Mac.

The rise in multifamily share might be credit positive -- though the quality of multifamily loans in CMBS has recently been among the lowest of the major asset classes.

Philipp added that poor sponsor and underwriting quality on multifamily loans combined with above-average delinquency rates could result in poor performance on an otherwise strong asset class.

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