Commercial mortgage bond investors may want to keep a closer eye on their exposure to California, according to Kroll Bond Rating Agency. The ratings agency warned Tuesday that some buildings that are not required to obtain earthquake insurance may still be susceptible to significant structural damage that could put the borrowers at risk of default.

CMBS lenders typically require earthquake insurance if a property is located in seismic zone 3 or 4 (which includes all of California) and the asset’s probable maximum loss exceeds 20% of the replacement cost of the improvements. That threshold is generally accepted across the commercial real estate lending industry, which in addition to CMBS, also includes banks and insurance companies.

Kroll thinks that this is a somewhat arbitrary cutoff, since properties with PMLs that are below 20%, but close to it, could still suffer moderate-to-significant damage in an earthquake. “This could meaningfully impact the collateral securing a loan, and the potential for losses if uninsured borrowers choose to forgo repairs and surrender the asset to the lender,” the ratings agency stated in its report.

After hearing a number of CMBS investors voice concerns about exposure to earthquakes this fall, Kroll attempted to determine how much exposure private-label mortgage bonds have to loans with PMLs just below the 20% threshold. Out of the total California conduit population of $39.7 billion (2,185 loans) of collateral, it was able to obtain enough information $30.6 billion ( 1,728 loans). It concluded that the aggregate proportion of CMBS assets with PMLs between 18% and 20% is meaningful — 10%.

Of the conduits in the study population, there were 254 transactions that had exposures in this “close range.” Of these, 209 transactions had minor exposure (0-2% of the pool balance), 31 had exposures ranging from 3% to 5%, 13 had moderate concentrations between 6% to 10%, and there was one outlier at 17%.

The rating agency relied on data from Trepp and from data it mined in rating CMBS.

“It is important to note that a PML is an estimate, and not an exact science,” the report states. “As such, there will be some variability around the proportion of assets that will require earthquake coverage in a given securitization. Transactions with a sizeable proportion of PMLs that are close to 20% may warrant a closer look by the marketplace, as they can pose additional risk to CMBS trusts.”

It noted that two to three earthquakes occur in California each year that are large enough to cause moderate damage to building structures, according to the state's department of conservation.

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