Analyzing non-performing and sub-performing commercial real estate securitizations in Japan requires a different methodology than that developed by Fitch IBCA to analyze such assets in the U.S. and in Europe. In the face of the deterioration of Japanese commercial and residential real estate following the burst of the bubble economy, Fitch IBCA believes that financial institutions and other owners of non-performing real estate loans (NPLs) will increasingly turn to securitization to rid balance sheets of mispriced assets. Securitizations of NPLs can be done either by the loan originator or the purchaser of these loans.

Unlike the U.S., a substantial amount of NPLs in Japan may provide no cashflows. Therefore, investors rely primarily on the asset resolution process to be paid interest and repaid principal. In cases where there is evidence of sustainable cashflows, certain credit is given for such cashflows whilst considering various related risks.

Fitch IBCA has developed a methodology that is liquidation-driven. The special servicer or the asset owner usually provides historical data. The special servicer acts as a servicer on behalf of the owner of the assets, where a licensed servicer is required by law for certain categories of assets. The data include original book value, amount amortized, and amounts realized upon sale, as well as costs to sell or liquidate.

Distressed asset liquidations take several forms, among them discounted payoffs, deeds in lieu of foreclosure, foreclosure and sale, sale of a loan, loans to a third party, or voluntary sale. The asset owner's or special servicer's strategy, the judicial process, lender remedies, and timing are some of the other factors reviewed. The data are used to determine loss severities. Increased stress scenarios are applied by multiplying loss severities for the higher rating levels.

Non-performing pool analysis usually requires greater amounts of cash reserved upfront than performing pools because of the resolution costs and uncertain cashflows for loans in default. Therefore, Fitch IBCA relies on cash, via credit for sustainable cashflow or reserves for interest payments and foreclosure/liquidation costs that are set aside upon issuance of the securities. Analysis also relies heavily on the legal framework, specifically property laws, lender rights, and treatment of bankruptcy.

Certain financial and legal features typically not seen in performing pools are provided for in NPLs to reinforce the safety of the return to debtholders. These safety measures include: payment of all excess cashflow to amortize debt before equity receives its return; amortization of specified levels of senior debt before the subordinate debt receives interest payments; engagement of a special servicer and employment of specialists such as property valuators, lawyers, accountants and due diligence firms, with skills to resolve problem loans; and an incentive compensation structure, wherein the special servicer or the asset owner typically has an equity stake as motivation to maximize returns on the assets.

General Methodology

Fitch IBCA's NPL analysis relies heavily on real estate fundamentals. Cashflow from a non-performing asset may vary from a situation with zero to some cashflow, depending on the circumstances. Therefore, site inspections are required for a larger number of assets and a greater percentage by book value than those usually undertaken for performing pools. Inspections involve a review of occupancy levels, tenancies, property uses, rents, market conditions, location, and physical condition, as well as accuracy of site inspection reports submitted by due diligence firms and property valuators.

Especially important in the liquidation approach is the past experience and level of expertise of the special servicer or workout team assembled by the asset owner. To the extent that there is no income production from the assets, there is no cushion available to pay the bondholders regularly. Therefore, the special servicer does not have the luxury of slowing down its liquidation process. However, a large and diversified portfolio mitigates such concern.

The importance of the workout team of the asset owner or the special servicer cannot be overemphasized in these securitizations. This is the reason Fitch IBCA undertakes a detailed due diligence review of the workout team of the asset owner or special servicer. Part of the due diligence is to visit many subject properties with representatives of the workout team of the asset owner or the special servicer and the asset managers and discuss their views on each property.

The qualitative factors that Fitch IBCA considers when rating a pool of NPLs involve two distinct risk categories: structural and real estate. Structural risks include the legal, tax, regulatory, financial, and management issues associated with the deal. Real estate risks relate to the quality of the underlying collateral securing the loans.

The Japanese Real Estate Market

Following the burst of the bubble economy in 1991, prices for commercial real estate have decreased significantly. Prices for commercial and residential land have fallen more than 75% and more than 50% respectively from the peak in 1991, with some regional markets performing worse than others. Prices have been falling primarily due to weak demand. Falling prices, the recession, and the unavailability of bank financing resulted in real estate developers, owners, investors, construction companies and non-banks having great difficulty financing, rolling over, or servicing loans with the result that many defaulted.

There is no reliable estimate for the size of the total market represented by non-performing real estate loans, either residential or commercial. The current estimate of the total amount of bad loans in the Japanese banking system, which is between 80 trillion and 100 trillion ($757 billion to $946 billion), suggests the potential scale of the problem. Allegedly, a substantial portion of such loans is secured by real estate. This amount includes the approximately 15 trillion in defaulted loans purchased from financial institutions and held by Credit Cooperative Purchase Co.

The abundance of these assets has created good investment opportunities for foreign investors. Such investors are predominantly from the U.S., some of which participated in the resolution of the Resolution Trust Corp.'s (RTC) assets. Some also have NPL experience in Europe and Asia. Foreign investors acquired the equivalent of approximately $2 billion of Japanese NPLs in 1998.

Asset Evaluation

The starting point of the evaluation is the non-performing loan. In Japan, evaluation of real estate historically has been performed based only on sales comparisons (sales comps). Sales comps refers to the actual price that a comparable property fetches upon sale, usually reported by a broker. During the bubble, even a property that was not generating cashflow was still valued highly based on the sales comps. Sales comps valuations predominated before the bursting of Japan's asset bubble and are still used in the evaluation of practically any type of property.

The collapse of the bubble economy in the early 1990s brought real estate prices down and led to wider use of the income approach (which though prevalent in the U.S., has not generally been used in Japan) in the case of properties that generate sustainable cashflows. It has been especially popular in evaluating office buildings.

An alternative use approach pertains to situations where the current building is not productive and has no possible alternative uses. It assumes that an investor intends to demolish the current building and erect a new one with a use better suited to the location and therefore includes assumptions about demolition and construction costs as well as income levels that can be generated from the asset. Expected cashflow from the new building results in the evaluation price under this method.

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