The chance a loan backing U.K. CMBS will default is bumped up once the loan-to-value (LTV) ratio exceeds 60%.

Analysts at Bank of America Merrill Lynch concluded this in their assessment of 459 commercial loans totaling €71.6 billion ($78.8 billon). Originated between 2000 and 2013, all were bundled into commercial mortgage-backed securities. The analysis might apply to non-securitized loans as well since BofA Merill pointed out that securitized loans tend to be average-to-slightly-better-than-average.

The analysts found that of the 95 loans with an initial LTV ratio of 60% or under, only two experienced a loss, translating to a loss frequency of 2.1%. That figure shoots up past the 60% mark.

The analysts suggest that this supports using a 60% advance rate as a limit for the leverage of the most credit-worthy or ‘senior’ loans in U.K. CMBS. The junior or mezzanine debt could naturally have more leverage.

The metric the analysts used was loss severity that corresponds to “loss-given-loss” and not defaults per se. But they still see their loss figure to be comparable to the default rate, albeit higher.

Interestingly, the average initial LTV ratio in the data set did not rise as commercial property prices boomed in the three-year lead up to the drop of 2007. Indeed, LTVs retreated a bit. But the overall debt load rose along with the climbing values.

This contributed to the fact that losses in the data set were concentrated in loans originated from 2005 to 2007, with the ‘07 vintage experiencing the steepest losses. The takeaway is that weaker underwriting might have spurred losses, but the impact was weaker than that of plummeting values. In terms of overall volumes, the data set is also heavily skewed towards the 2005-2007, which accounts for 90% of the loans analyzed by volume. This is no surprise given the explosion of origination in that three-year period.

The analysts suggest using a more “sustainable” LTV gauge that takes into account business cycles. Such an approach has already been proposed for the purposes of sizing how much capital banks need to hold against their property loans.

Overall, losses totaled €1.6 billion, or 2.3% of the €68.6 billion that came out in the 200-2007 period. The analysts predicted that the figure could rise as the performance of some outstanding loans “continues to struggle.”

Even though the figures were expressed in euros, most the loans are denominated in pounds sterling.

The analysts found that another common metric for measuring performance — the interest coverage ratio — was a poor predictor of loss severity. The ICR measures the ability to pay interest based on cash flow from the underlying property. While a lower ICR did predict a higher chance of default, as the ICR of a loan rose significantly losses only fell marginally. The analysts found that stability of the ICR over the life of the loan could be as important as the actual level.   

Among property types, hotel and industrial incurred the highest losses. But they represented a minority in the data set, with retail and office taking far larger shares.


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