Although refinancing risk for European CMBS deals is expected in another couple of years, market sources said that a more immediate concern for bondholders is the alarming rate of tenant defaults.
James Zanesi, an analyst at Unicredit, said that in 2009 the bank has monitored 47 downgrades in U.K. CMBS and 15 downgrades in other European deals (versus only two upgrades in Victoria Funding (EMC III) Plc).
Fitch Ratings has been particularly active with 34 downgrades, while Moody's Investors Service made nine downgrades. There were 19 downgrades by Standard & Poor's.
"We believe this trend will continue throughout 2009, since average LTV levels will tend to rise over time," Zanesi said. "Moreover, refinancing risk might play an even more important role for rating agencies toward the end of this year, since a higher number of loans will mature in 2010."
S&P's February's European CMBS loan-level performance showed a continued trend of increasing delinquencies, with three additional loans going into default. Of these loans, two loans defaulted because they were not refinanced (the CPFM loan in European Property Capital 3 PLC and the Belgian Bonds loan in Odysseus European Loan Conduit No. 21 FCC).
"This indicates perhaps that refinance risk has begun to materialize at the loan level in European CMBS," S&P analysts said.
In 2009, 34 loans in 27 transactions rated by Moody's (excluding small multi-borrower transactions) will mature. Most notably, only a few of these loans have extension options, and six of the exposures coming due are relatively large (greater than E250 million ($339 million).
At loan maturity, if refinancing is not possible, not many options are available. "Either the bank lends on a partly unsecured basis or the noteholders try to agree to extend the maturity to avoid the shocking bullet payment (this usually requires a 100% voting approval)," Zanesi said. "Alternatively, the sponsor might inject more equity, but the economic rationale behind this is rather unclear, as is the question of where the cash should come from."
The impact on individual deals will depend on the transaction's refinancing profile, the overall leverage, tenant and lease expiry profile and the property and/or regional diversity within a portfolio.
Christian Lambie, a partner at Allen & Overy, said that issuers look more inclined to ride out the storm rather than take action in this current environment.
"Borrowers are going to the bank and saying that they would have an LTV breach of the bank calls on the loan," Lambie said. "They reason that the loan is not due for another four years, and with 200% debt service coverage ration, what's the point of defaulting the loan now?"
This view puts refinancing further in the distance. However, he said the extension of the loan maturity would shift the refinancing risk into the future and delay the inevitable in certain cases because some borrowers may see their LTV swell to 120% from 70% over that break. "At which point they will be so far underwater that even a reasonable recovery of the market won't be enough to get them out," Lambie said.
Judith O'Driscoll, an analyst at S&P, said that extension of the loan was cut and dry only in cases where extension options are already built into the day-one credit arrangements. Borrowers are expected to begin requesting amendments to credit facilities so as to achieve loan extensions.
One of the main concerns to arise from loan extensions in 2009 will be litigation. "Mistakes in documentations might prolong debates among parties (noteholders and investors)," Zanesi said. "A recent example is Titan Europe 2006-4, where some discrepancies between the servicing agreement and offering circular have arisen. In this case, the decision to extend the terms of extension of the loan differed in the documentation."
Unicredit also noted that a sale of the EPIC Industrious portfolio seems likely after a loan event of default occurred in September.
Hans Vrensen, director of securitization research at Barclays Capital, said that given that loans maturing in 2011 will likely have been originated in 2004 to 2006, they have benefited from significant value upside up to the middle of 2007.
According to Moody's, older vintage CMBS are expected to outperform more recent vintages, given more moderate LTVs, better loan underwriting standards and higher credit enhancement from prepayments, which might be offset by the earlier upcoming maturity dates of loans from older vintages.
Refinancing Risk - Not the Only Headache
Given that most European CMBS notes won't mature for several years, a more immediate worry than refinance risk is the weakness in the general economy prompting businesses to fall into administration at an alarming rate.
The ratings of two Moody's-rated single-tenant transactions (Delamare Finance Plc and Epic (Premier) S.A.) were affected as a result of the significant linkage between the tenant's rating and the rating of a particular class of notes, following the downgrade of the tenant and lease guarantor. Furthermore, a number of tenants within EMEA CMBS transactions have gone into administration, especially in 2H08.
So far, the retail sector has been the most affected, with retailers like Woolworths Group, Wehmeyer and Hertie, among others, becoming insolvent and many other retailers experiencing financial difficulties (for example, Baugur Group associated retailers).
"Tenant defaults pose an immediate risk to noteholders if rental income becomes insufficient to pay the note coupons," said Mark Nichol, securitization research analyst at Barclays. "In cases where loans are backed by a single tenant that has gone into administration, such as Woolworths, noteholders can also suffer a second hit because the administration process is likely to crystallize principal losses earlier than if the loan had failed to refinance at maturity."
Ironically, though, senior ranking noteholders may benefit from this if recoveries are sufficient to pay them back in full earlier than expected, explained Nichol.
"Declines in property cash flows from tenant defaults and declining market rents can further knock values, after the previous impact of higher initial yields," Vrensen said. "This, combined with many banks not able and/or willing to lend, is likely to have repercussions for property value as well."
Although rents are expected to fall in most European property sectors, U.K. CMBS investors are protected to some degree by the upward-only nature of U.K. leases. Tenants' rental obligations typically do not go down in a falling market, so the rental income available to service the debt is unlikely to decline unless a tenant defaults or vacates upon expiration of the lease.
"Further declines in property values do not directly need to impact bondholders. It just means the loans are in default of their LTV covenants," Vrensen said. "But these loans are not being foreclosed as a result. The key deadline the servicers face is when the bonds need to be repaid at their legal final maturity, which could be years after the maturity of the loan. As a result, we have not seen and can expect to see no urgency to foreclose in a continuingly weak market."
Defaults a Problem across Ratings Spectrum
The number of loans that have been in default and/or in special servicing increased significantly since the beginning of 2008 compared with the few loans that were in default or in special servicing during 2006 and 2007.
The reasons for loans incurring an event of default have included, among others, breach of coverage covenant, breach of LTV covenant, non-payment of debt service and insolvency of a sponsor and borrower group, Moody's said.
The number of loans that have been added and remain on servicers' watchlists has increased significantly compared with 2007, and about half of the 73 large multi-borrower transactions monitored by Moody's have one or more loans on the respective servicer's watchlists. In Moody's opinion, this is an indicator of future developments in terms of potential loan events of default and transfer to special servicing.
One trend currently visible is that downgrades are no longer reserved just for mezzanine/junior notes; in some deals, some of the senior notes are also exposed to risk. "The intrinsic structure of CMBS loans and their bullet maturity makes them extremely sensitive to the macroeconomic outlook," Zanesi said. "The more pessimistic the outlook, the more likely it is that the changed assumptions might impact expected cash flow also on senior notes. Downside risk is much higher than in other asset classes: due to the concentration in maturities between 2011 and 2014, we doubt that even a recovery of the market in the next couple of years will prompt many positive rating adjustments."
Windermere XI (priced in July 2007) is the latest example. Fitch downgraded the notes because it estimated that the value of the notes might have declined by up to 45% from closing (estimating an LTV of 103.8% versus 68.9% at closing). Fitch said that the current outlook on Class A and Class B notes is negative since the ratings on these transactions may be affected by further income fluctuations. These fluctuations are caused by possible tenant defaults, continued property market declines and, in the medium/long term, failure to replace the issuer-level swap in full.
It's unlikely that the CMBS market will see this downward trend stop unless the financing availability for commercial real estates recovers. However, analysts believe it's unlikely to happen in 2009.
Zanesi said he does not expect the government to provide missing demand. "CMBS are not eligible for the BoE liquidity scheme, and ECB repo financing represents the only rationale behind new origination," he said. "Government initiatives are more likely to focus on the residential mortgage and corporate/SME market rather than on the commercial real estate sector."
Vrensen said that the investor base has been trying to shift. At the CMBS market's peak, during 2006 and 2007, a large number of more general ABS investors came into CMBS late in the cycle because the sector offered relative spread pickup. However, some of these investors were probably not able to fully analyze the various levels of risk. It's this part of the investor base that might consider selling but might be turned off by current spread levels.
"We have been seeing an influx of more property-focused investors for some time, looking into the sector," Vrensen said. "But there are some issues to get over. For one, most private equity firms will find the lack of total control and legal complexity of a CMBS deal structure difficult to accept. As a CMBS investor, you are implicitly accepting the servicer's discretion in dealing with the underlying loans. So far, we have not seen buy-to-own strategies pay off in European CMBS, and we expect this to continue. These investors might be natural property investors, but they are not always familiar or comfortable with structured finance."
Outside the CMBS market, Vrensen expects more appetite from private equity investors for highly discounted stock offerings from U.K. REITs and distressed loan portfolios. These other sectors are likely to divert investors' attention away from the CMBS sector.
"The key to recovery is realizing the full extent of the problem, to realize that you are in it, and over the last six to nine months there has been an extreme reluctance from issuers to enforce firesales," Lambie said. "There has been some high-profile restructuring in healthcare deals and hotel deals, but until the problems are properly worked out, it's difficult to gauge a recovery timeline for the CMBS market. The industry might be more proactive if you increased the involvement of the banks, and we are seeing that half of the banks remaining have moved into restructurings."
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