With the currently low interest rates and the increased number of IO loans in CMBS, many market participants have extension risk on their minds. This is somewhat of a "vague" risk, as history may not be a reliable indicator of future extension risk specifically for 2004 vintage deals, analysts said.
"While we admit we are at a loss for forecasting future extensions, we think that investors, particularly those managing buy-and-hold portfolios, should at least consider the potential implications of loan extensions when determining relative value," said Merrill Lynch in a recent report. Researchers added that though they do not yet have a good feel for the extension risk in the 2004 vintage, they argue that it is greater compared to other recent vintages.
Some investors agree. "We see extension risk as probably a bigger risk in loans created this year," said Principal Capital Real Estate CMBS Manager Marc Peterson. At this point, he said that investors should look to avoid bonds that will be negatively impacted by this risk and take it into account when pricing these bonds.
He explained that though a 10-year balloon goes a long way out, investors should now consider that loans currently being included in deals have historically low coupon rates, less amortization and higher leverage. This results in a higher probability of problems occurring during the balloon period.
He said that that there were new deals issued in second-quarter 2004 that had double-A, single-A and triple-B bonds pricing at a discount. Peterson said that to avoid extension risk, it would be a good idea to consider the negative impact that balloon defaults and extensions could have on the yield of these bonds.
Factors contributing to the risk
Merrill Lynch attributes the increased potential for loan extensions to various factors. The biggest one is the increasing number of IO loans. These loans serve as an attractive option for borrowers who want to lower their monthly payments. While reduced defaults may be expected because of the lowered payments, these IO loans with less or no amortization will have a bigger balloon balance at maturity. Therefore, they are more vulnerable to refinancing risk and increase the chances for more defaults occurring on the balloon date as well as more loan extensions.
Another thing causing increased extension risk: the current historically low-interest rate environment. Analysts explained that the average loan rate fell fairly consistently to 5.6% in the first quarter of this year from 8.3% in the second quarter of 2000. If recently originated loans balloon in a more normal interest rate scenario, Merrill said that today's borrowers might have difficulty refinancing their loans without a rise in the cashflow from the property. Aside from this, the existence of subordinated debt also could adversely affect a borrower's ability to refinance. Although the removal of this debt over the conduit loan's term is considered a positive factor, if the additional debt remains outstanding, it could add to the strain in an already unfriendly real estate or interest rate environment.
Rating agency perspective
Tad Philipp, managing director at Moody's Investors Service, said that the real problem is the refinance risk that occurs during the balloon period. For instance, if a deal has 1.30 coverage and the current average refinance coupon is 6%, there might be a problem if the refinance coupon reverts to the long-term average of 9% during the balloon period.
Philipp refers to a recent Moody's report called CMBS: Balloon Risk is Not "One Size Fits All," in which it states that many market participants have had the wrong responses to the concern over refinance risk. Some have adopted the stance of not worrying at all since rising interest rates usually result from a strong economy. They believe that under these circumstances, cashflow to commercial real estate assets should increase enough to cover debt service payments, even considering the higher debt service resulting from higher mortgage coupons. On the other hand, there are those who worry about refinance risk across the board - meaning across all geographic regions and property types.
Moody's takes a more nuanced and market-specific view. Philipp cited the example of people believing that since the economy is improving, then rents in commercial real estate must also be rising. He said that while interest rates are a national phenomenon, the income from rental properties is more of a local issue. For instance, though the national economy might be improving, San Francisco still has a 20% office vacancy rate, which might not allow for local rental increases.
"We have the tools to differentiate each market," said Philipp. He is referring to Moody's Commercial Mortgage Metrics (CMM). Through the metrics, the rating agency can distinguish between variables that lead to higher or lower refinance risk in the loans backing CMBS. The rating agency uses this tool to examine the factors that will affect the probability of default during the time that a borrower seeks to refinance.
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