European commercial real estate and European CMBS continue to feel the effects of the events of last year when credit contraction, asset-value declines, and dislocation throughout the global financial systems began to show their effects in European CMBS through rising rates of loan defaults. This article looks at the performance of the market since 2008 and considers some factors that are likely to be relevant in 2009 and that we review, among others, as part of our credit analysis of securitized pools or our assessment of the counterparty risk in the transactions we rate (all statistics in the article refer to 2008 unless otherwise indicated).
Property Market in Decline
European CMBS is secured predominantly by assets in the U.K. and Germany. In the U.K. the decline in property values that began in mid-2007 gathered pace in 2008. Derivatives markets forecast that U.K. property values are expected to fall by over 50% from peak to trough with realized declines to date of over 40% using IPD indices. As corporate occupiers, businesses and retailers begin to suffer from declining economic conditions the likelihood of tenant defaults increases, in our view. Borrowers will, we believe, be faced with rising vacancy rates and declining incomes, at a time when letting markets are weakening.
The change in the German property market landscape was less dramatic in the same period. Nonetheless, since 2008 we believe the German property market has experienced unprecedented level of uncertainty and this has resulted in a slowdown in activity. In our view as a consequence, commercial real estate investment activity in Germany may have decreased by as much as 50% from the record levels of 2007.
European CMBS Troubled Loans - Delinquencies and Non-Monetary Breaches
Despite the market turmoil and contraction in credit in the past year, loan delinquencies (loans suffering payment breach) and loans experiencing non-monetary breach (for example, breach of loan covenants) are currently modest in number: by the end of April, of the roughly 1,100 loans that collateralize European CMBS rated by us, the number of reported delinquent loans stood at 22. (This loan pool does not include loans in nonperforming loan securitizations or small loan securitizations). Loans in breach of other obligations (such as loan-to-value (LTV) covenants) stood at 17.
It is important to remember when considering these statistics that these breaches do not necessarily result in loan acceleration nor are they indicative of losses being experienced by noteholders. They are, we believe, first and foremost loan level issues, and structural mitigants (e.g. cash traps, liquidity reserves, and amortization triggers) may exist at the issuer level to alleviate the impact of these risks.
Servicing and the Work-Out of European CMBS Loans in an Environment of Increasing Default
As in other asset classes, servicing and special servicing of loans are important functions in CMBS loans. However, in CMBS, we believe servicing assumes greater significance given that the assets are not granular or fungible. When CMBS loans are nonperforming then certain functions (including management of work-outs) transfer to the special servicer.
The rise in delinquencies and non-monetary breach that has occurred at the loan level of European CMBS since around mid-2008 has caused a corresponding rise in the number of European CMBS loans that were in special servicing at the end of April 2009: 33 in total. This has a number of implications, in our view.
First, the practical outcome is that special servicing fees are now being paid in several transactions. Second, the servicers' mandate is generally to maximize recoveries and to handle competing junior/senior lender interests, acting to a prudent lender standard. One issue we believe they will increasingly be faced with as property values decline will be how to treat breaches of LTV ratio covenants.
In most cases, the servicer has the discretion to default and accelerate the loan on a breach or, if they perceive increased recoveries in the future, to wait. For a servicer managing a property with good cash flow where the loan has defaulted because of an LTV covenant breach, the issue is more difficult. Trying to work out if and when real estate values will come back to a reasonable level is not easy in our view, and certainly for some sectors could be outside five years. In our opinion, a prudent lender is unlikely to enforce if the loans are current with their cash flows.
In fact, we anticipate that a prudent lender is unlikely to enforce even if it is not cash flow current but it is accruing interest - if they believe the net losses will be mitigated by waiting. At the same time, while we believe that most balance-sheet lenders are not choosing to enforce security, there are some CMBS market participants who speak forcefully for swift enforcement as they wish to deploy capital at higher margins. We believe that servicers and special servicers of CMBS will have tough decisions to make in the year ahead, particularly where they have discretion to act.
Credit Deterioration of Some CMBS Participants
Another key development that we believe had a material impact in European CMBS in the past year was the credit deterioration of significant participants. These ranged from insolvencies of significant tenants and borrowers (Level One Holdings, for example) to insolvency or credit deterioration of issuer level supporting parties. These parties perform a variety of roles in European CMBS transactions, for example, derivatives counterparty, liquidity provider, or supporting collateral provider. Because the majority of CMBS transactions have small pools (in most cases fewer than 10 loans), these parties take on a greater significance in our rating analysis. The most notable of these issuer level counterparties and supporting parties in 2008 was Lehman Brothers, but the declining creditworthiness of other counterparties (AIG and Hypo Real Estate, Ambac and MBIA) also had an immediate impact on our credit opinion of the ability of issuer to meet its note payments on a timely basis, and this resulted in some rating actions.
Refinance Risk for European CMBS
Refinance risk continues to be a key risk for European CMBS given that 75% of all CMBS loans by principal balance outstanding are due to refinance in 2011-2014.
In 2009, 30 loans are due to mature across 24 transactions, representing E994 million ($1.35 billion) by euro senior loan balance and £2,957 million by sterling loan balance. Borrowers will, we believe, be aiming to sell the assets to pay down maturing bullet payments or (given the current unfavourable market conditions) to refinance the loans. If finance is not available, they are likely to seek an extension of loan maturities. Where extensions options are not already built into the Day 1 credit arrangements we believe that may start to see borrowers requesting amendments to credit facilities so as to achieve loan extensions. In an environment of declining values and credit contraction, we will be curious to see how willing transaction parties will be to extend loan maturities.
Further Credit-Related Downgrades Expected
Some deterioration in loan performance following a 10-year period of almost no loan defaults in European CMBS may be inevitable as economies weaken and the dislocation in credit markets continues. In 2008, 48 tranches rated by us were downgraded for credit reasons. We expect this to increase over the course of 2009. Recent Creditwatch placements in May are likely to result in material downgrades later in the year.
The topics discussed in this article are more fully explored in articles published on January 20, 2009 entitled European CMBS Performance Review 2008 - Poor Collateral Performance and Bank Downgrades Fundamentally Weaken The European CMBS Landscape and on March 4 entitled European CMBS Monthly Bulletin (February 2009): Three More Loans Fall into Arrears As Delinquency Trend Continues. We also refer the reader to our Principles-Based Rating Methodology For Global Structured Finance Securities published on May 29, 2007. These are available to subscribers of RatingsDirect.
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