There has been a rapid deterioration of rents and occupancy in commercial real estate over the past two years. This is why Fitch Ratings has taken a cautious approach in rating CMBS transactions that contain properties that are transitional in nature.

The rating agency has taken particular caution in rating floating-rate deals that often contain properties that are in transition or approaching stabilization.

These assets are often in the process of being repositioned or renovated, or the property characteristic are in the process of changing - therefore, the properties involved are not actually running at full financial capacity.

"Fitch feels it is important to emphasize the point that it is difficult in the current environment to execute on property-level strategy," said Fitch director Joseph Kelly.

Projecting future performance

In a recent report co-written by Kelly with two other authors, Fitch said that it has given preliminary feedback on several floating-rate transactions. The rating agency maintains that a lot of the loans associated with these deals have alarming real estate fundamentals as well as high leverage.

Fitch analysts wrote, "Projecting forward performance of commercial real estate always has risks associated with unforeseen factors that can continue or exacerbate poor performance in a down market," and then added, "Even the strongest assets in superior markets have not been spared from the pains of declining real estate markets."

A case in point would be the San Francisco office market, which was one of the "most sought after markets for real estate investment fairly recently," wrote Fitch analysts. Of course, this outlook has changed. Fitch said, "Interpretation of property market value via market rent and cap rate just a few years ago is vastly different from that same analysis performed with current market factors."

Fitch further noted that just three years ago, taking risks on "upside" in San Francisco seemed reasonably safe. Aside from this, in the market's downturn, some analysts within the commercial real estate sector actually expected the stabilization of rents and occupancy at levels much stronger than current experience.

Kelly explains that the performance of many markets is still in decline, and "therefore it is fairly hard to say with any real certainty if that imputed value will be achieved."

Fitch's approach

When computing debt service recovery ratios and loan to value ratios, Fitch's policy for all property types is to only accept rental revenue that is contractual or historical, said the report. Using these revenues as a start, the rating agency may apply stress to the cash flow by adjusting in-place revenues, expenses and leasing/capital costs when appropriate. "The resulting `haircut' to revenue provides a buffer to any cash flow variance that may occur at the property through normal operations," wrote analysts. "The objective is to provide stable ratings that can absorb normal stress to avoid reactionary downgrades."

Fitch's approach is different from other rating agencies. In some instances, the other agencies are said to give credit for the imputed value of the space that is not necessarily occupied.

Lagging the economy

The rating agency said that there is a possibility of further market deterioration or a slow rebound to market performance closer to 2000 and 2001. This is reason enough to be cautious when approaching transitional or stabilizing real estate, Fitch analysts wrote. They said that they will continue to approach deals with these collateral analytically and with the thought that value assumptions should be limited to those supported by empirical evidence and historical performance alone.

"It is hard to predict when a meaningful and sustained economic rebound will occur," said Kelly. "The performance of commercial real estate generally lags behind that of the general economy. Therefore a material recovery of real estate markets could be slow in coming."

Meanwhile, Fitch also released a related report on conduit loan defaults. The report said that the cumulative loan default rate in fixed-rate CMBS deals rated by Fitch rose to 2.66% while the annual default rate rose to 0.72%.

The rating agency also released a report on three major office markets with vacancies above the national average with substantial contributions of loans that are backed by office collateral in CMBS deals. The office markets are San Francisco, Dallas and Chicago. This report showed the subtle differences in how each market has been impacted by waning demand.

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