Commercial property valuations exceeding the initial purchase price could lead to greater loan defaults in European CMBS transactions, reported analysts at Standard & Poor's, who warned that lenders should be wary of valuations that do not reflect recent purchase prices.

"As commercial mortgage lenders find themselves in an increasingly competitive market, the pressure to finance borrowers might expose them to some of the riskier practices from the borrowing side," said one analyst at S&P. "There is sufficient concern that these practices could affect some existing [CMBS] deals and future transactions as well."

The trade of an asset reflects the price the market is willing to pay for the asset and the best indicator of property value is the recent purchase price. S&P, in most cases, discards any market value opinion that exceeds recent purchase price in its ratings process.

An increasing number of valuations are coming in above the most recent purchase price, without any indication as to why the valuation has been made at that level, according to S&P, and some of these reports neglect to even mention the purchase price. The concern is that lending under these circumstances could lead to an increase in incidence loss, where the borrower would be more inclined to just walk away from a property if prices were to fall below the valuation levels.

Lenders are typically willing to lend up to 80% of the purchase price toward the acquisition of a property - the borrower in this scenario must invest 20% of equity and thereby has more incentive to protect his investment. "S&P is talking about a growing trend of lenders lending anywhere from 105% to 120% of the purchase price - that's pretty big and means that if the market takes a fall, the borrower has little incentive to recover whatever is lost," said one industry source.

The level of borrower equity serves as a testament to the risk that the borrower is committed to in a property. When the equity commitment increases in a property, the owner's interests become more aligned with the lender, analysts explained. The level of borrower equity invested in a transaction plays an important part in S&P's overall analysis in rating CMBS transactions, added analysts.

In CMBS transactions, the level of default probability is correlated to the level of borrower equity invested. Excessive leverage and minimal borrower equity contribute to loan level defaults and S&P said that this relationship between debt financing and borrower equity runs particularly strong in recently traded assets. S&P said it rarely considered the potential increase in a property's value when evaluating a borrower's commitment to the property.

According to S&P an 85% loan-to-value ratio would allow the borrower to raise 100% of the acquisition costs. "If the property values rise, the purchaser will benefit from the increase," said analysts at S&P. "However if there is a fall in the value of property it is often simpler and less expensive for the borrower to hand back the keys to the lender, who is left with the problem loan."

Analysts said that in those cases where low levels of borrower equity were committed for the transactions rated by S&P, subordination levels are increased to reflect the increased probability of default. The agency said that further adjustments would be made to transactions where a lender's loan origination and credit agreement repeatedly ignored the current level purchasing price when deciding whether to finance the acquisition.

Copyright 2005 Thomson Media Inc. All Rights Reserved.

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