With interest rates expected to increase, floating-rate transactions will probably attract more CMBS investors. As a result, it has becoming a focus for some market participants.
In a recent report, Lehman Brothers said that the primary risk in CMBS floaters remains default risk. However, considering how lumpy floating-rate pools usually are, default rates have very limited use in evaluating floating-rate deals. There is no better alternative than to evaluate the risk of default on a loan-by-loan basis, said analysts. "While the same should also hold for prepayments and extensions, it's a lot more difficult to attach a probability of prepayment or extension to a particular loan," they wrote. "Hence, we provide some historical context to the prepayment and extension experience on floating-rate pools, with a view toward helping investors finetune their assumptions while evaluating floating-rate securities."
The report said that flexible prepayment terms versus fixed-rate conduit loans imply that prepayment rates are higher for floating-rate loans. In Lehman's sample, about 18% of the universe has prepaid. Analysts also noted that prepayment behavior differs with seasoning. The prepayment pattern can be attributed to prepay protection. Lockout periods usually last between one and two years, which becomes a reason for the pickup in prepayments over the second and third year of seasoning.
The extension rate for loans that reached their first maturity date is 61% and they extended 8.5 months on average. This pattern is so different from the conduit extension experience. Lehman's research has shown that only 8% of the conduit loans that have reached their balloon date have extended. The difference is expected because, unlike conduit loans, most floating-rate loans have predefined extension options. Extensions in conduits usually happen because the borrower could not secure refinancing. Although this applies to floating-rate loans, there are other reasons why floating-rate loans extend such as the fact that loans backed by transitional properties may extend if the borrower is not done re-leasing prior to the maturity date or if the borrower opts to exercise the extension option in response to the interest rate environment.
In terms of credit performance, the sample floating-rate loans performed well thus far, said the report. The delinquency rate remained relatively low at 0.3%. It is also noteworthy that the included loans have not had any losses to date, which is not bad for a universe that is reasonably seasoned, particularly for floating-rate standards. Ratings actions were also used as an alternative indicator of credit performance. The study found that higher-rated classes have performed much better versus lower-rated classes. But after dipping below single-A, the ratings become less favorable with downgrades dominating upgrades.
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