Commercial mortgage backed securities (CMBS) collateralized by floating rate loans (floaters) have become an important part of the CMBS market. Because they have low prepayment penalties and short lockout periods, floaters have generally appealed to borrowers with transitional assets or short-term holding horizons. However, based on their interest rate expectations, some conduit borrowers may opt for floaters as a flexible financing alternative that will provide them with the opportunity to refinance in a more favorable interest rate environment.
Moody's approach to rating floating rate CMBS transactions shares the same methodology as that used for fixed rate CMBS, except for an additional step necessary to assess the credit risk associated with floating interest rate. First, Moody's reviews the collateral performance and determines stabilized cash flows. A fixed rate-based baseline credit enhancement is derived using Moody's debt service coverage ratio (DSCR), loan-to-value (LTV) ratio and asset quality grade. In the next step, interest rates are stressed to determine the credit enhancement adjustment necessary to compensate for floating rate risk. This adjustment incorporates the impacts of both potentially higher interest advancing payments to the floating rate bondholders and additional term defaults associated with the interest payment volatility. The default frequency at balloon is identical for both fixed rate and floating rate CMBS. This adjustment is further calibrated to reflect the joint probability of simultaneous interest rate and real estate stresses. As in the fixed rate CMBS rating methodology, the final step consists of portfolio adjustments for elements such as diversity, structural characteristics and quality of underwriting.
Market Drivers
The CMBS market currently offers commercial real estate borrowers two primary financing alternatives: long-term fixed rate and short-term floating rate loans. Long-term fixed rate loans typically have 10-year terms, 20-30 year amortization schedules and strong call protection. This level of prepayment protection provides investors more certainty in modeling cash flows and has helped make the current CMBS interest-only (IO) market viable.
Long-term fixed rate financing typically suits the needs of long-term borrowers with stabilized assets. On the other hand, floating rate financing is more attractive to borrowers that require prepayment and refinancing flexibility due to the transitional nature of the real estate asset or the borrower's expected short holding period. In addition, traditional conduit borrowers with stabilized assets have also expressed interest in floating rate loans as a result of the recent increase in interest rates. These borrowers anticipate that interest rates will decline at some point over next few years, at which time they will prepay their loans and lock in more favorable fixed rate financing.
A CMBS floating rate loan generally has a two to five year term and provides for a one or two year contractual extension. The prepayment penalties are less onerous than its fixed rate counterpart and may include a short lockout period followed by a stepping down percentage penalty, as opposed to the potentially very expensive prepayment costs associated with yield maintenance and defeasance. Floaters are often interest only loans, so the initial coverage as well as the balloon balance are typically higher than for equivalent amortizing fixed rate loans.
Floating Rate CMBS Rating Methodology
The process for rating CMBS in general involves a review of individual property and loan terms, and an evaluation of the portfolio and structure characteristics. Moody's rating methodology for CMBS collateralized by floaters follows the general rating methodology applied to fixed rate pools, but incorporates an additional step for determining the floating rate credit enhancement adjustment.
In the first step, Moody's conducts a real estate cash flow analysis of the collateral pool. For stabilized assets, Moody's determines the sustainability of current cash flows and property values based on historical performance and market conditions. For transitional assets, Moody's focuses on assessing the "upside" stories presented by the underwriter . Based on Moody's assessment of the cash flow and asset quality, a baseline credit enhancement on a fixed rate basis is calculated for the loans. Note that the hurdle rate used in this step is the greater of current LIBOR rate plus the spread over LIBOR for the loan rate and Moody's refinance constant (currently at 9.25%).
After the credit enhancement for a loan on a fixed rate basis is derived, the second step is to calculate an adjustment to the base credit enhancement to account for the additional floating rate-related risk. It involves stressing short-term interest rates, typically the 1-month LIBOR, to assess the credit impact of the floating interest rate exposure on the loan. Moody's credit assessment on a loan is based on the expected loss concept, i.e., the product of the frequency of default and the severity of loss. The methodology for calculating this adjustment is discussed in detail in the next section.
The last step incorporates other portfolio adjustments such as quality of information, quality of underwriting, pool diversity, and other structural characteristics. Transitional assets generally have more complicated loan structures than do traditional conduit loans. Some of the complexities may include subordinate debt, future funding obligations, equity participations, extension options, exit fees and negative amortization. Furthermore, because of potentially rapid prepayments other structural complexities, such as modified sequential principal waterfalls, are frequently used.
The Impact of Floating Interest Rates on Expected Loss
The incremental credit impact of interest rate volatility on floating rate loans as compared to fixed rate loans, assuming no interest rate caps, can be broken into default frequency and loss severity components:
Default Frequency: The floating interest rate has no impact on balloon default frequency since both fixed and floating rate loans will face the same refinance environment. However, it could affect the term default frequency because rising interest rates may cause additional defaults during the loan term due to the mismatch between stable property cash flows and rising debt service . The probability of floating rate-induced additional term defaults depends on the stressed interest rate as well as the capacity of the property's cash flow to absorb rising debt service. Such capacity is reflected in the loan's break-even interest rate .
Loss Severity: For loans that would have defaulted under the related fixed rate stress scenario, the severity of loss associated with property value losses and workout costs for these defaults are assumed to be unaffected by the floating rate. However, interest advancing costs will be higher if interest rates rise during the related workout period when a floating rate loan defaults, as the advancing rate is based on the then current interest rate. In contrast, after a fixed rate loan defaults, the servicer is required to advance interest payments at the stated fixed rate to the CMBS certificate holders. The additional advancing costs, if any, are deducted from the final liquidation proceeds, resulting in a higher loss severity in the event of default. For loans that default during the term due to the floating rate feature, i.e. potentially higher interest payments, the loss severity is expected to be lower than defaults caused by changes in real estate values. The losses on additional term defaults caused by interest rate volatility come primarily from workout and advancing costs.
Joint Interest Rate and Real Estate Stress
Moody's has further considered the likelihood of both real estate and interest rate stress occurring during the same period. For example, arguments can be made that a severe real estate recession would typically be associated with a severe general demand contraction, during which period interest rates would be unlikely to rise to a high stress level. However, it would not be unlikely that a higher interest rate environment could coincide with a property market downturn. Moody's believes that the floating rate adjustment should not be a pure addition to the baseline credit enhancement, therefore a joint probability factor is applied to the floating rate adjustment to reflect the possibility of both real estate and interest rate stress not occurring during the same period.
The Floating Rate Credit Enhancement Adjustment
Moody's has developed a CMBS floating rate approach to quantify the credit enhancement adjustment necessary to compensate for the floating rate risk. The approach incorporates loan specific inputs such as term to maturity, terms of borrower extension options, DSCR and LTV ratios, spread over LIBOR and the strike rate of the interest rate cap if one exists. This loan specific information, together with the stressed interest rate assumptions discussed above, is used to calculate an adjustment for each rated class of securities.
In general, the floating rate credit enhancement adjustments have the following characteristics:
The floating rate credit enhancement adjustment increases with leverage, everything else being equal. For example, an investment grade loan may have a floating rate adjustment that is only half of the adjustment required for a loan with conduit-type leverage. This difference in the penalty reflects the capacity of the investment grade loan to absorb higher interest rate increases during the term without causing a loan default.
The floating rate penalty levels off at a Moody's leverage of 95% to 100%. At this level of leverage most of the loans in the pool are already assumed to default even under our fixed rate stress scenarios. For very high leverage loans, the floating rate penalty consists exclusively of increased advancing costs resulting from stressed interest rate scenarios.
The floating rate credit enhancement adjustment is higher for loans with longer terms to maturity, inclusive of contractual extensions. All contractual extensions are assumed to be exercised in our analysis. Higher interest rate assumptions are used for longer-term loans to reflect the increased uncertainty about interest rate levels over a longer horizon.
Floating rate loans are often interest only. Additional credit enhancement may be necessary for such lack of loan amortization besides the floating rate credit enhancement adjustments.
Interest Rate Caps
Often, borrowers are required by lenders to purchase interest rate caps to mitigate rate volatility during the loan term. An interest rate cap has two primary credit benefits: (1) reducing the additional default frequency during the term and (2) reducing the interest payment shortfall, until the cap expires, for loans that do default during the term. Moody's prefers that the cap issuer be rated at least Aa2 to get the full benefit for the interest rate cap.
In general, the lower the cap's strike rate, the higher the credit benefit, everything else being equal. The credit benefit of a cap is also higher for high leverage loans than for low leverage loans. The reason is that, even at high interest stress levels, investment grade loans are expected to have low defaults and have most of their defaults occurring later in the term or at balloon. Furthermore, interest rate caps during the loan term reduce floating rate risk but do not completely eliminate it. If a loan default occurs at balloon, interest advances during the tail period are made at the then current rate for floating rate loans, unlike fixed rate loans for which advances are made at a stated fixed coupon rate. It would be possible to eliminate all of the floating rate adjustment only if an additional mechanism were available to cap interest advancing following the maturity of the interest rate cap, such as a contractual limitation on the bond coupon (i.e. a rate cap or available funds cap).
