Moody's Investors Service last week released a report looking at the historical performance of loans backing CMBS deals. The highlights of the report include examining loan performance in terms of seasoning as well as city size.

The rating agency stated that there is now sufficient data on these mortgages to assess CMBS loans on the basis of CMBS loans, and not a "proxy." The Moody's report analyzes all existing loans - not just those rated by the rating agency - as a way to produce an unbiased sample size.

Sally Gordon, vice president at Moody's, said that historically, analysts had to use life company mortgages, which have had a long history, as an indicator of performance of commercial real estate. This was necessary because it is only through looking at a historical time series that credit performance parameters can be established - in other words, determining the highest and lowest expected loss that could be reached in a given cycle.

One of the highlights of the report is its use of seasoning to shed light on credit risk changes that occur over time. The report said that analyzing loans of the same seasoning allows a comparative assessment of the performance of mortgages of specific ages, though originated in varying circumstances, such as different interest-rate environments.

Gordon said that Moody's also makes use of seasoning partly to address the "bathtub problem," which means that the CMBS universe continues to replenish by adding new loans that are typically the best performing. The report likened this effect to adding warmer water to a bath to maintain a comfortable temperature. Gordon said that seasoning is an "analytical device necessary to address a problem that distorts or misleads loan performance."

However, the rating agency issued a caveat saying that although seasoning analysis helps in informing analysts' assessment of credit risk changes, the data only covers the last several years, which has been a relatively benign phase of the real estate cycle. For example, the period studied has been marked by falling interest rates.

The rating agency concluded that performance in the later seasoning years varies significantly by property type, with most core products - such as office, multifamily and industrial - experiencing less delinquency after the fifth year. In contrast, non-core assets such as hotel and healthcare still suffer from incrementally rising delinquencies even as these mortgages mature.

Another aspect that the Moody's study looks at is the size of the city where the CMBS loans are located. Gordon said that one thing that is fairly straightforward is that delinquencies are typically higher in smaller cities. According to the report, the performance is similar among cities of all sizes in the earlier years of a loan, but this lack of disparity disappears as the loan ages. The rating agency said that the "pack starts to separate" in the fifth and sixth year when delinquency stabilizes in 25 of the largest cities while still increasing progressively among medium-sized cities.

There are several factors involved in causing this effect. For instance, smaller cities have shallower capital markets and thinner economies, thus people tend to migrate out of them to look for better opportunities. These two factors combined create more real estate volatility.

"City size itself is often associated with greater economic diversity and deeper and more liquid capital markets, both of which can enhance the performance of commercial real estate," Moody's analysts wrote.

Additionally, larger loans - typically lower leveraged - are more common in bigger cities. To study the impact of leverage, Moody's looked only at delinquency of loans with initial LTVs of 70% to 75% for each city size group. The rating agency found that even while holding leverage constant, the smallest cities still suffer more stress compared to their big city counterparts.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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