The Canadian real estate market continues to strengthen as it moves into the new millennium. New construction is occurring in moderation and there has been increased capital markets involvement in both ownership and financing.

In a tight lending environment, commercial mortgage-backed securities (CMBS) are emerging as a viable alternative for Canadian borrowers. The effects of the credit crunch of late 1998 are still being felt in the form of a lack of available debt capital, decreased liquidity, and wider spreads. Life insurance companies, pension funds, and banks dominate the conventional lending market, but are facing demutualization and consolidation.

At this point, several Canadian financial institutions are in various stages of the commercial mortgage securitization business. Canadian banks, life insurance companies, and pension funds are either in the initial stages of gathering information or in the more advanced stages of assembling loans for securitization. Banks are expected to enter the market via conduits, while insurance companies and pension funds are expected to securitize existing mortgages. In addition, several U.S. based conduit lenders have set up Canadian operations in anticipation of accelerated CMBS growth.

Some of the major credit positives of the Canadian CMBS market are a creditor friendly legal system, a favorable position in the credit cycle, and recourse lending. Due to a scarcity of lenders, recent underwriting standards have been relatively conservative and leverage levels low. These credits are partially offset, however, by the concentration of loans in comparatively few markets and less liquid property and capital markets.

This article will detail Moody's approach to rating CMBS in Canada. It will also provide our credit concerns and outlooks for the major property markets and asset classes. It concludes with a database of Moody's CMBS Research and helpful information for commercial real estate transactions.

CMBS Rating Methodology

Moody's approach to rating Canadian CMBS is a combination of structured finance and fundamental credit analysis. Under structured finance, the credit enhancement needed to achieve a rating level for a proposed securitization typically depends on the expected frequency, severity and timing of future losses. An estimation of frequency and severity of losses is usually based on a statistical analysis of historical performance data for assets like residential mortgages and auto loans, which are quite homogeneous in character and for which historical data is available.

However, commercial mortgages are not uniform in character, and relevant historical loss information is limited. As a result, Moody's analyzes the fundamental real estate credit risk of each asset to determine the frequency and severity of losses while using the legal and structural framework of structured finance. Moody's also reviews the portfolio diversification aspects of a securitization, since they may impact volatility at the bond level, as a result affecting the level of credit enhancement needed for Canadian CMBS.

In the case of non-recourse lending, the default probability is assumed to be highly dependent on the debt service coverage ratio (DSCR) and the loan-to-value ratio (LTV) associated with the underlying mortgage loan. DSCR is the main driver of frequency, while LTV is the main determining factor in severity.

Cash Flow Analysis

To assess the credit risk of a loan, Moody's first performs a cash flow analysis on the underlying property. The purpose of this exercise is to arrive at what Moody's believes to be the long-term sustainable cash flow for the property. This process generally involves a review of at least three years' historical audited financial statements and also the projections for the following year. In certain cases, agreed upon procedures may be substituted for audited financial statements.

The purpose of a cash flow analysis is not to mark all income and expense categories to market, but to arrive at the most sustainable level of income and expenses, as well as certain capital items for a given property. Once a sustainable cash flow is determined, Moody's applies a stabilized capitalization rate to arrive at the Moody's value for the asset.

Capitalization and Interest Rates

Moody's capitalization rates are intended to derive stabilized values and may vary significantly from the market capitalization rates. Moody's captures the risks inherent in various asset classes in the stabilized cash flow analysis and in the utilization of different capitalization rates for different property types.

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