By Gale C. Scott, managing director, real estate, and Peter P. Kozel, research head, commercial real estate, Standard & Poor's Ratings Group

In its rating process, Standard & Poor's focuses on the capacity of the underlying assets to support the payment of principal and interest on structured securities through the entire business cycle. Unlike large pools of homogeneous assets, such as residential mortgages that have small performance variability, a pool of commercial mortgages tends to have more volatile cash flows. This is because commercial properties are more heterogeneous and sensitive to changing local economic and market conditions. Consequently, it is very difficult to predict the cash flows from a pool of commercial mortgages with a high degree of certainty.

In any credit analysis, it is important to analyze credit risk over entire real estate and economic cycles, or, at the very least, over the term of the mortgages. No one knows when the next real estate recession will occur or how severe it will be, but one can be reasonably sure that this current cycle has not yet reached its conclusion.

Why Is Value Important?

A property valuation is necessary at the time of loan origination, upon securitization, and on an ongoing basis during the term of the loan, especially as the loan nears maturity. At or near loan maturity, property value and LTV ratios are strong indicators of the ability of the property to obtain refinancing. Also, the assets in the current vintage conduits are highly leveraged.

Deriving credit support or sizing debt from a conservative value and LTV assessment protects investors against both defaults during the term of the mortgage as well as balloon date defaults. In the case of conduit loans, which are underwritten at considerably higher relatively high LTV ratios, and thus, have a higher propensity to default in stressed conditions, pool credit support must be sufficient to cover estimated losses.

Although this perspective may appear only useful to certain types of investors, all investors should consider the effects of highly leveraged collateral. In calculating expected yields, investors are concerned with the realization of an expected return over some holding period. Again, if it is not possible to refinance a property because its market value has declined, then the existing loans may have to be extended and/or defaulted, resulting in substantially lower returns.

Lessons From Previous Cycles

As the U. S. moves into its ninth year of uninterrupted economic expansion, some real estate analysts are beginning to promulgate the hypothesis that the property markets will never suffer a reversal of fortunes that parallels the one that occurred during the late 1980s and early 1990s. Of course, it should be remembered that the current economic expansion has been longer and more robust than most experts predicted earlier in the decade. Amid of strong growth in employment and profits, and stable prices, it is not unusual to find those who ridicule caution.

The abysmal performance of the property markets in the late '80s and early '90s was unprecedented. It appears that a number of structural changes in the domestic and international economies bore the principal responsibility for the problems that developed in the property markets rather than the trend of general economic activity. Deregulation of many financial institutions, changes in tax laws, the end of the cold war, the free flow of capital, and the surge of international competition are just some of the structural forces that contributed to the overbuilding and subsequent collapse of the property markets. These structural changes set the stage for the strong performance of the U.S. economy in the 1990s.

Structural changes are unique events and are unlikely to be repeated in the future. However, it is presumptuous to think that another set of events could not have the same dire impact on the property markets as the structural changes of the 1980s. For example, the financial crisis triggered by Russia's default on its debt nearly closed down the CMBS new issuance market during the fall of 1998 and dramatically widened yield spreads on outstanding bonds. Therefore, since the future is very difficult to predict, it seems prudent to at least start the credit risk analysis by looking at what has transpired in the past.

Mitigating Market Value Risk With Diversity

Can diversity mitigate market value risks? It depends. The general impact of lower risk derived from larger pools with more mortgages and property types is clear; however, the actual quantification of the advantage is not obvious. Simply increasing the number of mortgages in a pool does not necessarily significantly increase the diversification of the pool. The properties in the pool need to offer true economic diversity. Simple indexes of loan size and geographic dispersion may well fall short of providing a good measure of pool diversification. Even if the loans have a broad geographic distribution, they may not possess economic diversity.

In 1999, pools have gotten smaller and less diversified. This is offset by the exclusion of assets that are perceived to possess a riskier profile than the traditional "bread & butter" real estate. In the months and years ahead, we all hope the business environment remains as strong as it has over the past three years. However, at this stage of the real estate cycle, CMBS subordination levels should not be driven primarily by hope. In 1999, pools have gotten smaller and less diversified. This is offset by the exclusion of assets that are perceived to possess a riskier profile than the traditional "bread & butter" real estate.

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