Interest in small balance CMBS - an area that has heretofore been largely neglected - is on the rise, according to buzz generated at last week's Mortgage Bankers Association conference in Buena Vista, Fla.

Mary Metz, managing director at Fitch Ratings, said the audience had "tremendous interest" in the topic throughout a panel session in which she participated. "This is a new product we are definitely interested in," Metz said.

Prompted by this interest, Fitch released Evaluating Small Balance Commercial Mortgages, explaining the debt tracker's ratings criteria for this emerging sector. Small balance transactions consist primarily of loans under $1 million but may be as large as $3 million. Due to the relatively small size, these loans have limited, if any, lockout provisions. Although somewhat infrequent, these transactions have performed exceptionally well, de-leveraging relatively quickly and incurring nominal losses, the report said.

Default probability on larger loans is typically more related to its debt service coverage ratio. For smaller loans, however, factors such as LTVs, debt-to-income ratios, FICO credit scores, loan type and property type are used to measure default probability. In Fitch's estimation, full recourse is a strong incentive to the borrower not to default.

Traditional property types include multifamily, retail, office, industrial, hotel and self-storage. Loss severity for these property types is based on a stressed LTV. Loss severity for an individual loan will increase with additional debt, while loan amortization will bring that figure down. Additionally, the number will be adjusted upward for smaller loans to account for the fixed costs associated with foreclosure.

Loan diversity will be taken into account: assuming similar credit statistics for all loans, the more diverse the pool, the lower the expected subordination levels for the transaction.

Residential mortgage lenders have been paying particularly close attention to this area. "As their volume has declined, they see making a small commercial loan as an opportunity," Metz said. In fact, some RMBS originators have been originating small balance commercial loans and putting them into residential deals, Metz said.

CMBS analyst and author of the Fitch report Lee Green said that commercial originators have been sniffing around as well.

"With origination activity being so high in the CMBS arena in the past few years, it wasn't a high priority," Green said. "But once they have these programs up and implemented, small balance issuance should continue to grow in the future."

Green added that Fitch has been receiving more informal inquiries from CMBS originators seeking to find out what the rating agency typically looks for in a small balance program. The implication is that originators would not be able to provide the same third-party due diligence than they would in a typical CMBS deal, he said.

"Third-party due diligence costs are generally a fixed component of the overall closing costs of a commercial loan, and for small balance borrowers, can be prohibitively high relative to the loan proceeds," Green wrote in the report.

However, the risks associated with the abbreviated assessments can be offset by recourse to the individual, as well as by the diversification of the loan pool, he said. RMBS transactions are generally much smaller and are most likely to offer recourse, Metz said.

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