CMBS: Property values lean on CMBS

The precipitous fall in UK and continental European property values – in some cases 20% and higher – in the months since the sub-prime crisis began to bite has put pressure on a handful of commercial mortgage-backed securitizations. Refinancing risk is the greatest spectre in the CMBS market, with some deals facing dire consequences if banks remain tight-fisted with their cash in the next 12 to 18 months.

Fitch Ratings has put five tranches of four deals on outlook negative, citing refinancing risk as the main concern (see box). Deals from Credit Suisse, Deutsche Bank, Lehman Brothers and Morgan Stanley have all been flagged as headed for trouble if the credit markets’ stagnation develops into a fully fledged downturn.

"The property market has moved, particularly in the UK, where we’ve seen declines in value," says Andrew Currie, managing director at Fitch in London. "In January we did a review of all the 2006-07 vintage loans to UK property – 38 CMBS deals. Out of those we put five tranches of four transactions on outlook negative. That’s not a negative movement on the rating, but as we get closer to refinancing and as the market has already moved, our outlook on those ratings has declined."

Extension options

Given the small proportion of tranches put on ratings watch, Currie’s view remains positive for the time being. Very few CMBS transactions are due to mature in the next 12 months. "Some are up for refinancing but they have extension options," says Currie. "In the current market you would think the borrower would exercise the option to extend."

Refinancing risk might not be a clear and present danger to CMBS transactions. However, as the sub-prime fiasco has shown, no market is immune to contagion.

"The absolute level of refinance risk in European CMBS is extraordinarily low: less than 5% of the total universe of loans," says Ronan Fox, managing director at Standard & Poor’s in London. "That compares with the refinance in the UK bank sector, which is approximately 40% of all loans. There’s a much greater refinance issue in the banking sector as a whole, and how that plays out certainly will have an impact on the refinancing of European CMBS."

Further declines in property values could prompt increased cause for concern about CMBS performance. The movements that have come so far have been very fast and at a completely unprecedented speed compared with previous downturns.

"Some people are saying that’s good, it’s a quick downturn and it will bounce back," says Currie. "We’re waiting and watching to see what happens on the investment market side."

Occupancy levels, so far, have not gone into a decline. For Currie this is an important indicator of the property market’s continued health. However, a drop in occupancy prompted by weakness in the real economy coupled with continuing financial market turmoil could have repercussions for CMBS. That combination would be likely to cause these transactions to underperform.

"I’d stress that we’re not seeing that yet," says Currie. "The market’s been very strong since CMBS in Europe started. It’s incredibly strong almost to the point of tedium. This is the first real stress we’ve seen and it’s relatively limited."

Although there is uncertainty about CMBS performance, there is no doubt that in 2008 there will be a change in and reduction of issuance. The consensus is that there will be few deals and that they won’t be undertaken until at least the third quarter. When deals re-emerge, they are expected to be simpler and more investor-friendly. There could be an uptake in synthetic securitizations where portfolio lenders share their risks synthetically as a balance sheet and risk management tool rather than a funding tool.

"You could see CMBS covered bonds," says Fox. "The classic originate-to-immediately-distribute model of the investment banks will be a significantly lower share going forward. It will grow again in time – cycles come, cycles go, but in the short term it will be reduced."