Experts Anticipate Weaker Commercial Credit

After a few years of good performance on the commercial mortgage delinquency front, it looks as though delinquencies have hit a bottom and will start going up again in 2008. For one, it looks as though the subprime mortgage market-generated credit crisis that has taken over the news this year has started to slow down the economy as banks cut down on their lending while attending to their own books.

A slowing economy, which even has some economy watchers speculating on the possibility of a recession, will mean reduced job growth, which will cut down on the demand for all sorts of commercial space and limit possibilities for rent hikes. And people are also watching the impact of upcoming interest rate resets on adjustable-rate mortgages. The government plan to freeze resets to some extent could help with that situation. And the Federal Reserve is likely to do whatever is necessary with interest rates to smooth out any economic slowdown.

Even aside from the state of the economy, the excesses of underwriting on commercial mortgages seen in the last couple of years are likely to catch up with these loans at some point.

Fitch Ratings expects that 2008 will be an inflection point for U.S. commercial mortgage-backed securities, with loan defaults increasing over 50% even though real estate fundamentals continue strong. This could even go up more if the real estate markets start to deteriorate.

Fitch is anticipating that a decline in loan origination next year will cause CMBS default rates to increase by about 0.2% in 2008. Going by Fitch's loan delinquency index for October, performance in commercial real estate continues to be strong, with only 0.29% of delinquencies. Even if loan performance continues strong, without changes in the underlying commercial real estate performance, higher defaults are likely to occur due to the low issuance volume and the natural aging of the portfolio.

CMBS issuance volume was over $136 billion for the first half of 2007. However, thanks to volatility in the credit markets, there has been an about 75% decline in CMBS originations during the second half of the year, according to Fitch.

Data from the Commercial Mortgage Securities Association show CMBS issuance at over $220 billion at the end of November (for all of 2006, issuance was at over $200 billion). CMSA statistics also indicate that issuance of commercial real estate-backed CDOs was at over $33 billion at the end of November, compared to total issuance of over $35 billion for 2006. Fitch expects issuance of CMBS to be down during 2008 with total volume likely to be 50% of that for the calendar year 2007 or about $125 billion.

Fitch has seen a seasoning curve effect over an average 10-year loan term whereby loan defaults are nominal in the first two years, increase to 0.70% in the third year of seasoning, continue increasing through the eighth year, when they reach a peak rate of 1.45%, and then decline as maturity approaches.

"As new U.S. CMBS origination balances decline, loans with more seasoning will now account for a higher percentage of the outstanding loan population, and with increased seasoning comes higher default rates," according to Susan Merrick, a Fitch managing director and CMBS group head. Fitch projects that over the next year, the default rate will increase by more than 50% over that in 2006 to about 0.6%. Fitch is expecting an additional 0.2% increase in delinquencies in even a mildly stressed real estate environment.

The impact of rising loan defaults in 2008 will result in loan performance more closely resembling historical loan default rates.

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