Analysts Grow Concerned about Prospects for CRE

Heading into 2008, industry watchers are concerned about what impact a slowing economy might have on the commercial real estate sector.

In one sign of increased caution, Fitch Ratings is raising subordination levels on commercial mortgage-backed securities, based on the credit rating agency's view that commercial mortgage loan defaults are likely to rise.

The New York rating agency reports that for a "BBB" rating, an increase in enhancement levels of 10%-20% addresses the increased risk, while an "AAA" rated bond would require an additional subordination of 5%-10%.

The market is expecting higher commercial mortgage loan defaults, going by the spreads on the CMBX market indices (which are made up of CMBS deal tranches), the rating agency said.

However, Fitch does not expect defaults to rise as much as the level the indices appear to be anticipating. Susan Merrick, managing director and head of Fitch's CMBS group, noted, "Fitch expects loan defaults to rise given the current capital market environment, but not threefold." Robert Vrchota, a managing director in Fitch's CMBS group, said that the CMBX index is reflecting default rates that are three times historic default rates on CMBS. He believes this is because the index is also reflecting the fallout from an ongoing credit crunch.

The increase in Fitch's subordination levels is based on the rating agency's view that a slowing economy will impact commercial real estate performance. Also, the credit crunch is looking to be more extended than the rating agency expected, which could impact access to capital for commercial real estate borrowers.

Ms. Merrick expects that CMBS issuance for this year is likely to go down to a range of about $100 billion to $120 billion. According to statistics from the Commercial Mortgage Securities Association, 2007 CMBS issuance was at $223 billion. If commercial mortgage lenders don't get a chance to offload loans into the CMBS market, they are also likely to cut down on new lending activity. Loans with variable interest rates are finding fewer takers, according to Ms. Merrick.

Fitch expects losses on commercial mortgage loans to go up by 50%.

The increases in subordination levels will provide a cushion of over seven times expected loss for the "AAA" bonds and about two-and-a-half times expected loss for the "BBB" rated bonds, the rating agency said.

"Given that Fitch sees more defaults coming new issuance needs to have more protection everywhere, but particularly at the bottom of the capital structure since the top-rated bonds have demonstrated their ability to withstand various increasing stresses," said Mr. Vrchota.

Fitch also reports that CREL CDO delinquencies (on a base of 1,100 loans in 35 commercial real estate loan collateralized debt obligations (CREL CDOs) rated by Fitch) were up to 0.47% for December 2007, from 0.15% for November. On including repurchased loans (those that pool managers have bought out and removed from the pool due to credit impairment), the CREL CDO delinquency rate is an even higher 0.64%. This rate is double the CMBS delinquency rate of 0.31% for November.

"Retail bears watching because forecasts in personal income, a primary driver of retail demand, are still strong but are shallower than they were a quarter ago," says Sally Gordon, a Moody"s analyst/senior vice president.

"The issues in the single family sector, in turn, are a bit of a wild card for multifamily, both as to potential demand increase from owners facing foreclosure as well as potential supply increases from condo projects converted to rentals."

For the U.S. overall, the composite score is 70, down from 72 for the third quarter. Moody's also reports that the two largest markets backing CMBS, New York and Los Angeles, continue to have the two strongest scores. However, "Expectations of a weakening economy are starting to be reflected in the outlooks for several property sectors," according to Ms. Gordon.

The five worst U.S. markets for the fourth quarter, with the previous quarter's scores in parentheses are Jacksonville, Fla., 37 (39); Trenton, N.J., 38 (43); Hartford, Conn., 45 (52); Phoenix, 45 (45); and Ventura County, Calif., 47 (51).

Office vacancy rates, currently at 9% for central business districts and 14% for suburban, are expected to rise in the face of softening demand. The suburban office property sector saw its score decline to 42 from 47. The score for "full-service" hotels dropped to 61, from 64. The rating agency expects that demand growth will be negative in 32 of 49 full-service hotel markets. In case demand for business travel declines demand for full-service hotels is expected to weaken further. (c) 2008 Mortgage Servicing News and SourceMedia, Inc. All Rights Reserved. http://www.mortgageservicingnews.com/ http://www.sourcemedia.com/

Next in News ►