Experts Think Commercial Real Estate Will Continue to Perform Well

Commercial mortgage loans have weathered the current economic downturn well and indications are that they will continue to hold up in the future. Standard & Poor's for one believes that the strong credit performance of commercial mortgage-backed securities is likely to continue into the future, based on a study of 28,593 United States commercial mortgage loans that went into S&P-rated CMBS. The loans were originated primarily between 1993 and 2000, with a total original principal balance of $234 billion and an average interest rate on the underlying mortgages of 7.87%, with two-thirds of the loans carrying a mortgage rate between 7% and 9%.

Joseph Hu, a managing director in S&P's structured finance group, said, "With the real estate market gradually gaining strength following the anticipated stronger economic recovery in the second half of 2003 and beyond, one can expect that CMBS will continue to perform strongly."

For the purposes of the study, conducted by Dr. Hu and Roy Chun, another S&P credit analyst, a loan is considered to have defaulted if it became 60-days delinquent. As of March 31, 2003, 1,006 of the loans studied had defaulted. The S&P researchers have also used the findings from the study to come up with a default model to estimate the probability of default of commercial mortgages. Loans originated in 1995 had the worst credit performance of all the vintages, the study finds, with an annual default rate that escalated from 0.44% in the second year to a high of 2.37% in the eighth year. The 1995 loans had a nine-year cumulative default rate of 7.64%, which was the highest of all.

The theory that the credit performance of commercial mortgages depends more on the vitality of the local economy than the national one is borne out by the study. California and New York, two states that experienced great prosperity during the 1990s, had "markedly low cumulative default rates" of 1.1% and 2.5%, respectively.

On the other hand, Ohio and Florida, two states that did not share in the prosperity and property value appreciation of the 1990s, had "rather high cumulative default rates" of 5.2% and 4.8%, respectively. However, the incidence of default overall is linked to conditions in the national economy. During periods of economic prosperity there is a scant likelihood that commercial mortgage loans will default, while they are more likely to default at higher rates during periods of economic slowdown in the national economy.

The study finds "a wide variation in the default behavior among different underlying properties." Lodging-backed loans, which accounted for 6% of the population studied, had a very high default rate of 16.6%, and the researchers attribute this largely to the events of 9/11. The cumulative default rate for loans backed by health care facilities was also "alarmingly high" at 12.7%.

After excluding these two property types, the other types of underlying properties were found to have a lower-than- average cumulative default rate. Multifamily properties had a default rate of 2.5%, office properties 1.6%, industrial properties 2.2%, mixed-use properties 2% and self-storage facilities 0.6%.

Seventy-five percent of the defaults were found to occur between the second and fifth years after origination, and after the fifth year, the probability of default went down to 10% or less.

Multifamily loans were found to be more likely to experience default early on, within the second and third years. Lodging loans tended to default significantly only in the fourth and fifth years.

The pattern for retail loans was to encounter credit problems early on in the third year and to continue to have "significant defaults" until the fifth year. Health care defaults were "spread out evenly across many years."

The study points to a positive relationship between the mortgage rate and the default rate. The higher the mortgage rate, the higher the probability of default. For a mortgage rate of less than 7%, the commercial mortgage default rate was "almost negligible," it rose to nearly 2% when the mortgage rate ranged between 7% and 7.99%, it more than doubled again with a mortgage rate ranging from 9% to 9.99%, and when the mortgage rate exceeded 11%, the default rate reached nearly 16%.

Another finding from the study links debt service coverage ratios to commercial mortgage default rates. Loans with a DSCR between 1.5 and 2.0 had the highest default rates of between 4.2% and 4.5%, while those with a DSCR lower than 1.5 experienced average defaults, surprisingly. When the DSCR was greater than 2.0, the default rate dropped substantially.

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