S&P Worries about Deterioration in CRE Underwriting

Standard & Poor's has expressed concern about certain developing trends related to commercial mortgage-backed securities that could lead to higher risk for investors in future.

The credit rating agency said in a written release that it is seeing a deterioration in underwriting and origination standards for commercial mortgage loans; relaxed requirements for capital expenditure, tenant improvement and leasing commission reserves; a rise in interest-only loans or loans with interest-only periods; and "relaxed adherence" to structural and legal safeguards.

As well, the current CMBS landscape which is "characterized by increased liquidity, fierce competition, an influx of new buyers, and a CDO market-focused mindset has significantly altered the supply/demand dynamics of the market, possibly making future transactions more vulnerable to negative credit events," the rating agency reports.

While these trends are not yet a wider market concern, they are "looming on the horizon," according to Kim Diamond, a managing director in S&P's real estate finance group.

Expanding on the above concerns, S&P said that balloon-balance refinancing risk is likely to be a greater concern in a rising interest rate environment and with 10-year CMBS reaching the end of their lockout periods.

The rating agency is also seeing a "spate of new entrants into the loan origination market," which has spurred "fierce competition, leading to a gradual degradation of underwriting standards and criteria."

Originators, operating in what is widely seen as a borrowers' market, "have increasingly undertaken potentially troublesome practices, such as lending against the speculative value of a property." And the flow of capital to real estate, drawn by relatively attractive yields, has resulted in a "potential overinflation of property values," according to S&P.

As well, some originators are lending more money and have relaxed certain structural and legal safeguards, including a decreased use of "funded reserves and payment arrangements such as hard lockboxes."

The rating agency is also seeing a change in the market dynamics, with the increased liquidity having effectively reduced the clout of "B" piece buyers.

Ms. Diamond notes, "Whereas in the past, the small number of buyers could exert pressure on issuers, nowadays, demand has increased to the point that if one investor doesn't want to purchase a particular CMBS transaction, somebody else will step in and buy it."

Another concern is that subordinate and mezzanine investors can now "lay off risk into CDOs (collateralized debt obligations), instead of embracing a buy-and-hold strategy."

This means that is now possible for "B" piece buyers to have less "skin in the game."

Overall though, the rating agency is seeing credit support levels that are adequate and "appropriate on a historical basis."

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