CMBS Delinquencies Peak Lower than Expected

Commercial mortgage delinquencies have held up well in the current economic cycle, and appear to have peaked well below the 3% high that some commercial mortgage-backed securities market participants and rating agencies were anticipating CMBS delinquencies to touch during the recent economic downturn. And with the economic downturn clearly past, the delinquencies are not likely to climb further.

Fitch Ratings for one reports that its CMBS loan delinquency index declined to 1.27% in December, 42 basis points below its reading for December 2003 and two basis points lower than its November reading. Mary O' Rourke, a senior director with Fitch Ratings, observes, "In the course of the year, Fitch's delinquency index has gone from an all-time high of 1.69% to 1.27%, the same record-low rate last reported in September 2002. Fitch expects overall CMBS delinquencies to continue to decline over the next several months and believes a CMBS delinquency rate below 1.2% is possible by the end of 2005."

The rating agency reports declines overall on office, multifamily and industrial property-backed delinquencies. Fitch has seen retail-backed delinquencies edge up, however. Ms. O'Rourke notes, "Retail loan delinquencies may increase in the short term as a result of a post-holiday decline in consumer spending." Also, "There was an increase in hotel delinquencies in December, largely due to the inclusion of a previously unreported $87 million real estate-owned hotel property in Houston." Fitch expects office properties to show continued improvement in 2005 and multifamily loan defaults to decline, despite what the rating agency sees as "overbuilding" in some markets.

Delinquencies are down, but what happens to the loans that do ultimately default? Two other credit rating agencies have conducted loan loss severity studies on CMBS loans. One study carried out by Moody's Investors Service and Lehman Brothers found that the average loss severity for "all defaulted loans resolved with a loss" was 48% of the mortgage's outstanding balance. In the case of "all credit-impaired resolutions," including all loans 90 days or more delinquent that were resolved without a loss, the severity was 41%.

In the case of multifamily, retail, office and industrial property loans resolved with a loss, the study found average loss severity was 39% of the outstanding balance, while the average loss severity for "non-core" property types, such as hotels and health care, averaged 61%. The loss severity on the "core" property types was found to range from 32% on multifamily to 44% for retail, with office at 38% and industrial at 35%. A wider range of loss severity was seen on the non-core property types, with healthcare facilities experiencing 92% loss severity and hotels 53%.

The study also found that how the defaulted loans are resolved has an impact on the loss severity. Overall, 55% of the loans with losses studied were resolved through liquidation, 40% through discounted payoffs and the rest through note sales. Discounted payoffs were found to have about half the loss rate of liquidations for all the property types, with a 36% loss of principle for the former situation vs. a 62% loss in case of the latter. The Moody's and Lehman analysts believe this is because of several factors, including more borrower cooperation in the case of the DPOs, or because the properties involved in the DPOs could be under "somewhat less stress and therefore have option value that borrowers might want to retain." As well, "the process of liquidation is almost certainly more costly than a DPO because a liquidation is often associated with a lengthier resolution period and greater expenses."

Another statistic to emerge from the study is that irrespective of the loan resolution method used, about 30% of losses are attributable to servicer advances and other expenses. The study also finds, as one might intuitively expect, that the faster the resolution time, the greater the preservation of capital. The lowest losses were found to occur among the loans that could be resolved through a DPO in a short time, irrespective of the property type.

As well, the severity of loss was found to be bigger in small cities and smaller in big cities. And appraisals ordered within a year of resolution were found to be "only a rough guide to the ultimate severity of loss."

A Standard & Poor's study finds that defaulted CMBS originally rated "AA" experienced a principal repayment of 85%, those originally rated "A" 60%, and securities rated "BBB" 22% for the study period. The average realized principal loss rates were found to be about 11% for "AA"-rated bonds, 5% for "A"-rated bonds, 6% for those rated "BBB," 6.5% for those rated "BB" and 15% for "B"-rated CMBS.

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