Commercial Real Estate Securities Defaults Rising, Slowly

Securities backed by commercial mortgages have held up well compared with their residential counterparts, but Standard & Poor’s expects defaults to increase gradually in 2008 and 2009.

S&P says “deteriorating standards for loan underwriting and origination, as well as a rise in frothy property valuations over the past few years, could undermine the performance of commercial mortgage loans and lead to gradually increasing defaults and loss severities, especially over the next 12-24 months.”

North American CMBS performed well in 2007, but credit performance was not as strong as in 2006., S &P said in a new Default Study. “Last year saw 257 new loan defaults, up from 195 in the previous year. Despite the rise in new defaults between 2006 and 2007, the numbers still reflected notable declines from both 2004 (334) and 2005 (319).”

At year-end 2007, the overall default rate for North American CMBS by loan count was 4.25%, down from 4.60% at year-end 2006. By principal balance, the rate was 2.1% at year-end 2007, compared with 2.4% at year-end 2006. While an improving default rate is positive for the sector, the decline was largely caused by the elevated amount of new issuance that entered the CMBS market in 2006. 

If we look at the same loan population that we used in our Aug. 2, 2007, study (loans originated between 1993 and 2005), the default rate actually increased to 5.01%.

Other findings of the report:

• Rates of default increase significantly and consistently as LTVs increase. For example, loans originated at over 85% loan-to-value defaulted at a rate of 6.13%, more than twice the lowest rate of default (2.80%) for loans with LTVs of less than 60%.
• By loan count, the study showed that larger-balance loans are less likely to default than smaller ones, probably because large loans undergo greater scrutiny, and because their borrowers are generally well capitalized and typically employ third-party property management companies.
• Higher mortgage rate spreads appear to be associated with higher rates of loan default, as the size of the spread generally reflects the lender’s perception of an underlying asset’s risk.
• Loans secured by health care and lodging properties underperformed other loan types during the studied period, with cumulative default rates of 17.7% and 12.9%, respectively. Multifamily, which has a cumulative default rate of 5.4%, has been seeing increasing defaults as the sector has struggled with excess supply in overheated markets where there is a shadow supply of condominiums and single-family homes for rent.

Comments

[johnthebear]

"If we look at the same loan population that we used in our Aug. 2, 2007, study (loans originated between 1993 and 2005), the default rate actually increased to 5.01%."

Standard & Poor’s expects defaults to increase gradually in 2008 and 2009.

S&P says “deteriorating standards for loan underwriting and origination, as well as a rise in frothy property valuations over the past few years, could undermine the performance of commercial mortgage loans and lead to gradually increasing defaults and loss severities, especially over the next 12-24 months.”

This analysis suggest that the loan loss of the banking system which is now $468 B will rapidly increase in the 2009-2011 time period. How is it possible that anyone can suggest that we are near the end of our banking-credit crisis?

Where will the capital come from to enable mortgages to make sale of overvalued commercial real estate possible? Looks like the well is going dry and the treasury is on it's last legs. Who will bail out C, BAC or Washington Mutual? Looks bad IYR and the REITs that need to sell properties to continue paying high dividends investors have come to expect in the future.

With the drying up of capital for both residential and commercial mortgages, both interest rates and cap rates will rise sharply having a very negative impact on property values, which must be marked to market in coming quarters. This will be true for commercial property all over the world, not just a US problem!