Increasingly aggressive property appraisals, so-called “incentive management fees” for hotel properties, and the limited return of “pro forma” underwriting are among the troubling trends that Standard & Poor’s (S&P) cites as red flags in the quickly evolving revival of the commercial mortgage-backed securities (CMBS) market. In a report released earlier this week, S&P identifies several new trends – and a return to questionable “old” trends – in recent CMBS transactions. The U.S. CMBS market experienced “a somewhat swift evolution between late 2009 and early 2011, as single-borrower transactions gave way to a market characterized by relatively larger, more complex multi-borrower deals,” the rating agency wrote. “Several structural features have been loosened, while some property valuations are overly optimistic.”
“We continue to see instances where we believe that valuations are questionable, especially within the larger loans for certain property types, particularly office and hotel, in primary markets,” wrote S&P Credit Analyst James Manzi. “This is probably attributable to the fact that lending is very competitive in these types of markets, where insurance companies, pension funds, foreign investors, and REITs could be bidding alongside CMBS issuers.”
“The part that we believe should be most alarming to investors is that the appraisals appear to be building in upside in rents and occupancy to arrive at a value for the properties in question instead of using in-place rents and tenancy at the time of closing,” Manzi added.
S&P also cited numerous examples of a limited return of pro forma underwriting. According to S&P, the phrase “pro forma” indicates that some aspect of the loan underwriting for a collateral property is based on the occurrence of an anticipated (future) event, such as a projected increase in rents or an assumption that a tenant will occupy a currently vacant space and begin to pay rent.
The rating agency also noted more loans in recent deals with single-tenant exposure, which is generally more risky than buildings with large, diversified tenant rosters. Moreover, several top-10 loans in recent CMBS offerings are based on leases that expire before loan maturity. In that situation, there is always the risk that the tenant will not renew; there is a significant time and cost involved with replacing a major tenant if it leaves or defaults.
S&P said it is also watching other trends including an increase in the number of partial-term interest-only loans, a weakening of “recourse carve-outs” for bankruptcy and fraud, and increased deal structure complexity, as measured by the number of bond classes per transaction.