Key problems Less stringent loan underwriting and excessive leverage Complex securitization lengthens deleveraging and suppress a recovery - hundreds of direct and indirect owners across capital structure, with conflicting interests Over $500 bn of over-leveraged CRE properties to slowly reach market CRE values would remain below peak by 30- 40%
Tighter CRE underwriting New regulatory & accounting rules also affect negatively cost & benefit of new CMBS due to asset retention requirement (5%) and higher capital charge for issuing banks ($ mn)20062010Comments Net Operating Income (NOI)5.44.4 Lower occupancy and rents now Cap rate6.0%8.0% Investors demand greater returns now Property value89.254.4Value = NOI / Cap rate Target loan-to-value (LTV)90%65%Conservative underwriting Financing capacity80.335.3Property value x Target LTV Borrower can refinance only $35 mn (44%) of balance due Underwriting comparison: 2006 vs 2010 Source: BlackRock
Recent situation Some capital has returned to CMBS National price indices could be misleading when transactions are limited (fell nearly 90% from 2007 to 2009) and concentrated in trophy properties Effective office rents (with concessions) are lower than market reports’ asking rents while rental growth is limited by above-average vacancy CMBS delinquency rate reached 8.4% in mid-2010, triple from 2010, whereas Fitch’s estimated “loss-severity rate” of investors averaged 57% in 2009 Drop in property values coupled with tighter underwriting will affect many loans when principal is due New concept of loan modification vs. refinancing, will further deteriorate the valuation of the security
Valuation & Accounting for CMBS In 2009, the FASB provided Tier 1 core capital relief to banks by providing bifurcation of OTTI recorded for all debt securities between issuer specific credit deterioration and interest related fair value declines. Credit deterioration recorded through earnings (P&L); fair value declines through other comprehensive income (OCI). In late 2009, the NAIC followed suit by providing similar relief for Insurance Companies, and only for loan- backed and structured securities. If the intent and ability to hold until recovery of amortized cost exists, then record OTTI loss only for issuer specific credit deterioration measured as the reduction of expected cash flows at the current effective yield. Otherwise, Impair to fair value.
Valuation Methodology Carrying value and income (yield) are determined by expected cash flow and intent to hold or sell: Securities where receipt of all contractual cash flows is probable are carried at amortized cost. – Yield adjusted up or down as necessary when cash flow repayment assumptions change. Securities where receipt of all contractual cash flows is not probable due to credit deterioration. – If intend to hold and if FV < BV, then written down to expected cash flows discounted at current effective yield. – If intend to hold and if FV > BV, then yield adjusted as necessary when expected cash flows change. – If held for sale, then carried at lower of FV or BV