CMBS Research Double Secret Probation For-Profit Colleges Uncertain Future Heightens CMBS Default Risk

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1 CMBS Research Double Secret Probation For-Profit Colleges Uncertain Future Heightens CMBS Default Risk May 2016 Authors: Steve Jellinek Vice President Edward Dittmer, CFA Vice President Morningstar Perspective Morningstar Credit Ratings, LLC believes that government scrutiny and poor public perception of the for-profit education industry could intensify default risks on up to $1.88 billion in commercial mortgage-backed securities. The industry is reeling from a series of investigations and settlements that resulted in the closure of Corinthian Colleges and a 28% decline in enrollments between September 2011 and September In response, owners of for-profit campuses have shuttered entire brands and closed hundreds of locations nationwide. Formerly a tenant in collateral backing $82.3 million in CMBS loans, Corinthian, in April 2015, shut down its entire operation under an agreement with the Department of Education. Morningstar projects combined losses of about $3.2 million on two loans tied to Corinthian. The federal government has since turned its attention to the University of Phoenix and DeVry University over their marketing and recruiting practices, while state governments also have exercised their regulatory muscles. For example, the state of California, in March 2016, won a more than $1.1 billion judgment against Corinthian. Loan Losses Likely to Reach $51.8 Million Eleven loans totaling $144.7 million, or 7.7% of the loans backed by for-profit colleges, are specially serviced (displayed in Table 1), more than double the 3.7% rate of specially serviced loans for the entire CMBS universe in April. We forecast $51.8 million in losses on nine of the loans (we do not forecast a loss on the other two), including a $9.6 million loss on the $24.5 million University of Phoenix real estate owned collateral, 11.3% of CD 2005-CD1, in which the sole tenant, the University of Phoenix, vacated the three office buildings that backed the loan. The latest appraised value of $17.9 million is 60.7% less than the original 2005 appraised value of $45.5 million.

2 The University of Phoenix, which is a tenant at properties backing $241.6 million of CMBS, closed 115 locations in The university is the largest for-profit higher education institution in the U.S. and is owned by Apollo Education Group, Inc. The University of Phoenix s enrollment of 179,600 in February 2016 was less than half of its 470,800 students during its peak in For year-end 2016, enrollment is expected to decline to the 140,000 student range, according to transcribed January 2016 earnings call comments made by Greg Cappelli, Apollo s CEO, and Greg Iverson, the company s CFO. The Federal Trade Commission is investigating the University of Phoenix for alleged deceptive marketing tactics. Amid declining enrollment, Phoenix-based Apollo Education Group will be taken private by a group of investors by year-end Apollo Education Group is the sole tenant at its headquarters building on a lease that expires in 2031, which backs a $91.5 million loan in CGCMT 2015-GC29. Given the drop in performance for the University of Phoenix, the appraiser provided both an as-is value as well as a "go dark" value, which assumes the tenant vacates. The as-is appraised value of $183.0 million results in a 50% loan-to-value ratio, and the go dark value of $122 million suggests a 75% LTV. While our largest projected loss among loans exposed to for-profit colleges is $16.5 million on the $32.0 million Gateway Chula Vista II loan, the collateral s second-largest tenant, San Joaquin Valley College, Inc., remains a tenant in the southern California office property. Our projected loss on the loan has more to do with the property s history of low rents and tenants leaving than the college itself. The asset, which was foreclosed on, became real estate owned in Table 1 Specially Serviced Exposure to For-Profit College Loans Deal ID Property Name Tenant/Former Tenant Name Unpaid Balance Projected Loss WBC06C29 Gateway Chula Vista II San Joaquin Valley College, Inc CD05CDC1 University of Phoenix University of Phoenix GCC07GG9 TBC Place ITT Educational Services GSM211G5 The Hills ATI Enterprises BACM0602 GSA - Milwaukee Kaplan University BSC07P16 Rockside Road Portfolio DeVry University LBUB07C2 Rancho Las Polomas DeVry University BACM0503 High Ridge Office Complex Corinthian Colleges, Inc MSC06HQ9 University of Phoenix Building University of Phoenix TIAC07C4 Baymeadows Business Center Corinthian Colleges, Inc MLT08C01 Strayer University Strayer University Source: Morningstar Credit Ratings, LLC

3 Looming Lease Expirations Near-term lease expirations throw further uncertainty over loans with for-profit education exposure. For-profit tenants in collateral backing more than 13.8% of the loans, or $259.1 million, have leases that expire through The bulk of this exposure, $174.5 million, is concentrated in three tenants: the University of Phoenix, DeVry, and Strayer University, displayed in Table 2. Of the master-serviced loans, the $23.8 million Osprey Portfolio loan has the greatest default risk because the University of Phoenix s lease expires in July 2017, four months after the loan s maturity date. In addition, the University of Phoenix had a January 2016 lease expiration at the University of Phoenix Building, which backs a $7.0 million specially serviced loan. According to loopnet.com, an online database of listings for commercial properties, the tenant reduced its space to 34% from 98%. Although we don t project a loss, our analysis suggests an LTV of 95.2%. DeVry, a tenant backing $166.0 million of CMBS, has leases expiring in October 2016 at properties securing two loans, although neither loan matures before In April 2015, DeVry, which saw undergraduate enrollment from 2010 to 2015 plunge more than 50% to 34,524 students, announced it was closing 14 campuses in 11 cities. The university has 59 campuses remaining. In January 2016, the FTC accused DeVry of deceiving consumers with false postgraduate employment rate claims. Strayer Education Inc. ($122.6 million in CMBS), whose programs have not failed any of the government s recently implemented regulations, is a tenant in six properties with leases expiring through December The greatest risk lies with the $5.6 million specially serviced Strayer University loan because the school s lease on 71% of the Ashburn, Virginia, property expires the month before the loan s January 2018 maturity. Although Strayer has not failed the regulations, its enrollment is far from the 2010 peak, sinking to 43,000 for fall 2015 from 60,700 in fall Washington, D.C.-based Strayer operates 78 campuses across the country, following the closure of 20 campuses in

4 Table 2 Largest Exposure to Near-Term Lease Expirations Deal ID Property Name Tenant Name Property Balance % Gross Leasable Area Lease Expiration Maturity Date Specially Serviced JPC06LD John F. Kennedy Boulevard DeVry University /11/2015* 8/11/2016 No WFR12C10 Ayrsley Charleston Row DeVry University /31/ /1/2022 No LBUB07C2 Rancho Las Polomas DeVry University /30/2017 3/11/2017 Yes MSC15UB Point Boulevard DeVry University /31/ /1/2025 No CTG15G27 Reunion Park Strayer University /31/2017 1/5/2025 No WFR13C14 Heron Bay III, IV & Waterway Shoppes Strayer University /30/2015* 5/1/2023 No COM12CC2 Legacy Park Office Strayer University /14/2017 7/11/2022 No MLT08C01 Strayer University Strayer University /20/2017 1/11/2018 Yes WBC06C27 Wakefield Business Park Strayer University /30/2017 8/11/2016 No COM15C25 Briarwood One Strayer University /30/2017 8/6/2025 No JPC07L10 Osprey Portfolio (Tampa Oaks I) University Of Phoenix /31/2017 3/1/2017 No GSM210C2 Cal Twin Centre University Of Phoenix /30/2016* 11/6/2020 No JPC11C04 Enterprise Place University Of Phoenix /30/2017 6/1/2021 No MSC06HQ9 University of Phoenix Building University Of Phoenix /31/2016** 3/1/2016 Yes LSPT15LS Granite Street University Of Phoenix /30/2016 9/15/2018 No LSPT15LM Granite Street University Of Phoenix /30/2016 9/15/2018 No * The tenant continues to rent. ** The tenant reduced its space at the property. Source: Morningstar Credit Ratings, LLC Ramped Up Government Monitoring Follows Explosive Growth The intense growth the industry saw in the early 2000s began a sharp reversal a decade later following the Obama Administration s decision to impose new student-loan rules that targeted for-profit colleges. While enrollment at these schools quadrupled between 2000 and 2010, according to the National Center for Education Statistics, between September 2011 and September 2015, regulatory and legal challenges brought the numbers down by 28%, according to the National Student Clearinghouse Research Center. For-profit colleges reliance on financial aid has more strings attached. To improve transparency for students, the U.S. government has tightened its regulations and oversight. In 2015, the Department of Education released a list of colleges that are under scrutiny for financial reasons to increase accountability. The government classifies these institutions as under heightened cash monitoring. A college makes the list for a number of financial or federal compliance issues that could put restrictions on a college s ability to access federal aid. Notable for-profit institutions on the March 2016 Heightened Cash Monitoring list include campuses for Education Management Corp.-owned Art Institutes ($211.3 million in CMBS exposure), ITT Technical Institute ($110.2 million), and Career Education Corp.-owned Le Cordon Bleu ($39.2 million). 4

5 Education Management, in May 2015, said it was shuttering 15 Art Institute campuses following a more than 40% drop in enrollment to 90,000 students between Subsequently, in November 2015, it settled a nearly $100 million case to resolve long-running allegations accusing it of illegal recruiting practices. Career Education in May 2015 began closing or selling its colleges following a $10.3 million settlement in 2013 with the New York attorney general s office over allegations the company misled students with phony job placement rates. After unsuccessful sales negotiations, Career Education announced it would gradually discontinue its Le Cordon Bleu brand of cooking schools in December The company still runs its universities: Colorado Technical University and American InterContinental University. Under the U.S. government s gainful employment rules, enacted in July 2015, for-profit colleges will be at risk of losing their federal aid should a graduate s annual loan repayments exceed 20% of his or her discretionary income, or 8% of his or her total earnings. There is also legislation, known as the Court Legal Access and Student Support Act and introduced by Sen. Richard Durbin, that seeks to bar schools from using mandatory arbitration if they want to receive federal funds. If the legislation passes, students would be able to file lawsuits against their colleges in court instead of through arbitration, which critics say is usually conducted in secret and affords students fewer rights. In addition, the Obama Administration proposed to make the first two years of community college free for students who keep up a 2.5 grade point average. If enacted, this would likely draw students away from for-profit colleges and toward community colleges. No Relief Although some companies have filed for bankruptcy or been challenged by government intervention, for-profit colleges fill a niche area of education for some students that traditional colleges were either unwilling, or really unable to serve in the same way, Kevin Kinser, an associate professor at SUNY Albany, told U.S. News & World Report in an April 28, 2015, online article. Still, criticism of leaving students with loads of debt and few real job prospects weighs on the industry. As for-profit colleges continue to face governmental pressure, shrinking enrollment and profits threaten the CMBS loans with for-profit education exposure. 5

6 Table 3 For-Profit College Tenants Tenant Name Total Square Feet % Gross Leasable Area Unpaid Balance Morningstar Watchlist Balance % Morningstar Watchlist Specially Serviced Balance % Specially Serviced Apollo Group/University of Phoenix 1,052, Universal Technical Institute 559, ASA College 493, Education Management Corp. 384, Career Education 348, DeVry University 297, Bridgepoint Education Inc. 273, ITT Educational Services 230, Strayer University 216, Corinthian Colleges Inc. 211, Fashion Institute of Design & Merchandising 188, Virginia College 168, West Coast University 108, National American University 107, South College 84, ATI Enterprises 78, Mildred Elley 56, American Academy of Art 53, Vatterott College 50, Concorde Career Colleges 46, Florida Career College 37, SAE Institute of Technology 35, Harris School of Business 32, Rasmussen College 12, United Education Institute 26, Springfield College 23, San Joaquin Valley College Inc. 18, National College 16, Kaplan University 12, Kaplan College 10, Source: Morningstar Credit Ratings, LLC 6

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