Methodology. CMBS North American Surveillance

Transcription

1 Methodology CMBS North American Surveillance january 2015

2 CONTACT INFORMATION Chase Purdom Assistant Vice President Erin Stafford Managing Director, Global CMBS Mary Jane Potthoff Managing Director, Global CMBS DBRS is a full-service credit rating agency established in Privately owned and operated without affiliation to any financial institution, DBRS is respected for its independent, third-party evaluations of corporate and government issues, spanning North America, Europe and Asia. DBRS s extensive coverage of securitizations and structured finance transactions solidifies our standing as a leading provider of comprehensive, in-depth credit analysis. All DBRS ratings and research are available in hard-copy format and electronically on Bloomberg and at DBRS.com, our lead delivery tool for organized, Web-based, up-to-the-minute information. We remain committed to continuously refining our expertise in the analysis of credit quality and are dedicated to maintaining objective and credible opinions within the global financial marketplace.

3 CMBS North American Surveillance TABLE OF CONTENTS Scope and Limitations 4 Introduction 4 Application of CMBS Surveillance Methodology 4 Specific to Non-Performing Loan Liquidating Trusts 5 CMBS Surveillance 5 Monthly Review 5 Bond-Level Review 5 Collateral-Level Review 6 In-Depth Reviews and Rating Actions 7 Collateral (Loan-Level) Surveillance 7 Property Types Review 8 Liquidation Scenario 9 Model and Recommendations 9 Large/Single Borrower Commercial Mortgage Loans 10 3

4 Scope and Limitations DBRS evaluates both qualitative and quantitative factors when monitoring structured finance transactions. This methodology represents the current DBRS approach to monitoring North American commercial mortgage-backed securities (CMBS) ratings. It describes the DBRS approach to analysis, which includes (1) analysis of the bonds and (2) evaluation of the collateral providing security for the bonds. It is important to note that the methods described herein may not be applicable in all cases. Further, this methodology is meant to provide guidance regarding the DBRS methods used in the sector and should not be interpreted with formulaic inflexibility, but understood in the context of the dynamic environment in which it is intended to be applied. Introduction The collateral underlying CMBS transactions is dynamic. A variety of events can affect the collateral of a CMBS pool and the cash flow necessary to ensure timely and ultimate payment of CMBS bonds. During the life of a transaction, many changes may occur: loans can perform as expected, go delinquent, take losses, defease or prepay; at the property level, tenants may renew their leases or vacate; markets may improve or soften; and property values may increase or decrease. When initially establishing a rating, DBRS assumes that changes in the performance of the underlying loans can and do occur; therefore, it assigns ratings designed to withstand a certain level of volatility within the underlying commercial mortgage loans. Surveillance is critical to measuring and communicating to the investment community whether or not a change has occurred outside the original expectations that has the potential to affect the ratings assigned to the bonds. The magnitude of the changes with each property and each loan and the loan s relation to the other loans in a transaction can determine whether or not a rating action is necessary. This methodology details DBRS s surveillance procedures as they relate to all CMBS rated by DBRS (inclusive of public ratings, private ratings and CMBS collateral contributed to asset-backed commercial paper, CMBS resecuritizations or resecuritizations of real estate mortgage investment conduits (ReREMICs), non-performing loan liquidating trusts and collateralized debt obligations (CDOs)) and describes the analysis taken to arrive at any rating actions arising from the surveillance. This methodology gives the reader greater clarity into the DBRS CMBS surveillance philosophy. This methodology should be read in conjunction with DBRS s CMBS Rating Methodology and its Rating North American Commercial Real Estate Non-Performing Loan Liquidating Trusts methodology for a cumulative representation of the processes behind DBRS s analysis. DBRS expects its ratings to hold throughout a cycle; however, DBRS is committed to performing surveillance and releasing surveillance reports at a level that increases the transparency of its ratings. APPLICATION OF CMBS SURVEILLANCE METHODOLOGY The following diagram describes the overall process to analyze a CMBS surveillance transaction: (1) DBRS usually conducts loan and property-level analysis. (2) DBRS typically uses the results from the portfolio and loan-level analysis as inputs into the CMBS model. The resulting number provides the base credit enhancement. 4 (3) Reference to legal summaries or documents that govern the transaction may be undertaken and consideration of any qualitative factors is made; if necessary, DBRS may undertake a more thorough legal review.

5 (4) The final credit enhancement levels are frequently compared with a liquidation scenario (if applicable) and a final rating action is determined. The CMBS model is generally a substantial component of the DBRS surveillance process. A material deviation from the rating implied by the CMBS model would be a three-notch or more rating difference. The quantitative and qualitative factors that could result in a material deviation are included in this methodology. SPECIFIC TO NON-PERFORMING LOAN LIQUIDATING TRUSTS The process of each review follows the Rating North American Commercial Real Estate Non-Performing Loan Liquidating Trusts methodology. In addition, the ongoing surveillance also measures the performance of the servicer in terms of its liquidation timing and recovered liquidation proceeds. Performance in terms of these two metrics is used to recalibrate and reassess the DBRS non-performing loans (NPL) model to provide more realistic views of the structure s future performance. Additionally, the review focuses on the performance of the remaining assets. DBRS expects the collaterallevel performance to be much more volatile than regular performing loans and measures whether cash flow may be deteriorating faster than assumed at issuance. It is also possible that cash flow increases at some of the properties. Ongoing loan performance is used to recalibrate and reassess the DBRS NPL model to provide a more realistic view of the future performance of the structure. Surveillance activities provide a continuous feedback loop to DBRS rating methodologies. Performance metrics revealed in the surveillance process that may affect or challenge the premise of this methodology are considered and evaluated in a timely manner. CMBS Surveillance MONTHLY REVIEW Each month, DBRS performs a review of its entire CMBS portfolio for changes. There are some changes that occur in CMBS transactions monthly for which DBRS receives advance information, such as new defeasances, loan assumptions and/or loan modifications for large assets. DBRS needs to review any changes in delinquencies when the remittance report is made available. Every month, DBRS reviews changes that occur at both the bond level and the collateral level. In some instances, these changes prompt additional steps that DBRS takes to monitor the transaction. Changes that directly affect the bonds and need to be addressed immediately generally include losses, classes paid in full and interest shortfalls to a rated class. Since each transaction is monitored monthly, none of these changes should be a surprise; however, each has different consequences as it occurs. The results of DBRS s monthly review are published in the monthly CMBS surveillance reports, which can be found at under Monthly Reports. In the case of CMBS resecuritizations or ReREMICs, DBRS reviews each transaction remittance report and capital structure on a monthly basis. The monthly review for ReREMICs confirms that interest shortfalls on the underlying CMBS have not reached a level that may increase sensitivity to the ReREMIC structure, and further, ensures that losses on the underlying CMBS have not occurred that fall outside the expectation in the DBRS-simulated loss and liquidation scenario at the last ratings action for the respective ReREMIC transaction. 5

6 BOND-LEVEL REVIEW Losses Losses occur as specially serviced assets are resolved and sold from the pool. Losses erode credit enhancement. As losses occur, DBRS reviews the actual loss compared with the DBRS model estimated loss. If the actual loss is greater than anticipated, it may lead to a detailed review of the transaction. Classes Paid in Full As classes are repaid in full, DBRS discontinues the ratings in its ratings database and on the website. The ratings for the class are then designated as Discontinued Repaid. Interest Shortfalls Interest shortfalls most commonly occur when the full monthly payment on an underlying loan is not being advanced. Interest shortfalls can also occur as special servicers recoup fees or appraisal subordinate entitlement reduction interest is recovered upon loan liquidation. If interest shortfalls occur on a rated class, DBRS assigns an Interest in Arrears designation to the affected class(s). COLLATERAL-LEVEL REVIEW Changes that affect the collateral and ultimately the bond performance are also monitored monthly. Delinquencies and Specially Serviced Loans Changes in delinquencies and specially serviced loans are scrutinized. Every month, DBRS reviews the loan-level data, such as the CRE Finance Council (CREFC) Investor Reporting Package (IRP) delinquent loan status report, to determine any changes in the status of specially serviced loans. If new delinquencies appear, DBRS typically wants to know more about these loans and whether the borrower has been contacted. To ascertain more information on the specially serviced loans status, DBRS may contact the special servicer or the 17g-5 Information Provider directly for further information. Prepayments and Defeasance Prepayments and defeasance are mostly considered credit positive and/or neutral to a CMBS transaction. While prepayments may be credit neutral, there is the potential for adverse selection with respect to prepayments. For sequential-pay transactions, prepayments cause the credit enhancement to increase for the existing bonds, which may mitigate the potential for adverse selection as a result of prepayments. In addition, when a loan is defeased or when the existing mortgaged property collateral is replaced with government securities, this effectively matches the risk profile of the loan to that of the sovereign rating of the related government entity. Watchlist Changes and Additions Loans move on or off servicer watchlists when a loan meets or no longer meets certain criteria identified in the CREFC IRP. The criteria were established as a guideline to highlight loans that may have a higher likelihood of default. DBRS reviews the pivotal watchlisted loans and the servicer commentary on the watchlist on a monthly basis to understand the risks associated with the loan performance. Some loans have concerns that can be mitigated with external research and others are legitimate concerns that may result in further investigation. Loans are placed on the watchlist generally based on the CREFC IRP standards/criteria or for reasons otherwise defined in the transaction documents. Loan-Level Financial Review DBRS also generally looks at the financial reporting of a transaction monthly. If DBRS is awaiting financials to complete a deal review or if financials reveal large variances (both positive and negative), it may prompt more investigation at the loan level. 6 After all the monthly bond and collateral reviews are completed, the portfolio is usually assessed and in-depth reviews and surveillance reports are completed as necessary. If no significant changes in collateral are observed in the monthly review, DBRS typically conducts an in-depth review of all its rated transactions in accordance with DBRS policies.

7 IN-DEPTH REVIEWS AND RATING ACTIONS As mentioned above, typically each month, all DBRS-rated CMBS transactions are reviewed for statistical changes and cumulative credit evolution. Following the monthly review of the portfolio, a full review process may be accelerated on a transaction when there are significant changes in the collateral (as highlighted in the above collateral-level review process). Because of concentrations within CMBS transactions, DBRS usually considers the cumulative impact on small loans as well as the changing credit dynamics on large loans. Upon initiation of an in-depth review, each of the 15 largest loans and a pool s troubled loans are subject to further analysis. Troubled loans are identified as those that are delinquent, in special servicing and/or those perceived by DBRS to have a higher likelihood of default. In the surveillance process, DBRS analysts have the ability to identify additional loans of concern that may not specifically fall into the delinquent or special servicing bucket or be on the servicer s watchlist but nonetheless remain pivotal loans with potential credit risk. Examples of this credit risk may include a substantial change in the property-level net cash flow, a substantial change in the property-level occupancy rate, etc. The pool is then re-modeled to account for all changes to its collateral and financial performance. During the in-depth review process, changes to the ratings may be recommended. The CMBS structure allows for interest shortfalls; as such, there are classes of CMBS where interest payments are in arrears but the cumulative or ongoing shortfall is expected to be ultimately recoverable or paid. When there is an interest shortfall, DBRS notes this with the Interest in Arrears designation for the class affected. In addition, ratings can be placed Under Review with Negative, Positive or Developing Implications or trends can be added or changed. Classes within transactions are generally placed Under Review when something occurs that would change the credit makeup of a pool in one direction or the other. DBRS typically keeps a class Under Review until more information becomes available to determine the magnitude of the action needed. A rating typically maintains the Under Review status for only a short period of time as information gaps are often waiting to be filled by the servicer. CMBS uses Positive, Negative and Stable trends to indicate a change in the credit dynamics of the pool that are not significant enough to warrant a rating action. For example, there may be a situation where a particular CMBS transaction has significant exposure to loans secured by properties with a common single tenant, which, at the company level, is under stress. In that situation, there would be an increased likelihood of future property performance volatility for the properties occupied by that particular tenant. The uncertainty surrounding the tenant and the increased volatility, given the exposure level within a CMBS transaction, may lead to a Negative trend on certain bond classes within the respective transaction. COLLATERAL (LOAN-LEVEL) SURVEILLANCE Collateral surveillance includes loan-level surveillance and modeling. Focus is placed on property analytics, with a review of the property s rent roll, operating statements and servicer site inspections. Cash flow is further analyzed by scrutinizing revenue and expenses and looking at voluntary versus involuntary expenses. Each property is assigned a DBRS cash flow, which is stressed and subject to a general haircut, and in some instances, DBRS re-underwriting. Term Risk Certain risks associated with commercial mortgage loans are more relevant over the loan term as opposed to the time of loan maturity. The CREFC IRP servicer watchlist guidelines outline the most common term risks for commercial mortgage loans. The criteria in the CREFC IRP watchlist guidelines are focused on financial conditions, borrower issues, property condition issues and lease rollover/tenant issues/vacancy. More information on the common issues associated with each of these respective guideline categories can be found in the servicer watchlist triggers in the CREFC IRP. 7

8 Balloon Risk It is important to monitor liquidity near a loan s maturity date because, at any given time, the availability of capital differs based on the property type and a property s location. Balloon defaults and extensions may occur more often if there is a lack of lenders in the area. Further, market dynamics could have changed throughout the loan term and interest rates may have risen. Loans that do default are likely to have greater losses because there are fewer participants in less efficient markets. As the loan s maturity date nears, DBRS adjusts refinance constants based on what interest rates are available in the market. If current market constants are higher than what the loan is currently paying, the loan could have difficulty refinancing. Loans that may have a higher propensity to default or extend at balloon include loans with a refinance debt service coverage ratio (DSCR) below 1.0 times (x) loans with large lease expirations prior to the maturity or shortly thereafter, interest-only loans and loans with lower DSCRs secured by properties located in rural and tertiary markets. PROPERTY TYPES REVIEW When analyzing the dynamics of each loan, one must consider the property that secures it and the nuances associated with each property type. Because of the terms of their leases, some properties are viewed as more stable than others. For example, an office building with five- to ten-year leases is going to have more predictable revenue than a hotel that rents rooms daily. While a hotel may have a more volatile cash flow, it can adjust more rapidly for market rate increases and decreases. For this reason, we highlight some of the credit concerns that our analysts are reviewing when doing analysis of the loans within a CMBS transaction. Superior locations clearly help a property perform even in soft markets. In addition to the location of the asset and market conditions, there are several unique attributes to each property type that DBRS considers. Office Above-market leases that roll within the term or shortly after loan maturity. Tenant improvement and leasing commission reserves sufficient for re-leasing. Master leasing. Location. Industrial Functionality and clear height, including specialized improvements, loading facilities and truck turnaround radius. Leases rolling within the term and relation to market. Office build-out and flex space. Location. Retail Sales of the anchor tenants and in-line space. Co-tenancy clauses. Competition in the market from major discounters. Location in relation to residential and high-traffic nodes. Multifamily Concessions offered at the property. Affordability of housing in immediate area and replacement costs. Employment diversity and trends in the area. Location. Other property types that are often in CMBS transactions include manufactured housing communities, hotels, self-storage units and even some health-care and retirement communities. These are all considered individually as performance can fluctuate if the property has seasonality issues or high tenant turnover. 8

9 For more information on how DBRS analyzes different property types, please refer to DBRS s CMBS Rating Methodology and the Rating North American Commercial Real Estate Non-Performing Loan Liquidating Trusts methodology. LIQUIDATION SCENARIO A key component of the in-depth review process is the concept of a liquidation scenario. With each in-depth review, surveillance analysts simulate a liquidation and loss scenario for delinquent and specially serviced loans where a loss to the trust is anticipated. To arrive at a property value to be used in these scenarios, analysts are informed by either the most recent property valuation or a recent net cash flow against a stressed cap rate. In both instances, a further discount is applied to the value. Specially serviced loans in North American CMBS are typically bound to annual valuations. For the purposes of quantifying the loan exposure, DBRS incorporates the outstanding principal balance of the loan, a liquidation fee as defined by the respective transaction s pooling and servicing agreement, any outstanding advances and related fees as well as an estimation of potential future expenses that may be incurred between the time of the DBRS-simulated liquidation and the actual loan liquidation. The analyst then looks at the differential between the DBRS-simulated total loan exposure and the stressed value, with the difference between the two being the simulated realized loss to the trust. The value assigned in the liquidation scenario, less the liquidation fee, outstanding fees and advances as well as future anticipated expenses, is looked at as the proceeds to the trust upon liquidation. The resulting cumulative simulated losses, for all loans subject to the liquidation scenario, are run through the current capital structure in reverse sequential order. At the same time, the cumulative proceeds to the trust upon liquidation in the DBRS liquidation scenario are run through the current capital structure in sequential order. The resulting bond balances are considered to be the DBRS liquidation scenario bond balances, which are then used to calculate the liquidation scenario credit enhancement at each respective bond class. These liquidated credit enhancement levels are what the DBRS model output is compared with when making rating action recommendations. MODEL AND RECOMMENDATIONS After all the analysis is complete, DBRS runs the CMBS model and compares the output with the liquidation scenario and the DBRS liquidated credit enhancement of each of the classes within the transaction. Rating Agency Conditions As mentioned earlier, the portfolio of loans securing the CMBS transactions have proven to be very dynamic. A rating agency condition (RAC) is often requested when there is a material change in a pool s assets or in the transaction s participants. The RAC is a review undertaken by the rating agency to ensure that such changes do not affect the creditworthiness of the pool as a whole. RAC requests typically reflect changes that occur at both the trust and the loan levels, such as substitution of the special or master servicer; changes to material legal documents; additional indebtedness; loan assumptions; defeasance, collateral substitution, re-lease or redevelopment; property management changes; and changes in franchise affiliations (flags) of hotel properties. DBRS believes that ratings initially assigned to CMBS must reflect the possibility of changes in collateral that may be allowed for in the borrower s loan documents and of which DBRS receives notification. Each type of RAC request requires a specific methodology to determine whether or not the change would, in and of itself, cause a downgrade to the trust. 9

10 RACs are generally limited to significant loans as defined by an individual transaction s legal documents. This most commonly refers to the loans that are greater than 5% of the trust and/or $20 million or more. DBRS generally contemplates waivers of RACs where transaction documents allow. DBRS does not waive RACs that affect any party involved in the operational risk of the transaction (i.e., replacement of special servicer, master servicer, etc.). Upon receipt of a loan assumption or modification RAC request, DBRS considers whether the change weakens, strengthens or is neutral to the subject collateral, the property management, the borrower, the guarantee on the loan and/or the financial viability of the loan. In addition, all legal documents attached to the request and the case memo provided by the servicer or special servicer must be sound. An RAC request satisfactory to the rating agency results in the issuance of a no-downgrade letter to the master servicer, stating that the change does not, in and of itself, result in a downgrade, withdrawal or qualification to the ratings of the certificates. In this way, the RAC provides a check against the variety of changes that affect a pool s underlying assets and/or a guarantee that the current bond ratings remain relevant. Generally, DBRS finds that the credit work presented by the servicers is thorough and sufficient since the servicer is also working for the benefit of all bondholders when consenting to these requests. LARGE/SINGLE BORROWER COMMERCIAL MORTGAGE LOANS When initially establishing a rating on a large/single asset commercial mortgage loan, DBRS assumes that changes in the performance of the subject property can and do occur; therefore, the rating assigned can withstand a certain level of volatility. DBRS expects its rating to hold throughout the term of the mortgage loan; however, the mortgage loan and the performance of the underlying asset are subject to surveillance. In accordance with DBRS policies, DBRS undertakes an in-depth review of the rating assigned. As part of this process, DBRS s analysts source and receive performance documents including, but not limited to, most recent audited annual and unaudited interim financial statements of the subject property, current rent rolls, copies of current certificate of insurance, property tax payments, mortgage loan status and third-party real estate market studies. Current asset performance is then compared with DBRS s initial underwriting of the loan and direct sizing results. 10

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