During the past year, The U.S. economy improved dramatically leading to a rebound in commercial real estate valuations. Improving fundamentals reduced concerns that defaults might reach catastrophic levels, and as a result, the Barclays CMBS (Commercial Mortgage Backed Securities) Index rallied sharply, generating a total return of 20.4% in 2010. Despite the strong performance and improved fundamentals, many maturing loans are encountering difficulty being refinanced. In 2010, we saw issuance of a mere $10 billion, which refinanced only half the loans maturing during the year. Due to shoddy underwriting and poor performance, many loans did not meet the criteria to be refinanced and will have to be either liquidated or modified.
There are $138 billion in commercial loans that are set to mature over the next three years. Table 1 displays these loans by year of origination. About 50% of the loans maturing between 2011 and 2013 were originated after 2005. While the loans originated before 2005 are finding it easier to refinance, loans originated after 2005 are finding it difficult to refinance due to optimistic pro forma underwriting, high loan to values (LTVs) and the prevalence of 5-year interest only loans. In addition, approximately 9% of the CMBS market is comprised of non-performing loans that will need to be worked out in a similar fashion to the loans coming due. These non-performing and maturing loans will be likely candidates to be liquidated or modified since refinancing is not likely to be an option.
Foreclosing and liquidating commercial properties in a market where refinancing is hard to obtain leads to distressed prices and larger losses. In comparison, loan modification can buy time for the borrower to improve the performance of the property, and for market valuations to rise, thereby mitigating losses. Loan modifications have been positive for the CMBS market with about 85% of loans modified since 2001 paying off in full. This is unlike the residential mortgage backed securities market, where loan modification has proved to be ineffective. Therefore, we expect that many more servicers will choose to modify maturing and delinquent loans as opposed to liquidate them in the open market.
A loan modification is a change in the terms of a loan. This strategy is used to ensure a borrower continues to be able to pay monthly principal and interest. Loan modification can be a change of one or more terms of a loan. The most popular method of modification has been the extension of the maturity date, followed by interest rate reduction, change in the amortization term, principal reduction, and, in some cases, a combination of these methods are employed.
Charts 1 and 2 show the modification methods used between 2001 and 2005 (Chart 1), and between 2006 and 2010 (Chart 2) as a percentage of all modifications in the CMBS space.
According to Standard &Poor’s, since the year 2000, 629 loans have been modified, which constitutes about 4.2% of the CMBS universe. Modification volume has nearly tripled since 2006 to almost $29 billion and with almost $16 billion modified in 2010 alone. The composition of the loan modification terms have also changed. In Chart 1, maturity date extension used to be the main source of modification prior to 2006, with about 64% of the maturing loans being modified using maturity date extensions only. This number has decreased to 42%, even though the actual volume for the loans that had maturity date extensions has risen to $12 billion. Servicers are more aggressively using multiple modification strategies to mitigate losses since simply lengthening the loan terms has not been enough to keep loans current and prevent them from defaulting. Rather than maturity extensions, these charts reflect that the extensions are being deemphasized, with a change in amortization term making up about 13% of modifications since 2006 compared to 3% between 2001-2005. Generally, loans with an LTV of less than 100% are offered maturity extensions, while loans with low debt service coverage ratios are offered interest rate reductions. Only loans with very high LTVs are being offered principal reduction.
Liquidations and modifications have a significant impact on the cash flows of CMBS securities. If distressed properties are liquidated, principal will be received earlier than anticipated, shortening the average lives of the bonds, while modifications delay the receipt of principal, thereby, lengthening the average lives of the bonds. With most of the CMBS universe trading at a premium, the evaluation of the disposition of these distressed loans will significantly impact the cash flows and the inherent valuation of these securities. To further complicate matters most of these distressed loans are larger in size and make up a significant portion of the 2005 and latter vintage securitizations. The change in terms of these loans will cause an even greater variance in the average lives of the bonds than smaller loans. For these reasons, we prefer seasoned securities issued before 2005 and the last cash flow senior bonds that are less susceptible to variance in cash flows due to liquidations and modifications of the distressed loans.
The CMBS market will benefit overall from the increased funding availability from the reemergence of the securitization market, but will also benefit from increased loan modifications as a means of mitigating losses. Given the positive track records of loans that have been modified to date with 85% of loans paying off without a loss to the investors, the servicers will aggressively use loan modifications and will employ multiple strategies to keep loans current. Thus, the interpretation of strategies used by the servicers and the timing of such modifications will be pivotal in bond valuations and trading decisions.
1 “U.S. CMBS Loan Modifications Reached An All-Time High In 2010,” U.S. CMBS Loan Modifications Reached An All-Time High In 2010, Standard and Poors, January 4, 2011, Page 9; Website, January 18, 2011.
Structured Products Analyst
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