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 cites as red flags in the quickly evolving revival of the CMBS market.
In a report released earlier this week, Standard & Poor’s 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 characterised 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, S&P wrote.
“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.
Most of the loans flagged by S&P have leasing/occupancy issues. For instance, a loan on the Promenade Shops at Aventura, outside of Miami, was in the JPMCC 2010-C2 CMBS transaction, and the property appraisal reflects a so-called “stabilised value”, meaning that the appraisal utilised certain assumptions about future income, rather than realistic “as-is” value.
In the case of Promenade Shops, though a lease was in place at closing for a tenant, Nordstrom Rack, the space was vacant at closing, and no rent was payable until the property was occupied. “While scenarios like this are perhaps not ideal, they are less risky, in our opinion, than scenarios in which loans assume significant increases in rents or occupancy during their term, as was the case with many pro forma loans that were underwritten during the peak years,” Manzi wrote.
S&P also noted that several 2011-vintage CMBS deals include lodging, or hotel loans, in their top 10 loans. The sector is generally considered less stable than the other core commercial property types, primarily because hotels reset their room prices daily.
But what is more troubling is a structural twist that S&P cites on a hotel loan (Marriott Crystal Gateway in Crystal City, Virginia) within the DBUBS 2011-LC1 CMBS transaction relating to a so-called “incentive management fee” due to Marriott.
Term-sheet details for the transaction show that the fee to Marriott was senior to the so-called debt service payment to the lender, which is highly unusual, S&P says, and “will take a significant chunk from net cash flow when it happens”, the analysts wrote. “As such, one would need to assume a significant increase in revenue per available (hotel) room (known as ’RevPAR’) to offset it.”
Manzi said that in S&P’s estimate, the hotel’s average daily room rate would need to increase approximately 30% to maintain the most recent trailing-12-month net cash flow, assuming the fee increase happened today.
The rating agency also noted there have been 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 an increase in deal structure complexity, as measured by the number of bond classes per transaction.
Adam Tempkin