WINTER 2005 by gabyion

VIEWS: 11 PAGES: 4

									®
                          The Pool Refinance
                             Loss Factor
                                                                                                            Larry Duggins



                                                                   “
                        Over the past six years, ARCap has
                                                                         Loss estimation is a central component in the
                        consistently applied the same cash


                                                                                                                          ”
                        flow-based loss methodology to             evaluation of below-investment-grade CMBS investments.
                        its commercial mortgage-backed
                        securities (CMBS) pool selection
                        and investment decisions. In 2004,          given foreseeable market conditions, the B-piece
                        that methodology has revealed a             investor can analyze property performance and relate it
        Duggins         startling increase in risk associated       directly to mortgage performance and loss estimates.
                        with     balloon    maturities.      A
    meaningful number of CMBS mortgages being                          It has become industry practice to provide potential B-
    originated today cannot refinance at maturity, if Treasury      piece investors with indicative data tapes approximately
    rates return to their 10-year averages and mortgage             six weeks prior to the public launch of a CMBS pool.
    spreads return to their 5-year averages. This article           The potential high yield investors review this
    discusses the underpinnings of ARCap’s loss                     preliminary data – approximately the same information
    methodology, examines its recent findings, and finally,         that will ultimately end up in Annex A of the prospectus
    proposes the use of the Pool Refinance Loss Factor              supplement issued in connection with the sale of
    (PRLF) as a standard component of investment-grade              the CMBS – to form indicative bids for the non-
    CMBS pool evaluation.                                           investment-grade bonds. ARCap developed an Excel-
                                                                    based model that utilizes the information on the
       Loss estimation is a central component in the                indicative data tape to estimate the potential
    evaluation of below-investment-grade CMBS invest-               performance of each mortgage.
    ments. Each B-piece investor develops a loss estimation
    methodology which in turn guides its real estate due               ARCap’s analysis begins with the issuer’s assessment
    diligence process. Some investors focus on the growth of        of normalized net cash flow for each property. Cash flow
    collateral value over time with an emphasis on market           available for debt service is calculated by dividing the
    conditions and cap rates, while others focus                    normalized net cash flow by a market level, property-
    on property level cash flows and the ability of the             type specific debt service coverage ratio. We then
    property to refinance its mortgage at maturity. The loss        calculate a “refinance interest rate” equal to the sum of
    estimation methodology allows the B-piece investor to           a “benchmark rate” of the 10-year average of the 10-year
    project the timing and severity of potential losses in the      U.S. Treasury bond at the time of the analysis plus the
    mortgage pool, which in turn allows the analysis of             “spread” which we calculate using the 5-year average of
    potential returns for the non-investment-grade bonds            spreads for similar properties in our portfolio. The
    themselves.                                                     “refinance interest rate” calculation is intended to reflect
                                                                    average market conditions as opposed to peaks or troughs
       Since its inception, ARCap has focused on cash flow          in the Treasury or mortgage markets. We then determine
    rather than value estimation as the basis for its evaluation    a refinance amortization term based on the age and
    of potential losses in CMBS pools. This bias stems from         condition of the property. Generally speaking, the model
    our conviction that cash flow methodologies are more            uses a 30-year amortization term for assets younger than
    theoretically sound from a real estate perspective              30 years old, and a “half-life” amortization for properties
    because they are directly rooted in the analysis of the         that are older. The “half-life” amortization is calculated
    operations of the individual collateral properties. Value-      by subtracting one half of the initial loan term from the
    based loss methodologies begin with cash flow analysis          initial loan amortization, i.e. a 10-year loan with a 30-year
    but then introduce “cap rate” factors which, for many of        original amortization would have a 25-year refinance
    the small markets in which CMBS loans are originated,           amortization.
    are nothing more than educated guesses by due diligence
    reviewers. By focusing on the ability of a property to              Using the cash flow, the rate and the amortization
    generate sufficient cash flow to refinance its mortgage         term, we then calculate a hypothetical “refinance


    16 CMBS WORLD™
The Pool Refinance Loss Factor (cont.)


                                                                       Chart 1: PRLF Methodology Flow Chart
                                                                                                                                                                                                     ®




      Commercial Mortgage Loan


                                                                  Year of
       Property Net                                                                     Maturity
                                 Property Type                   Property
        Cash Flow                                                                       Balance
                                                               Construction




                                                                                      Benchmark                 Spread: 5-Year
                                                              Amortization           Rate: 10-Year               Average of
      Normalized Net             Property Type
                                                             Schedule Based           Average of                 Spreads for
        Cash Flow                   DSCR
                                                             on Property Age            10-Year                    Similar
                                                                                       Treasury                   Properties




                                   Maximum
                                 Monthly Debt                                                                                        Maximum
                                    Service                     Refinance                            Refinance
                                                                                                                                   Reference Loan
                                  Payment of                   Amortization                        Interest Rate
                                                                                                                                       Amount
                                  Refinance




                                                                                                                                                      NO

                                                                                                                                                                             >
                                                  Maximum                                           Potential                                                 Maximum
                                                                          Maturity                                                     Loss of                                       Maturity
                                                  Reference                                         Refinance                                                 Refinance
                                                                          Balance                                                    Refinance?                                      Balance
                                                 Loan Amount                                          Loss                                                   Loan Amount
                                                                                                                            LOSS                      LOSS



                 Swept Loss —                                                                                                      Refinance Loss —                  Calculate Pool
                                                                          4 Months                   Adjusted
               Assume Borrower                                                                                                     Assume Borrower                   Refinance Loss
                                                  Maturity               of Servicer                 Maturity
               Will Protect Equity                                                                                                   Will Default                     Percentage
                                                  Balance                Advancing                   Balance
                                                                        with Interest               (with loss)
                                                                                                                                                                         Sum of
                  Maximum                                                                                                             Maximum                          Shortfalls
                  Refinance                                                                                                           Refinance                       Greater Than
                 Loan Amount                                                                                                         Loan Amount                    7.5% of Maturity
                                                                                                                                                                        Balance



                    Adjusted                                                                                                           Adjusted
                                                                           Shortfall                                                                                       Cut-Off
                    Maturity                                                                                                           Maturity
                                                                         Percentage?                                                                                        Pool
                    Balance                                                                                                            Balance
                                                                                                                                                                           Balance
                   (with loss)                                                                                                        (with loss)




                   Shortfall                                                                                                          Shortfall
                                                                                                                                                                          Pool
                  within 7.5%                                                                                                       Greater Than
                                                                                                                                                                     Refinance Loss
                  of Maturity                                                                                                         7.5% of
                                                                                                                                                                      Percentage
                   Balance                                                                                                         Maturity Balance

                                                                 Source: ARCap REIT, Inc.




amount” for each loan which is compared to the loan                                                          The remaining losses generated by each loan are then
balance at the test date (usually loan maturity). If the                                                  totaled to calculate the percentage of the total pool which
refinance amount exceeds the loan balance at the test                                                     we anticipate losing at refinance. This methodology
date, we assume there is no loss on that loan. If the                                                     yields a single data point, the PRLF, which measures the
refinance amount is less than the balance at the test date,                                               relative refinance risk of two or more pools. Additionally,
we assume that the servicer advances for four payments                                                    we run sensitivity analyses in which we reduce the
and then liquidates the loan at the refinance amount,                                                     issuer’s cash flow by 5% and 7.5%, which obviously
with the difference being recognized as a loss. If the                                                    increases the loss percentage. Essentially, the model
refinance amount is less than the balance at the test date,                                               tests the ability of properties to refinance their associated
but the shortfall is within 7.5% of the original balance, we                                              mortgages if Treasury rates and mortgage spreads revert
remove the loss from the calculation based on the                                                         to the mean. The model assumes that cash flows are
assumption that the borrower will protect his equity at                                                   normalized and remain constant, recognizing neither
that time.                                                                                                revenue growth nor expense inflation over time.


                                                                                                                                                                            WINTER 2005         17
    The Pool Refinance Loss Factor (cont.)


                                                                                       Chart 2: PRLF for Q1-Q3 2004 CMBS Conduit Transactions
®



                                       0.06


                                       0.05
         Pool Refinance Loss Factor




                                       0.04


                                       0.03


                                       0.02


                                       0.01


                                          0
                                                   4   8 4    1 3 8 1         5 2 7        3   2 1 9 1 1        3 2 1       2 3     2 1 1 -2 -1 4 2 Y2 3            2 4     0 1      6 -3 1 1 A A 2
                                                -T1 -IQ WR 4-C -T1 -CB 4-C -T1 4-C -IQ WR 4-C NC -CB 4-C 4-C 4-C -LN -GG -GG 4-C 4-C KB 4-C 04 04 4-C 4-C KE -HQ 4-C -C1 -C1 4-C 4-C 04 4-C 4-C B3 B2 -C1
                                             04 004 4-P 00 004 04 00 004 00 004 4-P 00 4-P 04 00 00 00 004 04 04 00 00 4-M 00 20 20 00 00 04- 04 00 04 04 00 00 20 00 00 04-L 04-L 04
                                             20   2 00 B 2 2 20 C 2 2 C 2 2 00 B 2 00 20 S 2 C 2 B 2 2 20 20 C 2 C 2 00 T 2 M M S 2 C 2 20 20 S 2 20 20 T 2 S 2 M C 2 S 2 20 20 20
                                           S SC 2       S SC C C SC C SC 2              S 2 C B M        S C C       S M M 2 M AC AC B C T C                 B   T   T M B AC C M                  T
                                         CM M MS CF M MC JPM M JPM M MS CF CC MC LBU EC CF PMC CCF SM EC EC MT BC B B LBU MA LM MS LBU BCM BCM GC LBU B MA GS MM MM BCM
                                      BS       SC          JP                    SC    JP
                                                                                          M JP     G      J G     G G      G L W
                                                                                                                             M
                                                                                                                                                G M           W W      C           G     CO CO W
                                             B                                 B

                                                  Sources: Trepp, LLC; Bloomberg; ARCap REIT, Inc.




                                                                   Chart 3: PRLF and AAA Subordination Levels for Q1-Q3 2004 CMBS Conduit Transactions



                                      0.17
                                      0.16
                                      0.15
                                      0.14
                                      0.13
                                      0.12
                                      0.11
                                      0.10
                                      0.09
                                      0.08
                                      0.07
                                      0.06
                                      0.05
                                      0.04
                                      0.03
                                      0.02
                                      0.01
                                         0
                                            4  8 4    1 3 8 1     5 2 7 R3 C2 C1 B9 C1 C1 C3 N2 G1 G2 C3 C2 B1 C1 -2 -1 C4 C2           2 3  2 4 10 C1 C6 -3 C1 C1 3A 2A 12
                                          T1 IQ R -C T1 B -C T1 -C IQ              -     -  -  -            -  -      -   4   4 -   -  Y Q -C 1        -  -  4 -   -
                                        4- 4- PW 04 4- 4-C 04 4- 04 4- PW 04 -PN 4-C 04 04 04 4-L 4-G 4-G 04 04 MK 04 00 00 04 04 -KE 4-H 04 4-C 4-C 04 04 00 04 04 -LB -LB 4-C
                                    2 00 200 04- 20 200 00 20 200 20 200 04- 20 04 00 20 20 20 200 00 00 20 20 04- 20 M 2 M 2 20 20 04 00 20 00 00 20 20 M 2 20 20 004 004 00
                                   S SC 20 SB SC C 2 CC SC CC SC 20 SB 20 C 2 BS MC SB C C 2 S 2 MC MC 20 MT AC AC BS CC 20 C 2 BS T 2 T 2 MT BS AC CC MS 2 2 T 2
                                 CM M MS CF M MC JPM M JPM M MS CF CC MC LBU EC CF PMC CCF SM EC EC MT BC B B LBU MA LMT MS LBU BCM BCM GC LBU B MA GS MM MM BCM
                              BS          C        JP                  C
                                                                            JP
                                                                               M JP   G     J G    G G   G L W                G M        W W    C          G   CO CO W
                                       BS                           BS                                     M

                                                                                           Pool Refinance Loss Factor           Subordination % to AAA at Issuance

                                                  Sources: Trepp, LLC; Bloomberg; ARCap REIT, Inc.




       A confluence of factors occurred in 2004 that has                                                                  investor competition has dramatically increased,
    resulted in the origination of a significant number of                                                                reducing the ability of individual B-piece investors to
    high leverage loans with low coupons and minimal                                                                      influence credit standards. The PRLF clearly illustrates
    reserves. Competition among mortgage originators is                                                                   the impact of this deterioration of credit standards.
    fierce, with competitive pressures adversely affecting
    credit quality. In addition, the rating agencies have                                                                    Chart 2 illustrates the PRLF for CMBS issues placed
    moved to bring ratings parity to fixed income products,                                                               during the first three quarters of 2004. The outcomes
    thereby reducing subordination levels. Finally, B-piece                                                               range from a low of 0% for the BSCMS 2004-TOP14 to


    18 CMBS WORLD™
The Pool Refinance Loss Factor (cont.)

                                                               associated with CMBS, increasing the amplitude of


“      A review of the outcomes for the first three
             quarters of 2004 . . . seems to imply that
        significant refinance risks are not being
                                                               future real estate cycles with CMBS investors taking the
                                                               brunt of the losses. However, by using simple tools like
                                                               the Pool Refinance Loss Factor to uncover hidden risks,
                                                               investment-grade investors can direct the fundamental
                                                                                                                             ®




                                                      ”
                 addressed in AAA subordination levels.        credit quality in CMBS, reintroducing adherence to
                                                               common sense underwriting. Mortgage originators,
                                                               reacting as they must to their competitive environment,
5.23% for the WBCMT 2004-C12. The PRLF indicates               are driven to reflect the minimum standards of the
that the risk of refinance loss in the WBCMT 2004-C12          investment community. Their borrower-clients will
is substantially greater that of the BSCMS 2004-TOP14.         absorb as many concessions as they are offered until
Of course, additional due diligence would be necessary         they are stopped by the investors who are the ultimate
to incorporate other factors which might reduce the            owners of their mortgages. It is time for investment-
projected loss for WBCMT 2004-C12 or increase the              grade CMBS investors to raise the bar. ❑
projected loss for BSCMS 2004-TOP14 before an actual
investment decision was made. It is critical to recognize
that the PRLF only addresses refinancing risks and does        Larry Duggins is President and Chief Operating Officer of
not incorporate other elements of credit risk. A pool          ARCap REIT, Inc. The author gives special thanks to Timothy
with a low PRLF may have other serious credit-related          Riddiough, Ph.D., E.J. Plesko Chair of Real Estate and
issues and vice versa.                                         Urban Land Economics, University of Wisconsin, for his
                                                               comments; and Kyle McGlothlin, Steve Carnes and Ryan
   A comparison of the AAA subordination levels for            Stephens of ARCap for their analytical contributions.
those issues indicates 12.13% for the BSCMS 2004-              ARCap’s Pool Refinance Loss Factor model may be
TOP14 and 13.38% for the WBCMT 2004-C12, which                 downloaded without charge from www.arcap.com.
does not seem to be an adequate recognition of the
additional refinance risk. Chart 3 further illustrates this
observation by overlaying AAA subordination levels on
the PRLF data from Chart 2. The expected outcome of
increased subordination levels for pools with greater
refinance risk does not occur.

    More CMBS issues will have to pass through their
complete life cycles to generate a data set that is
sufficiently complete to empirically test the statistical
predictive value of the PRLF. A review of the outcomes
for the first three quarters of 2004, however, seems to
imply that significant refinance risks are not being
addressed in AAA subordination levels. Further, this
predictive tool is indicating the possibility of pool losses
substantially higher than those implied by the widely
circulated historical default and loss severity studies.
Investment-grade CMBS investors can easily implement
the tool as one of their evaluation criteria in their
discussions of CMBS offerings.

   Our conclusion is caveat emptor. Investment-grade
CMBS investors can never forget that mortgages and
real estate support the bonds in which they invest. Such
investors are ultimately responsible for maintaining
the credit quality of their investments by rejecting
the offerings of issuers whose aggressive lending
approach may adversely affect that credit quality. That
responsibility cannot be shirked to the ratings agencies
or the B-piece investors, who each face their own
competitive dynamics. The combination of unrestrained
competition and declining subordination could
meaningfully reduce the real estate market discipline


                                                                                                        WINTER 2005    19

								
To top