Investors in CMBS tend to focus on the top 10 loans in CMBS pools, as these loans tend to comprise in excess of 50% of the principal balance of a CMBS issue, and therefore, they would have the largest impact in the event of default. In general, though, the top 10 loans are higher quality and better underwritten relative to the rest of the pool.
CMBS investors should consider looking deeper into the next 10 largest loans (which combined with the top 10 loans typically represent 75%-80% of the total loans in a CMBS issue), according to a recent report from the rating agency Kroll. The report suggests the credit quality of the next 10 is slipping more rapidly than the bigger loans that tend to get all the attention.
The report notes gradual deterioration over the past year in underwriting standards for the 20 largest loans in Kroll-rated transactions. And it finds that the trend is more pronounced at the lower end of that range, which has always tended to be of lesser quality than collateral in the first tier. The agency says careful scrutiny of the 10 biggest loans “can mask credit creep” among mortgages ranked 11th to 20th by initial balance.
“When we evaluate CMBS issues for possible acquisition to add to Country Bank’s CMBS portfolio, we look at the top 20 loans as well as a sample of the balance of the loans,” commented Jim Brett, head of CMBS analytics at ValueXpress. “We clearly see the loans below the top 10 as poorer quality and more aggressively underwritten. The balance of the loans below the top 20, typically $3-million to $10-million loans are even worse.”
“We factor these results into our loss analysis,” noted Michael D. Sneden, Executive Vice President at ValueXpress. “In 2010, we were projecting bond losses of about 3%, but now we are more in the 5%-6% range. We require 200% cushion, which means the CMBS subordination levels must be 12% or more for us to recommend that Country Bank buy bonds from the issue.”