Last March we reported on deteriorating credit quality based on data provided by the rating agency Kroll. At that time, Kroll reported gradual deterioration over the prior year in underwriting standards for the 20 largest loans in Kroll-rated transactions, particularly at the lower end of the range.
Another review recently by the rating agencies has spurred additional discussion on the topic. There is widespread belief that credit quality continues to deteriorate, but there is disagreement among originators, CMBS investors and rating agencies on the severity of the decline. From a rating perspective, the agencies are seeing their stressed LTVs, one of their key metrics of credit quality, continue to escalate. Moody’s reports that the average stressed LTV for deals it rated last year was 111%, up from just 84% in 2010. More worrisome is that the 111% stressed LTV is not far from the peak level of 114% reached in 2007, at the height of aggressive underwriting.
But originators counter with the fact that no “pro-forma” loans are underwritten today versus in 2006-2007 when loans were underwritten based on rent projections that in hindsight did not pan out and ended up being some of the worst performing. All CMBS conduit loans today are written based on income in-place. Originators also point out that the average LTV of current CMBS pools is in the 65% area, reasonably below the 70% peak in 2007. Finally, an important underwriting metric, debt yield (property net cash flow divided by the loan amount), while declining, is still above a 10% average versus the 8.9% recorded in 2007. So the trend is still in the direction of deterioration. according to the rating agencies, but not yet to dangerous levels, according to CMBS originators.