Capital constraints and the massive demand for loan refinancing are likely to cause substantial defaults in the US and Europe, as Anish Shah and Clint Myers report

In the era of tightened underwriting standards and battered lending markets, the downside risks associated with a deepening recession are grave. In addition to that, the need for refinancing of loans held on balance sheets and within the commercial mortgage-backed securities (CMBS) structures in the short term will impose additional especially recent vintages of CMBS - will provide a backdrop of uncertainty. The combination of required debt service coverage ratios, higher coupon rates, loan amortisation, and equity cushion at the time of refinancing of loans will lead to an increase in defaults. In particular, five-year interest-only loans and part-amortised balloon loans (long-term loans, often mortgages that have one large - balloon - repayment) originated over the 2004-07 periods will face substantial pressure as they will be due for refinancing up to the end of 2012.

According to the Washington, DC-based Mortgage Bankers Association analysis of the Federal Reserve flow of funds data, the level of commercial/multi-family debt outstanding in the second quarter of 2008 stands close to $3.44trn (€2.43trn). The CMBS market accounts for approximately 22%, or $762bn, of that $3.44trn CRE universe, and the life insurance sector holds another 9%, or approximately $313bn, of the total. A large chunk of loans from the CMBS and the life insurance market - an estimated $230bn  - is due for refinancing through to 2012. Estimates predict about $58bn-worth of refinancing demand in 2009 and $68bn in 2010. Combined with the demand for refinancing of loans held on balance sheets, which account for a big chunk (43%) of the CRE market, this will create demand en masse for funds in an already strained lending market and fragile economy.

Using the PPR measure of the market value of the whole CRE universe, which stands at approximately $4.5trn, we can calculate the current period average loan-to-value ratios of all CRE in the US at 77%. Now, the average property values across all the major property types are forecast to fall by 9% through 2009 and by 14% through 2010, compared to current levels. This will cause loan-to-values to rise even higher, making it increasingly difficult to refinance, particularly for aggressively underwritten mortgages.

In the 2007 vintage of CMBS, 44% of the portfolio loans have debt service coverage below 1.25. Any loan with debt service coverage below 1.25 for which the outstanding loan amount exceeds 75% of the collateral value will face significant hurdles for refinancing. The combination of required amortisation and higher monthly payments will create an extra burden in stressed recessionary conditions, and it will be increasingly difficult for borrowers to generate extra cash to keep up to the debt service coverage of 1.25 that most lenders would usually require at the time of refinancing. For example, a five-year, interest-only loan initially issued at a 5% coupon would face about a 40% increase in monthly payments when refinanced into a 7%, 10-year balloon with a 30-year amortisation schedule.

As underwriting standards tighten, banks will be unwilling to finance at such high loan-to-values, and borrowers will be unable to write the cheques themselves to bridge the capital-financing gap. The expected outcome is a substantial rise in defaults. For instance, we separately analysed the interest-only loans due for refinancing from now through to 2012. Our model returned lifetime loss estimates of 569bps in a recessionary scenario. However, the loss estimate is based on trustee-reported debt service coverage ratios and loan-to-values of the collateral loans. We therefore applied a 10% shock, both to debt service coverage ratios and loan-to-values across all the interest-only vintage loans, and came up with a lifetime loss estimate of 709bps. The cumulative loss numbers for the 15-month reporting period are 239bps in the recessionary scenario and 319bps in the applied-stress scenario.

The defaults will be concentrated in cities with a high percentage of employment in the financial services sector as well as in the secondary and tertiary markets that are witnessing a capital flight to quality. The office demand attributable to financial activities in urban areas such as New York, Stamford, Hartford, Chicago, San Francisco, and Charlotte is significantly above the national average of 26%. Continued instability in this sector and consolidation through deleveraging are sending ripple effects throughout the job market. Overall, apartments would be least affected as the housing market collapse is boosting the number of renters, keeping apartment occupancies high and firming up rentals. Retail would fare the worst followed by hotel and office as rising unemployment takes a toll on consumer spending, and a decline in the level of business and travel reduces hotel occupancies while the poor economic conditions, cost-cuts, and lay-offs take a toll on office leases.

However, battered lending markets and deteriorating fundamentals will force banks to negotiate loan extensions in an effort to forestall foreclosures. As long as the borrower has maintained the monthly payments and is able to continue to do so, the initial outcome will most likely be loan extension, since the bank or the special servicer will likely not move toward selling a property in a distressed market and incurring a value loss.

Europe appears to be leaning toward a prolonged and severe recession. Its investment market is unlikely to stabilise until banks have successfully restructured their balance sheets. As of October 2008, there are about €524bn in mortgages outstanding in the euro-zone, of which €34bn are backed by commercial mortgages. In the UK, the similar numbers stand at £265bn and £33bn, respectively.

There have already been cumulative marked-to-market losses of €65.8bn in the euro-zone area and £29.5bn in the UK, which translates to about 12% and 11% in write-offs so far. With property values set to fall by another 10-20% and with banks largely inactive, an estimated €160bn-worth of mortgage refinancing through 2009 will either force banks to sell in the distressed market, which will provide a further negative feedback loop, or negotiate loan extensions wherever the cash flows are still fluid.

These market disruptions and funding gaps have created huge market opportunities for equity/mezzanine lenders. However, until financial markets stabilise, investor sentiment will remain subdued and, given the depth of economic uncertainty, is expected to deteriorate further.

In the current cycle, there is leverage all the way across the system, which leaves no way to extract capital from any unlevered properties, as was possible in the previous cycle. It will be increasingly difficult for investors to contribute additional capital, and lenders will not provide the necessary debt financing on favourable terms. Therefore, tighter lending standards coupled with the need to refinance loans held on balance sheets and loans within the CMBS structures will lead to substantial defaults and value losses in the short term, unless the market turns around or stabilises.

Anish Shah: debt research and risk management, PPR
Clint Myers: debt research and risk management, PPR