Avoiding collateral damage

Issuance of commercial real estate collateralised debt obligations (CRE CDOs) has seen impressive growth since 2002. Fitch-rated 2006 volume (through November) is nearly twice the 2005 issuance volume with nearly 50% issued in the three months between September and November.

CRE CDOs have developed rapidly over a relatively short time period. The primary asset types owned by CRE CDOs include real estate investment trust (REIT) debt, commercial mortgage-backed securities (CMBS), and commercial real estate loans (CREL). REIT debt is generally publicly rated senior unsecured debt obligations. CMBS consist primarily of public ratings on pools of long-term, fixed-rate first mortgage loans with stringent lockout provisions. CREL consists of B-notes, mezzanine loans, and whole loans. Less than 5% of CRE CDOs are composed of other collateral, including direct loans to REITs, real estate operating companies, and retailers, as well as other securities such as asset-backed securities (ABS), RMBS, and other CDOs. Resecuritisation of Real Estate Mortgage Investment Conduit (ReREMICs) consist entirely of CMBS tranches.

The collateral mix of CRE CDOs has evolved over the past six years. Figure 1 shows the issuance by deal type for CRE CDOs and ReREMICs by vintage. For vintages prior to 2002, the average collateral pool consisted of roughly 50% CMBS and 50% REIT debt. In the 2002 and 2003 vintages, the collateral pools shifted to a higher concentration of CMBS. During this period, more below-investment-grade CMBS investors began using CDOs to access the capital markets to finance business operations. At the same time, there was a general tightening of REIT spreads that made them less attractive for CDO structures.

Beginning in 2004, CREL was introduced into the collateral pools. Since then, the inclusion of CREL within the CRE CDO collateral pool has grown exponentially. Year-to-date 2006, CREL represented over 50% of all collateral for CRE CDOs, mainly due to transactions that are composed entirely of CREL. As CREL has become an acceptable asset in the CDO vehicle, specialty finance companies and large institutional lenders have begun using CDOs as a cost-effective way to finance their commercial real estate loan portfolios. Despite the increase in CREL, CMBS remains the predominant asset class of Fitch-rated CRE CDOs overall, representing approximately 60% of all collateral.

The trend toward revolving deals has grown; in 2003 and 2004, roughly 25% of all Fitch-rated CRE CDOs were revolving, whereas in 2005 and 2006, about 60% were revolving. In large part, this increase in revolving deals is due to the CREL CDO issuance.

Hybrid deals, consisting of a mixture of synthetically referenced assets and cash assets, are another trend for 2006. Four deals with $2.6bn (€2bn) in rated liabilities were issued in 2006 up from less than $500m (€382m) in 2005. Fitch expects an increase in hybrid CDOs for 2007 as issuers continue to search for collateral.

The overall performance of CRE CDOs and ReREMICs has been strong, with 37 transactions receiving upgrades and only three receiving downgrades. Over the past 12 months, Fitch upgraded 195 tranches in 37 CRE CDOs and ReREMICs and downgraded three tranches from two transactions. Additionally, six transactions (32 tranches) were called and paid in full in 2005. Figure 2 summarises the CRE CDOs and ReREMICs rating actions by vintage. Generally, the deals that received upgrades were static pools fully ramped at the closing of the transaction, tying the performance directly to the performance of the underlying assets.

Three factors have driven the upgrades of the CRE CDOs: improving credit quality of the underlying CMBS collateral, the seasoning of the portfolios and the deleveraging of the CDO liabilities.

Highlighting the improved credit quality of the underlying CMBS is the outstanding upgrade to downgrade ratio. During the first six months of 2006, Fitch upgraded 976 tranches, downgraded 28, and affirmed more than 1,600. These rating actions translate into a CMBS upgrade-to-downgrade ratio of almost 35:1, more than triple the 11:1 ratio for all of 2005. Earlier vintage CDOs are benefiting from the shortening of the weighted average life of the assets.

The sequential-pay feature of static CRE CDOs and ReREMICs provides that proceeds from maturing assets are used to repay the most senior CDO liabilities. This results in increased credit enhancement to the CDO notes and ReREMIC certificates. Repayments averaged approximately 5% across the Committee on Uniform Securities Identification Procedures (CUSIP) CDOs that were upgraded in the past 12 months.

In the few instances prior to the past 12 months when a CRE CDO experienced a downgrade, the performance of the underlying collateral was the primary driver. Two transactions issued in 2000 were previously downgraded as a result of poor performance of non-CRE assets, specifically manufactured housing securitisations.

CRE CDOs composed of commercial real estate loans are gaining traction. In fact, in the second half of 2006, CREL CDOs accounted for over 70% of all Fitch-rated CDOs. Fitch has observed two trends in CREL CDO issuance.

The first is riskier loan types: Of the CREL assets, the percentage of whole loans continues to grow. Earlier CREL CDOs were composed mostly of B-notes and mezzanine loans, while more recent vintage CREL CDOs have a higher proportion of whole loans. 2006 CREL deals are composed of more than 70% whole loans, compared with less than 20% in 2004.

Not all whole loans have the same risk profile. Investors should not automatically assume that predominantly whole loan pools are less risky than B-note/mezzanine debt pools. Some asset managers of B-note/mezzanine debt pools focus on lower leverage debt on stable assets to institutional quality borrowers. Some whole loan deals concentrate on developmental loans, as opposed to income-producing properties. Although the loss severity for whole loans is expected to be less than that for B-notes and mezzanine loans, the probability of default for developmental loans could be much higher.

The whole loans can be grouped into three types: stabilised, transitional and developmental. Fitch sees a trend to an increasing percentage of developmental loans.

Developmental whole loans can be characterised as highly transitional assets, commonly land in the early stages of development, ie, often requiring re-zoning, acquiring additional sites to effectuate a business plan, or submission of plans for approval. These loans are also secured by vacant or tear-down properties, condominium conversions or construction loans. As spreads remain tight on more traditional CREL collateral, Fitch has observed the inclusion of higher yielding and riskier types of whole loans in the transactions.

itch anticipates few upgrades on deals composed of these riskier assets because more time is needed for the development plan to actualise. Delays in a project's timeline could significantly diminish values. Although the revolving deals are rated to withstand some negative collateral quality migration, deals whose collateral quality cushion has eroded face a risk of downgrade.

The second trend is that cash balances may swell: Uninvested principal cash has averaged approximately 7% for CREL deals that have had at least nine months of reporting available. One CREL CDO averaged as high as 22% for several reporting periods. Cash balances within a CDO pose two concerns. Firstly, that the presence of significant cash balance erodes the excess spread in the deal from the negative arbitrage between yields on cash equivalents and the liabilities.

Secondly, given heightened competition for loans, either the average spread on the reinvested assets will come down, thereby eroding spread cushion, or there might be negative collateral quality migration due to reinvestment into higher yielding assets to maintain the spread covenants.

Faster than anticipated prepayments have contributed to cash build-up, as some collateral managers did not have replacement collateral available. Other managers who have been able to keep their CDOs fully invested to date are having difficulties finding replacement collateral with equivalent or higher spreads, given the collateral quality constraints of the pool and the tight spread environment that managers currently face. Fitch's ratings allow managers some negative collateral quality migration and reduction in the weighted average spread. However, too much additional risk, combined with decline in performance on existing assets, could mean a tight reinvestment cushion for managers in the future.

In other structured finance CDOs, issuers have requested relief on the weighted average spread covenant. Fitch anticipates this as a possibility for seasoned CRE CDOs as well. Most likely, reinvestment parameters will have to be tightened to offset reduction in the excess spread covenant. Fitch will prepare a cash flow model of the transaction and work with the issuer to determine the new collateral quality tests.

Fitch expects fewer upgrades on the CUSIP CDOs and ReREMICs in 2007 due to the anticipated slowing of upgrades on the underlying CMBS collateral, as defeasance is expected to decline. Additionally, newer vintage CMBS transactions have a concentration of full or partial interest-only loans that will slow the amortisation of the most senior CMBS classes.

Also, Fitch anticipates fewer upgrades on the newer vintage CRE CDOs, given the revolving nature of many of these transactions. Of particular concern are those CREL deals with concentrations of condominium conversion, land, and construction loans, as these are the riskiest loan types. A downturn in the US economy would have a negative impact on these projects. Delays in actualisation on the business plan for the asset would significantly erode values. Existing revolving deals are rated to withstand some negative collateral quality migration; downgrades will be tempered based on the amount of reinvestment cushion built into the deals at closing.