by Jade J. Rahmani, Director, Keefe, Bruyette & Woods, Inc.,
Ryan Tomasello, Associate, Keefe, Bruyette & Woods, Inc.
Although we are optimistic about the outlook for real estate fundamentals and mortgage REITs have had solid performance metrics in recent years, the increasingly competitive lending environment could create risk of increased losses in future years. Based on the current profile of loans owned by commercial mortgage REITs, recent levels of financial leverage, and the potential for a decline in property values and property performance, we believe the sector is well-positioned relative to where it was before the last downturn, although concentration risks that could produce outsized losses if REITs do not maintain lending standards.
We remain optimistic on the investment outlook for commercial mortgage REITs. Our optimism is based on expectations for continued positive economic growth, modestly improving real estate fundamentals, the large pipeline of CRE debt maturities, and ongoing availability of attractive financing options (including current low rates and improving execution through securitization). However, increased competition is a growing concern, including from banks and insurance companies, CMBS conduits, and non-bank lenders. As a result, we believe capital availability is driving yield compression and loosening underwriting standards, including higher LTV ratios and increased deal mix with IO loans.
As the lending environment becomes more aggressive, the potential for mispricing increases as lenders do riskier deals with increased leverage to maintain target returns. While we believe sector dividend yields of 7-8% remain attractive on a relative value basis and are in-line with historical average spreads over treasuries and high yield debt, the current environment has prompted investor questions on how we frame potential losses. Broadly speaking, average loan to value ratios of 68% and average debt-to-equity ratios of 2x (equivalent to 65% to debt-to-capital) remain low enough to suggest modest loss rates on loans made thus far in the cycle since theoretical loss severities remain within existing equity cushions while property prices continue to rise. On the other hand, we believe risk is increasing on new originations. We also believe an effect of increased competition and yield compression in the market for CRE loans is a likely increase in loan repayments, which for the commercial mortgage REIT sector have so far been modest on recent vintage loans. As a result, we believe portfolio risk is likely to increase going forward. Lastly, CRE lending has high concentration risk, so statistical averages may not fully capture idiosyncratic default risks.
Historical Performance and Lending Profile
Commercial mortgage REITs originate and acquire commercial real estate (CRE) debt. Pricing of the assets and liabilities is based on a credit spread over benchmark interest rates, which is sensitive to market dynamics including supply/demand, interest rates, and relative value. Assets tend to have concentrations in hotel, office, mixed-use, and multifamily with disproportionate geographic exposure to markets with strong origination and capital markets activity, including New York in particular. Through a real estate lending platform, companies typically originate, acquire, and manage commercial real estate loans and securities. Portfolio risk depends on credit underwriting, position in the capital structure, sector diversification, asset level performance, as well as macroeconomic trends. Since commercial mortgage loans tend to be large (averaging $25 million or 1.5% of loans for our coverage), portfolios are subject to concentration risk since an individual loan’s performance can have a material impact.
Since loans may be transitional or higher yielding, durations tend to be relatively short (approximately 2-4 years), similar to credit facility terms including extensions as long as assets remain performing. Last-dollar loan-to-value (LTV) ratios average approximately 65-70% but can reach 85%-90% or higher in the case of subordinate debt or preferred equity. Additionally, not all property types should be viewed equally since there may be considerable variance in how asset value is determined (whether on initial cost, projected construction cost, market value, or sell-out value) particularly on properties undergoing development and/or repositioning.
Historical delinquencies in past downturns ranged from 5-9% in 2009-2010 and 10-12% in 1991-1992 while loss severities ranged from 14-29% in 1994-2011 and 25-50% in 2006-2013 according to data from the Federal Reserve, the American Council of Life Insurers (ACLI), Moody’s, and S&P. Property prices fell 25.8% in 2009 and 19.7% in 2008 (including 32.4% and 20.9% for Office) according to Moody’s CPPI and 11.2% in 1991 and 10.0% in 1992 according to the MIT TBI.
Given an average LTV of 68% for the commercial mortgage REIT sector and debt/equity ratio of 2x (50% debt/capital), we believe the companies can withstand approximately 15-20% of losses at the property level before impacting equity and that loss severities of 25-35% would produce equity losses of 4-7% depending on asset mix and corporate leverage. Hypothetically, assuming a 5-9% default rate, 25-45% decline in property value, 7-20% in capital expenditures, and 1-3% in legal, administrative, and foreclosure costs, cumulative loan losses would total 1.7-3.5%. Adjusting for debt/equity ratios of 1-2x, this would suggest equity losses of 4.2-7.0%. The high end of these estimates includes an assumption for interest costs to the senior lender in the case of a subordinate interest. A potential loss mitigant is close asset surveillance.
Since the above scenario is based on statistical averages, it does not account for concentration risk. For example, while BXMT and STWD disclose average LTVs of 63% and 65%, we estimate approximately 61% and 58% of each portfolio is above 65%, respectively.
Assessing Theoretical Loss Rates
Exhibit 1 below summarizes 2Q commercial real estate loan portfolios, average loan sizes, LTV ratios, and debt-to-equity ratios for the commercial mortgage REITs. Given an average loan to value ratio of 68% for the commercial mortgage REIT sector and average debt/equity ratios of 2x, we believe the companies can withstand approximately 15-20% of losses at the property level before impacting equity and that loss severities of 25-35% would produce losses to equity of 4-7% depending on asset mix and corporate leverage.
Exhibit 1: Commercial Mortgage REIT Portfolio Data – 2Q14
Hypothetically, assuming LTVs of 50-80%, a 25-45% decline in property value, 7-20% in capital expenditures, and 1-3% in legal, administrative, and foreclosure costs, loss severities would total 0.0-59.4% with an average of 23.5%. In the case of a subordinate position in the capital structure with an LTV of 65-85%, loss severities would total 0.0-61.8% with an average of 33.7%. These ranges are similar to historical loss severity data from ACLI, Moody’s, and S&P from 1993 to 2013. However, our estimates have conservatively assumed property price declines of 25-45%, which should hopefully prove severe (see discussion below for historical property price performance).
Assuming a 5-9% default rate (approximately 75% of a 7-12% delinquency rate), cumulative loan losses would total 1.7-3.5%. Adjusting for debt/equity ratios of 1-2x , this would suggest equity losses of 4.2-7.0%. The low end of these estimates assumes a whole loan or first mortgage position while the high end of these estimates includes an assumption for interest costs to the senior lender (over 6 to 12 months) in the case of a subordinate lender that forecloses on the borrower. All ranges include an assumption for property expenses and/or capital expenditures incurred prior to property liquidation. One potential loss mitigant is that commercial mortgage REITs make loans on transitional assets, which should result in close asset surveillance with unfunded loan commitments subject to business plan execution.
Exhibit 2: KBW CRE Loan Loss Model
How We Model CRE Losses
To assess potential loss rates, we examined historical losses based on data from the Federal Reserve, the American Council of Life Insurers (ACLI), and several ratings agencies. We also reviewed historical commercial real estate pricing data based on the Moody’s Commercial Property Price Index (CPPI) and the MIT Transaction-Base Index (TBI).
The data show historical commercial delinquencies of 4.2% and commercial charge-offs of 0.7% for the Federal Reserve data and delinquency rates of 1.5% and loans in process of foreclosure of 0.63% for ACLI. We estimate a maximum delinquency rate of 12.1% in 1991 for the Federal Reserve data and delinquency rate of 8-9% in 2009-2010 during the financial crisis. However, commercial charge-offs reached an all-time high of 3.05% in 2009. For the ACLI data, we estimate commercial delinquencies reached a max of 7.5% while foreclosures reached a max of 3.5% in the 1992-1993 commercial real estate crash and remained modest during the financial crisis (less than 1%).
Exhibits 3 through 6 below summarize historical delinquency rates and charge-offs based on data from the Federal Reserve and ACLI.
Exhibit 3: Historical Commercial Delinquencies – Federal Reserve
Exhibit 4: Historical Commercial Charge-Offs – Federal Reserve
Exhibit 5: Historical Commercial Delinquencies (incl. loans in foreclosure) – ACLI
Exhibit 6: Historical Commercial Loans in-Process of Foreclosure– ACLI
Historical Loss Severities (Principal Losses Incurred)
Next we reviewed historical principal losses on loans that defaulted. Based on the ACLI data, we estimate loss rates of 10.8-29.4% from 1994-2012 and an average of 20.6%. Additionally, Moody’s data on multi-year cumulative loss rates for CMBS 1993-2006 vintage loans shows seven-year loss rates of 0.7% for the Ba tranche, 7.3% for the B tranche, and 25% for the Caa for the tranche. The loss rates increase from 0.15% to 0.7% in years 3-7 for Ba, 0.25% to 7.3% in years 2 through 7 for B, and 2.9% to 25% in years 3 to 7 for Caa. We would consider the credit risk that the major commercial mortgage REITs are taking with average LTVs of 65% to be similar to the BBB-/Baa2 tranches so far on an average portfolio basis. Additionally, S&P data on CMBS loss severities range from 25-50%.
Exhibit 7: Historical Principal Losses Incurred – ACLI
Exhibit 8: Multi-year Cumulative Loss Rates (1993-2006) – Moody’s
Property Price Changes
The Moody’s CPPI index shows price declines of roughly 20-30% in the 2008-2009 period and declines of 5-10% in the early to mid-2008 period of the financial crisis. Additionally, the MIT TBI index shows price declines of 11.2% in 1991, 10.0% in 1992, and an average decline of 25.5% in 2009. Finally, NCREIF’s Property Index returns data show declines of 5.6% in 1991, 4.3% in 1992, and 18.0% in 2009.
Exhibit 9: Moody’s CPPI Indices
Exhibit 10: Annual Percent Change in Moody’s CPPI Indices
Exhibit 11: Annual Percent Change in MIT TBI Index
Exhibit 12: Annual Percent Change in NCREIF Property Index
What about CRE Concentration Risk?
CRE lending has high concentration risk, so statistical averages may not fully capture idiosyncratic default risks. To evaluate potential concentration risk, we think Blackstone Mortgage Trust (BXMT) and Starwood Property Trust (STWD) provide helpful data on their portfolios.
- For example, BXMT discloses an average LTV of 63% for the overall portfolio, while we estimate approximately 61.3% of the portfolio is above 65% LTV, 28.6% is above 70% LTV, and 10.1% is above 75% LTV. We estimate an average loan size of $73.2 million or 2.1% of the portfolio.
- STWD discloses an average LTV of 65.2% for the overall portfolio, while we estimate approximately 57.9% of the portfolio is above 65% LTV, 34.9% is above 70% LTV, and 22.5% is above 75% LTV. We estimate an average loan size of $46.4 million or 0.9% of the portfolio.
- Assuming a 50% higher default rate for the above 75% LTV cohort, we estimate cum. losses would increase to 1.8% for BXMT and 2.5% for STWD from a generic average of 1.7%, resulting in equity losses of 5.4% for BXMT and 4.9% for STWD adjusted for corporate leverage from a generic average of 4.2% assuming a 2x debt/equity ratio for the sector. This analysis does not account for any potential revenue benefit to LNR, STWD’s commercial mortgage special servicer.
Historical Commercial Mortgage REIT Stock Performance
Commercial Mortgage REITs came into being in the 1990s post the prior CRE downturn. As a result, the data we have is from the last cycle, which included the financial crisis that should be a rarer occurrence than a normal recession. In Exhibit 13 below, we show historical performance of the commercial mortgage REIT sector vs. the S&P 500 and S&P 500 Financials while Exhibit 14 shows historical performance including dividends, which is much stronger. However, it is worth noting that there is a survivorship bias to this data set as the analysis assumes capital is reinvested in surviving CMBS REITs so dividends continue. If you measured performance against legacy REITs only, returns would plummet since many failed during the financial crisis.
Exhibit 13: Historical Price Performanc
Exhibit 14: Historical Total Return (incl. dividends)
Commercial Mortgage REITs are Correlated with Treasuries and High Yield Bonds
We believe it is worth comparing commercial mortgage REIT dividend yields with treasuries and the high yield bond index. Exhibit 15 below shows a historical spread over the three-year treasury of 7.5%, in line with the current spread of 7.8%, and the historical spread over the high yield bond index (HYB) of roughly 0.0% in line with the current spread of 0.7%. As a result, we believe the stocks trade as yield instruments, which is why we prefer that measure to price-to-book value.
Exhibit 15: CMBS REITs vs. Fixed Income Historical Spreads
Exhibit 16 below summarizes historical leverage ratios for the commercial mortgage REITs. We estimate average historical leverage (debt/equity) of 2.5x and a peak of 7.4x as compared to current leverage ratio of 2.0x. While underwriting standards in the prior cycle deteriorated leading up to the financial crisis, we believe the primary reason that legacy commercial mortgage REITs went out of business was due to excessive financial leverage and mismatched terms between assets and liabilities. In the case of credit facilities/repo, the terms were shorter than assets that extended due to borrower inability to repay or refi the loan. In the case of securitized debt, the commercial mortgage REITs held the first loss position, which resulted in greater losses than the overall market. Another nuance is that companies leveraged mezzanine loans and subordinated debt in the prior cycle, which we believe does not yet meaningfully exist today.
Exhibit 16: Historical Leverage