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As the second year of CMBS 2.0 begins, credit ratings agencies say they are taking stock of where credit quality stands and where it may be headed from here. With that assessment, conflicting views persist on the strength of the underwriting behind new commercial mortgage-backed securities (CMBS).
[IMAGE]While the real estate and financial crises invoked a tightening of credit and lending criteria, some say questionable practices, particularly related to appraisal assessments, have begun to make their way back into the picture. Others, however, argue that concern is misplaced, with little evidence of so-called pro forma underwriting.
_Pro forma_ has become a four-letter word in the world of loan underwriting, according to Tad Philipp, director of CMBS research for ""Moody's Investors Service"":http://www.moodys.com.
The market research firm ""Trepp LLC"":http://www.trepp.com explains pro forma as the class of loans underwritten based upon future events, such as an anticipated rent increase or a tenant that hasn't yet committed to the space.
""At present, Moody's sees only limited amounts of pro forma underwriting taking place,"" Philipp said. ""There have been several recent instances of underwriting future income that some may call pro forma but these have not had any negative credit consequences.""
""Standard & Poor's"":http://www.standardandpoors.com research analyst James Manzi says he too is seeing a return of pro forma to a ""limited degree,"" but he feels it's cause for greater concern.
""We continue to see instances where we believe that valuations are questionable, especially within larger loans for certain property types, particularly office and hotel, in primary markets,"" Manzi and his colleagues wrote in a report.
[COLUMN_BREAK]""This is probably attributable to the fact that lending is very competitive in these types of markets,"" they noted, adding, ""The part that we believe should be most alarming to investors is that the appraisals appear to be building in upside in rents and occupancy to arrive at a value for the properties in question instead of using in-place rents and tenancy at the time of closing.""
Moody's says the practice among appraisers of using expected, but unrealized rents and occupancies in their valuations is normal.
""While Moody's does not hold appraisers accountable for considering upside adjustments to income we do hold debt underwriters accountable, and our views are expressed as higher cash flow haircuts and subordination levels,"" Philipp said.
He concedes that pro forma underwriting based on speculative future performance was indeed widespread during the last peak in the market. Philip says with the present lending environment so highly competitive, many loan originators that used pro forma underwriting in the past may use it again in the future.
S&P cites data from Trepp that indicates eight loans from 2010 and 2011 multi-borrower deals included characteristics of pro forma underwriting at closing, and the agency points out that Trepp only ""flags"" a loan as pro forma if the information provided to investors states that there were certain assumptions regarding future income.
As a telltale example of pro forma, Trepp points to what it describes as ""the beginning of the end for CMBS 1.0,"" which came in the summer of 2008 when a big New York City multifamily loan â€" The Riverton â€" went into default.
Trepp says the loan was underwritten assuming the borrower would be able to convert a large chunk of rent stabilized apartments to market rent units. Its default helped trigger a long bear market in CMBS, according to Trepp, and sent investors scurrying to read the fine print on many 2006 and 2007 loans for signs of pro forma underwriting.
""The steady erosion of loan-to-value requirements and debt service coverage ratio standards is not as concerning as the reintroduction of pro-forma loans,"" commented David Eyzenberg, managing director and head of commercial real estate at ""NewOak Capital"":http://www.newoakcapital.com.
""It is one thing to make a bet on what you know is there, but quite another to make bets on what may or may not be,"" according to Eyzenberg.
