The Pool Refinance Loss Factor

Larry Duggins
Over the past six years, ARCap has consistently applied the same cash flow-based loss methodology to its commercial mortgage-backed securities (CMBS) pool selection and investment decisions. In 2004, that methodology has revealed a startling increase in risk associated Duggins with balloon maturities. A meaningful number of CMBS mortgages being originated today cannot refinance at maturity, if Treasury rates return to their 10-year averages and mortgage spreads return to their 5-year averages. This article discusses the underpinnings of ARCaps loss methodology, examines its recent findings, and finally, proposes the use of the Pool Refinance Loss Factor (PRLF) as a standard component of investment-grade CMBS pool evaluation. Loss estimation is a central component in the evaluation of below-investment-grade CMBS investments. Each B-piece investor develops a loss estimation methodology which in turn guides its real estate due diligence process. Some investors focus on the growth of collateral value over time with an emphasis on market conditions and cap rates, while others focus on property level cash flows and the ability of the property to refinance its mortgage at maturity. The loss estimation methodology allows the B-piece investor to project the timing and severity of potential losses in the mortgage pool, which in turn allows the analysis of potential returns for the non-investment-grade bonds themselves. Since its inception, ARCap has focused on cash flow rather than value estimation as the basis for its evaluation of potential losses in CMBS pools. This bias stems from our conviction that cash flow methodologies are more theoretically sound from a real estate perspective because they are directly rooted in the analysis of the operations of the individual collateral properties. Valuebased loss methodologies begin with cash flow analysis but then introduce cap rate factors which, for many of the small markets in which CMBS loans are originated, are nothing more than educated guesses by due diligence reviewers. By focusing on the ability of a property to generate sufficient cash flow to refinance its mortgage
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Loss estimation is a central component in the evaluation of below-investment-grade CMBS investments.

given foreseeable market conditions, the B-piece investor can analyze property performance and relate it directly to mortgage performance and loss estimates.

It has become industry practice to provide potential Bpiece investors with indicative data tapes approximately six weeks prior to the public launch of a CMBS pool. The potential high yield investors review this preliminary data approximately the same information that will ultimately end up in Annex A of the prospectus supplement issued in connection with the sale of the CMBS to form indicative bids for the noninvestment-grade bonds. ARCap developed an Excelbased model that utilizes the information on the indicative data tape to estimate the potential performance of each mortgage. ARCaps analysis begins with the issuers assessment of normalized net cash flow for each property. Cash flow available for debt service is calculated by dividing the normalized net cash flow by a market level, propertytype specific debt service coverage ratio. We then calculate a refinance interest rate equal to the sum of a benchmark rate of the 10-year average of the 10-year U.S. Treasury bond at the time of the analysis plus the spread which we calculate using the 5-year average of spreads for similar properties in our portfolio. The refinance interest rate calculation is intended to reflect average market conditions as opposed to peaks or troughs in the Treasury or mortgage markets. We then determine a refinance amortization term based on the age and condition of the property. Generally speaking, the model uses a 30-year amortization term for assets younger than 30 years old, and a half-life amortization for properties that are older. The half-life amortization is calculated by subtracting one half of the initial loan term from the initial loan amortization, i.e. a 10-year loan with a 30-year original amortization would have a 25-year refinance amortization. Using the cash flow, the rate and the amortization term, we then calculate a hypothetical refinance

The Pool Refinance Loss Factor (cont.)

Chart 1: PRLF Methodology Flow Chart

Commercial Mortgage Loan

Property Net Cash Flow

Property Type

Year of Property Construction

Maturity Balance

Normalized Net Cash Flow

Property Type DSCR

Amortization Schedule Based on Property Age

Benchmark Rate: 10-Year Average of 10-Year Treasury

Spread: 5-Year Average of Spreads for Similar Properties

Maximum Monthly Debt Service Payment of Refinance

Refinance Amortization

Refinance Interest Rate

Maximum Reference Loan Amount

Maximum Reference Loan Amount

Maturity Balance

Potential Refinance Loss LOSS

NO Loss of Refinance? LOSS

Maximum Refinance Loan Amount

>

Maturity Balance

Swept Loss Assume Borrower Will Protect Equity

Maturity Balance

4 Months of Servicer Advancing with Interest

Adjusted Maturity Balance (with loss)

Refinance Loss Assume Borrower Will Default

Calculate Pool Refinance Loss Percentage Sum of Shortfalls Greater Than 7.5% of Maturity Balance

Maximum Refinance Loan Amount

Maximum Refinance Loan Amount

Adjusted Maturity Balance (with loss)

Shortfall Percentage?

Adjusted Maturity Balance (with loss)

Cut-Off Pool Balance

Shortfall within 7.5% of Maturity Balance

Shortfall Greater Than 7.5% of Maturity Balance

Pool Refinance Loss Percentage

Source: ARCap REIT, Inc.

amount for each loan which is compared to the loan balance at the test date (usually loan maturity). If the refinance amount exceeds the loan balance at the test date, we assume there is no loss on that loan. If the refinance amount is less than the balance at the test date, we assume that the servicer advances for four payments and then liquidates the loan at the refinance amount, with the difference being recognized as a loss. If the refinance amount is less than the balance at the test date, but the shortfall is within 7.5% of the original balance, we remove the loss from the calculation based on the assumption that the borrower will protect his equity at that time.

The remaining losses generated by each loan are then totaled to calculate the percentage of the total pool which we anticipate losing at refinance. This methodology yields a single data point, the PRLF, which measures the relative refinance risk of two or more pools. Additionally, we run sensitivity analyses in which we reduce the issuers cash flow by 5% and 7.5%, which obviously increases the loss percentage. Essentially, the model tests the ability of properties to refinance their associated mortgages if Treasury rates and mortgage spreads revert to the mean. The model assumes that cash flows are normalized and remain constant, recognizing neither revenue growth nor expense inflation over time.
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The Pool Refinance Loss Factor (cont.)

Chart 2: PRLF for Q1-Q3 2004 CMBS Conduit Transactions

0.06

0.05 Pool Refinance Loss Factor

0.04

0.03

0.02

0.01

0
4 8 4 1 3 8 1 2 1 9 1 1 5 2 7 3 2 1 2 4 3 2 1 1 -2 -1 4 2 Y2 3 0 1 2 3 6 -3 1 1 A A 2 -T1 -IQ WR 4-C -T1 -CB 4-C -T1 4-C -IQ WR 4-C NC -CB 4-C 4-C 4-C -LN -GG -GG 4-C 4-C KB 4-C 04 04 4-C 4-C KE -HQ 4-C -C1 -C1 4-C 4-C 04 4-C 4-C B3 B2 -C1 04 004 4-P 00 004 04 00 004 00 004 4-P 00 4-P 04 00 00 00 004 04 04 00 00 4-M 00 20 20 00 00 04- 04 00 04 04 00 00 20 00 00 04-L 04-L 04 2 00 B 2 2 20 C 2 2 C 2 2 00 B 2 00 20 S 2 C 2 B 2 2 20 20 C 2 C 2 00 T 2 M M S 2 C 2 20 20 S 2 20 20 T 2 S 2 M C 2 S 2 20 20 20 S SC 2 T T T M B AC C M S 2 C B M S SC C C SC C SC 2 S C C B S M M 2 M AC AC B C T C CM M MS CF M MC JPM M JPM M MS CF CC MC LBU EC CF PMC CCF SM EC EC MT BC B B LBU MA LM MS LBU BCM BCM GC LBU B MA GS MM MM BCM C G G L W G M G G G O CO W C C J G BS JP PM JP W W S S C M J B B 20

Sources: Trepp, LLC; Bloomberg; ARCap REIT, Inc.

Chart 3: PRLF and AAA Subordination Levels for Q1-Q3 2004 CMBS Conduit Transactions

0.17 0.16 0.15 0.14 0.13 0.12 0.11 0.10 0.09 0.08 0.07 0.06 0.05 0.04 0.03 0.02 0.01 0
2 3 2 3 2 1 1 -2 -1 4 2 3 2 1 2 4 4 0 1 6 -3 1 1 A A 2 8 4 2 1 9 1 1 3 5 2 7 1 3 8 1 -T1 -IQ WR 4-C -T1 -CB 4-C -T1 4-C -IQ WR 4-C NC -CB 4-C 4-C 4-C -LN -GG -GG 4-C 4-C KB 4-C 04 04 4-C 4-C EY -HQ 4-C -C1 -C1 4-C 4-C 04 4-C 4-C B3 B2 -C1 04 004 4-P 00 004 04 00 004 00 004 4-P 00 4-P 04 00 00 00 004 04 04 00 00 4-M 00 20 20 00 00 4-K 04 00 04 04 00 00 20 00 00 04-L 04-L 04 0 2 2 2 2 0 2 2 2 2 0 2 2 2 0 2 2 2 2 2 2 0 0 0 0 0 0 0 0 0 0 2 2 2 2 2 S SC 20 SB SC C 2 CC SC CC SC 20 SB 20 C 2 BS MC SB C 2 C 2 S 2 MC MC 20 MT ACM ACM BS CC 20 C 2 BS T 2 T 2 MT BS ACM CC MS 20 20 T 2 CM M MS CF M MC JPM M JPM M MS CF CC MC LBU EC CF PMC CCF SM EC EC MT BC B B LBU MA LMT MS LBU BCM BCM GC LBU B MA GS MM MM BCM S C G L W G G M G M JP G G C C J G B JP W W CO CO W M JP BS BS

Pool Refinance Loss Factor

Subordination % to AAA at Issuance

Sources: Trepp, LLC; Bloomberg; ARCap REIT, Inc.

A confluence of factors occurred in 2004 that has resulted in the origination of a significant number of high leverage loans with low coupons and minimal reserves. Competition among mortgage originators is fierce, with competitive pressures adversely affecting credit quality. In addition, the rating agencies have moved to bring ratings parity to fixed income products, thereby reducing subordination levels. Finally, B-piece
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investor competition has dramatically increased, reducing the ability of individual B-piece investors to influence credit standards. The PRLF clearly illustrates the impact of this deterioration of credit standards. Chart 2 illustrates the PRLF for CMBS issues placed during the first three quarters of 2004. The outcomes range from a low of 0% for the BSCMS 2004-TOP14 to

The Pool Refinance Loss Factor (cont.)

A review of the outcomes for the first three quarters of 2004 . . . seems to imply that significant refinance risks are not being addressed in AAA subordination levels.

5.23% for the WBCMT 2004-C12. The PRLF indicates that the risk of refinance loss in the WBCMT 2004-C12 is substantially greater that of the BSCMS 2004-TOP14. Of course, additional due diligence would be necessary to incorporate other factors which might reduce the projected loss for WBCMT 2004-C12 or increase the projected loss for BSCMS 2004-TOP14 before an actual investment decision was made. It is critical to recognize that the PRLF only addresses refinancing risks and does not incorporate other elements of credit risk. A pool with a low PRLF may have other serious credit-related issues and vice versa.

associated with CMBS, increasing the amplitude of future real estate cycles with CMBS investors taking the brunt of the losses. However, by using simple tools like the Pool Refinance Loss Factor to uncover hidden risks, investment-grade investors can direct the fundamental credit quality in CMBS, reintroducing adherence to common sense underwriting. Mortgage originators, reacting as they must to their competitive environment, are driven to reflect the minimum standards of the investment community. Their borrower-clients will absorb as many concessions as they are offered until they are stopped by the investors who are the ultimate owners of their mortgages. It is time for investmentgrade CMBS investors to raise the bar.

A comparison of the AAA subordination levels for those issues indicates 12.13% for the BSCMS 2004TOP14 and 13.38% for the WBCMT 2004-C12, which does not seem to be an adequate recognition of the additional refinance risk. Chart 3 further illustrates this observation by overlaying AAA subordination levels on the PRLF data from Chart 2. The expected outcome of increased subordination levels for pools with greater refinance risk does not occur. More CMBS issues will have to pass through their complete life cycles to generate a data set that is sufficiently complete to empirically test the statistical predictive value of the PRLF. A review of the outcomes for the first three quarters of 2004, however, seems to imply that significant refinance risks are not being addressed in AAA subordination levels. Further, this predictive tool is indicating the possibility of pool losses substantially higher than those implied by the widely circulated historical default and loss severity studies. Investment-grade CMBS investors can easily implement the tool as one of their evaluation criteria in their discussions of CMBS offerings. Our conclusion is caveat emptor. Investment-grade CMBS investors can never forget that mortgages and real estate support the bonds in which they invest. Such investors are ultimately responsible for maintaining the credit quality of their investments by rejecting the offerings of issuers whose aggressive lending approach may adversely affect that credit quality. That responsibility cannot be shirked to the ratings agencies or the B-piece investors, who each face their own competitive dynamics. The combination of unrestrained competition and declining subordination could meaningfully reduce the real estate market discipline

Larry Duggins is President and Chief Operating Officer of ARCap REIT, Inc. The author gives special thanks to Timothy Riddiough, Ph.D., E.J. Plesko Chair of Real Estate and Urban Land Economics, University of Wisconsin, for his comments; and Kyle McGlothlin, Steve Carnes and Ryan Stephens of ARCap for their analytical contributions. ARCaps Pool Refinance Loss Factor model may be downloaded without charge from www.arcap.com.

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