The lone improvement in U.S. CMBS underwriting last year stands to deteriorate in 2014, which could translate to a spike in credit enhancement on new deals, according to Fitch Ratings in a new report.
Fitch notes that every major CMBS underwriting metric declined in 2013 except for debt service coverage ratio (DSCR). However, with interest rates likely to rise over the next two years, DSCR will likely decline too. In turn, Fitch is likely to raise CMBS credit enhancement levels if higher interest rates push DCSRs down.
And, even if current levels of DSCR are maintained, Fitch will, as it has steadfastly maintained over the past two years, increase CMBS credit enhancement if other underwriting parameters continue their deterioration.
'Debt on new CMBS deals will be increasingly comprised of first and second mortgages and mezzanine financing in order to refinance loans coming due over the next few years,' said Managing Director Huxley Somerville. 'Subordinate debt in CMBS deals already rose in the second half of last year and stands to do the same in 2014 as the refinancing debt wall approaches.' Particularly problematic may be CMBS deals containing loans underwritten with expected net operating income increases that do not come to fruition.
Another troubling trend taking place in 2013 was the increase in interest only loans (IO), with Fitch reporting over 50% of loans having some form of IO period. Fitch finds this counterintuitive given the current low interest rate environment. With the likelihood of interest rates being higher at refinance and the potential for lukewarm economic growth over the term of the loan, 'the logic of removing a strong mitigant to CMBS refinance risk in a higher rate world is questionable at best,' said Somerville.
It should be noted that Fitch has already baked in higher interest rates into its CMBS ratings. Fitch's analysis provides benefit to the fixed rate of interest through the term but recognizes the potential stress at maturity when the loan may need to be refinanced with a higher interest rate.
'CMBS 2014: DSCR Down, Credit Enhancement Up' is available at 'www.fitchratings.com' or by clicking on the above link.
Additional information is available at 'www.fitchratings.com'.