Fitch: Credit Enhancement Insufficient for 'AAA' on New NorthStar CMBS Deal
The first U.S. CMBS deal to come to market with transitional collateral lacks sufficient credit enhancement to achieve 'AAA' ratings, according to Fitch Ratings.
While approached to provide feedback on NorthStar 2012-1 Mortgage Trust (NorthStar 2012-1), Fitch was ultimately not asked to rate the deal due to the agency's more conservative credit stance. In fact, the most senior class (Class A), as structured with 56.5% credit enhancement, would likely achieve a rating no higher than 'Asf', two full rating categories below where the class is expected to be rated by two other rating agencies.
Fitch is concerned that a significant portion of the collateral is sub-performing and transitional in nature with a reliance on borrower pro forma business plans to improve performance. Absent significant growth in cash flows, Fitch would be concerned about refinance risk and the high likelihood of default at maturity, especially in a higher interest rate environment. Fitch's view is that the default probability for the collateral in this pool exceeds any that Fitch has seen to date in CMBS 2.0. Further, in high stress scenarios, Fitch concludes that there is a potential for very limited recovery prospects upon default.
For example, Buena Park, the largest loan in the pool (20.8%), is an anchored retail center located in Buena Park, CA with a sub-performing mall component. Fitch is concerned with the below market occupancy, the significant amount of temporary tenants, and low reported in-line tenant sales of approximately $200 per square foot (psf), including falling per screen sales for the movie theater. Fitch is also concerned over stiff competition in the submarket, including healthier malls nearby.
Further, the loan is subject to interest rate risk given that it does not have an interest rate cap. Fitch has recently seen several instances of sub-performing malls experiencing significant loss severities, which in some cases have exceeded 100%. If the borrower's business plan is not successful, the mall component of Buena Park could experience substantial losses or face significant challenges refinancing in a higher interest rate environment.
Another example is the Cranbrook Multifamily Portfolio (5.7%), which consists of three garden-style apartment properties located north of downtown Houston, TX. Fitch is concerned that the cash flow is not stabilized given that overall occupancy had fallen below 50%. Additionally, while the portfolio has experienced significant lease-up, sizeable concessions had been offered. As such, the loan is highly leveraged compared to its in-place cash flow.
The loan is also subject to interest rate risk given that it does not have an interest rate cap and has additional debt in the form of a mezzanine loan. Again, if the borrower's business plan is not successful in renovating and stabilizing the property, the loan could be subject to sizeable losses and have substantial difficulty refinancing in a higher interest rate environment.
Concentration risk also subjects the pool to a high potential for adverse selection. It is easy to envision a scenario where a few of the better performing loans pay off and the remaining loans are sub-performing or defaulted. The deal could be heavily dependent on the servicer's ability to work out loans to realize value recovery to pay down the bonds. Additionally, the bonds could also be susceptible to interest shortfalls if the servicer experiences significant costs to work out the loans and passes these costs and other workout fees through to the trust. Fitch has seen recent examples in concentrated pools where servicer fees and costs have resulted in interest shortfalls impacting senior bonds.
The rating methodology for this type of pool would track the methodology used for large loan multiborrower transactions. The large loan multiborrower analysis puts a heavy weight on the idiosyncratic risks associated with a smaller, more concentrated pool. While Fitch is not opposed to rating these types of deals, Fitch has a conservative view on transitional properties and properties with less stabilized operating history than those typically securing CMBS loans. Fitch will look at in-place cash flow and in-place value with no credit for pro forma income.
According to Fitch's Sept. 21, report, 'Criteria for Analyzing Large Loans in U.S. Commercial Mortgage Transactions', Fitch may consider a rating cap for loans with more than one key risk factor, even if each risk individually may not be considered substantial, to account for the layering of risk. In this case, the key risk factors include loans subject to idiosyncratic risk associated with exposure to a single asset or industry with a heightened degree of cash flow volatility and loans backed by unconventional or non-stabilized properties, as well as, the pool overall being concentrated.
Fitch relied on publicly available information in its analysis including rating agency presales. Fitch has not reviewed the transaction's documentation or performed detailed real estate analysis on the final underlying assets in the pool.
Additional information is available at 'www.fitchratings.com'.
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