Fitch: performance pressure building for European CMBS

Fitch Ratings has warned of the threat to European CMBS (commercial mortgage-backed securities) performance posed by a rising trend of commercial mortgage loan defaults, which for Fitch-rated debt currently stands at 7%.

In light of this, the agency has so far this year downgraded EUR47.2bn of European CMBS notes (nearly 60%), and maintains either Rating Watch Negative or Negative Outlook on EUR52bn of notes.

Negative rating action has been concentrated in European CMBS with non-UK exposure, with 69% of such tranches downgraded. The most severe rating action centred on junior tranches, especially those from multi-borrower transactions.

"As measured by the degree of erosion of borrowers' equity in property portfolios, the distress in commercial real estate markets in the last 12 months explains both the volume of Fitch's downgrades and the severity of rating changes - averaging between three and four notches," says Euan Gatfield, Senior Director, in Fitch's CMBS team.

"This has taken place despite the fact that few borrowers have yet to deal with a loan maturity in European CMBS. With a prolonged wave of maturities arriving in two years time, financing pressures are building in the sector."

Although less than 5% of European CMBS loans have suffered a missed payment, Fitch notes that the growing number of financial covenants that are in breach signals the difficulties even performing borrowers will face when it comes to repaying largely bullet debt. Across Europe the EUR5bn maturing in 2010 will be overshadowed by the EUR61bn due between 2011 and 2014, a third of which is due in 2013.

CMBS servicers have placed 19% of the commercial mortgage loans they administer in Europe on their 'watchlists'. Fitch's own watchlist takes in an even higher share (28%) of the sector. Moreover, whereas a quarter of loans on servicer watchlists are fully performing, this ratio rises to almost a half in Fitch's case.

This reflects differences between the agency's estimates of value and those contained in formal appraisals, few of which were commissioned recently. This disparity is underlined when comparing the weighted-average LTV of 75% reported across European CMBS loans with Fitch's estimate of approximately 95%.

The scale of the declines in commercial property value estimated by Fitch largely explains why only three of the 20 CMBS loans due this year managed to repay. While one, the Quattro loan, is still in its grace period, the majority, including the loan underpinning White Tower 2006-3 plc, failed to redeem at maturity. This caused their transfer into special servicing pending possible restructuring or liquidation.

In the case of eight loans, there has been an extension to the term, as a result of the exercise of an option or a rescheduling of loan maturity.

Balloon risk remains centred in the UK due to the distressed commercial property market, and because most underlying CMBS debt due this year has been secured on UK property, with more due next year. However, there are early signs of value stabilisation, although this is largely limited to prime assets.

"It is questionable whether a recovery in UK values and refinancing availability will be in time and in sufficient magnitude to absorb the wave of bullets falling from 2011 onwards, which peak at a sterling equivalent of EUR6.6bn in 2012," says Gatfield.

"However, there is hope that the worst is over for UK commercial real estate, something that cannot be said for most mainland European markets. Refinancing risk for pan-European CMBS could be even greater than in the UK given so many transactions were completed in 2006 and 2007, at or near the market peak."

With three in every four European CMBS tranches issued in 2006 or 2007 suffering a downgrade this year, rating action has been skewed towards non-UK CMBS, despite conditions in the key German, Dutch and French commercial property markets being less distressed.

However, this apparent strength could be down to the effect of markets lagging, which would suggest further deterioration is in store for Germany, The Netherlands and France - just as CMBS loan maturities begin to gather pace.

In each of the next five years more underlying CMBS debt is due from borrowers in mainland Europe than UK borrowers. There is a particular bottleneck in Germany, with the EUR13.5bn worth of CMBS loans due in 2013, including a staggering EUR10bn from just four multifamily housing mortgages, being twice the UK's peak of EUR6.6bn projected for 2012.

Combined with the point in the respective property market cycles, the sheer volume of commercial mortgages maturing in the next five years across mainland Europe will be a major test for pan-European CMBS credit quality.

A feature on the servicing of CMBS will appear in the December issue of Mortgage Finance Gazette.