Fitch: Remember 2007

If the adage that commercial real estate follows a 10-year cycle with only a seven-year memory holds true, it would be wise to refresh some memories, said Fitch Ratings Managing Director Huxley Somerville.

“Weakening loan characteristics, declining underwriting quality and concerns about originator, banker and rating agency competition are not new items on investors’ minds,” Somerville said. “And there are reasons to believe that this time around will be different. For instance, pro forma income is greatly discounted or ignored altogether and perhaps most importantly, credit enhancement levels are substantially higher. But market participants can ill afford to forget how quickly performance can change.”

Commercial real estate reached bottom in late 2009, when the National Council of Real Estate Investment Fiduciaries’ Property Index indicated that total returns declined 23 percent for office, 15 percent for retail, 21 percent for industrial and 23 percent for multifamily compared with 2007 peaks.In 2007, the average debt service coverage ratio across 40 fixed-rate conduit transactions that Fitch rated equaled 1.05x compared to 1.18x so far in 2015. But the difference comes largely from the current low interest rate environment, Somerville said. The average Fitch loan-to-value ratio in 2007 equaled 110.7 percent, just a bit higher than the 110.3 percent thus far in 2015.

Two major distinctions exist between 2007 and 2015, Somerville said. First 2007-vintage loans were often originated based on an expectation that cash flow would continue to rise in a market that had already experienced dramatic upward trends. “Thus, the above 2007 metrics were driven in part by pro forma income that artificially provided numbers than were never actually achieved, he said. And second, credit enhancement today is much higher than eight years ago.”Therefore, it’s unlikely that the next 12 months will bring the same level of misery that followed the September 2008 peak,” Somerville said.

“But it is important to remember that economic cycles are, by definition, cyclical. The current upturn commercial real estate has been enjoying since 2009 will eventually come to pass and the commercial mortgage-backed securities market can ill afford to forget the tough lessons learned in previous cycles.”Somerville said there is nothing inherently dangerous about the real estate cycle. “It only becomes dangerous when market participants forget there is one,” he said. “CMBS cannot afford a repeat of the 2008-2009 experience. Seven years on from 2008 is a very good time for all CMBS market participants to remember that.”