Impressive performance of commercial real estate mortgages.

Everyone is well aware of the severe deterioration in property-market fundamentals over the past several years. Vacancy rates have risen from record lows to near-record highs, and rents are down dramatically. As a result, Net Operating Incomes (NOIs) have fallen, and values are down as well, albeit not to the same extent, since cap rate compression has kept values much firmer.

From a debt investor's perspective, this collateral deterioration certainly increases the default risk on in-place loans. Traditional fixed-rate mortgages have encountered decreases in debt-service coverage ratios (DSCR) and increases in loan to value (LTV), and the borrower's economic incentive for loan repayment has changed for the worst. In other words, the protective cushion available to the lender has decreased, making existing loans much more likely to experience default.

However, CRE mortgages have performed surprisingly well. Although delinquencies have increased somewhat over the past couple of years, they nonetheless remain at miniscule levels. The American Council of Life Insurers (ACLI) tracks delinquencies for life company mortgages, and their numbers outlined in the chart (right) vividly illustrate the dramatic difference between today's delinquency levels and those of the last downturn.

Although the delinquency numbers for CMBS are much higher, they also remain far below the truly problematic levels that ACLI mortgages encountered during the early 1990s. Overall, CMBS delinquencies are in the 200 basis-point range, but this all-inclusive number is driven up by the very high delinquencies being exhibited by hospitality (around 600 bp), and health care (around 1100 bp). A review of delinquencies encountered by the four main property types puts the average closer to 160 bp.

The question that remains is whether overall CRE de faults will increase: That is, how much of a lag is there in mortgage performance? Is this merely the beginning of more severe issues or have the problems already peaked?

PPR assesses the situation by applying a proprietary risk model that outlines expected defaults across loan structure, markets, and property types. The model is calibrated to historical default experience and prospectively quantifies expected loss.

Our view is that defaults are indeed likely to increase but are also highly unlikely to reach the problematic levels encountered during the last downturn.

The chart at left outlines our loss expectations for a typical 75% LTV, 1.3 DSCR, 10-year bullet originated today. Each blue tick mark is the median prospective loss for each of PPR's 54 markets across each property type.

On average, these loss expectations are only about one-quarter of the 6% overall principal loss experienced by mortgages originated through the 1980s and early 1990s, and less than 15% of the loss attributed to the worst origination cohort of that period, which was in the range of 11%-12% (Esaki, 2002). Furthermore, stress-testing the loans under a recessionary scenario does double our loss expectations, but even this level is only about half those encountered during the last downturn.

Perhaps more important, these are median loss expectations. That is, there is a range around these expectations, and the probability of experiencing given loss levels can be quantified.

Our analysis shows that there is a very high likelihood (nearly 40% probability) that losses will be below 25 basis points; While on the other hand, there is only about a 3% chance that losses will exceed those of the worst origination cohort of the last downturn.

All in all, solid expectations for mortgage performance are anticipated. Although we do expect some problems, the current real estate market dynamics suggest low loss expectations.

Our anticipation is that most of the problems will be seen in the origination cohorts of 2000 and 2001. These loans were underwritten at the top of the cycle, and we expect them to experience about 30% more loss.

Nonetheless, impressive overall mortgage performance is expected to continue.

Contributed by Property & Portfolio Research, Inc. (PPR), a leading independent provider of real estate research, portfolio strategy, and risk management advisory services.