Commercial Mortgage Insight

How Rating Agencies Approach Rating Commercial Mortgage-Backed Securities

Rating agencies have specific approaches to analyzing the quantitative and qualitative characteristics of CMBS pools.

BY JENNIFER (JENNY) PERKOVIC-STORY

The rating process begins with a preliminary analysis of a mortgage loan pool, considering both the quantitative and qualitative characteristics of the pool.

Quantitative characteristics include the debt service coverage ratio (DSCR) and the loan-to-value (LTV) ratios of the loans. Qualitative factors include the strength of the originator's policies and procedures, amount of reserves in place, number of loans, structure of the borrowers, diversification by property type, location, borrower and loan size, property age and loan seasoning.

Depending on the type of CMBS transaction (e.g., conduit, seasoned loan, credit-tenant lease, large loan), rating agencies have specific approaches through which the quantitative and qualitative characteristics of a pool can be analyzed.

In order to analyze the quantitative characteristics of the pool, rating agencies determine cash flows and values to be used to derive DSCR and LTV ratios for each of the loans. Duff and Phelps Credit Rating Co. (DCR) reduces the cash flows based on either past experience with the originator when available, or by 5%.

Values are determined by applying selected capitalization rates by property type to the reduced cash flows. Rating agencies also perform various stratifications of the pool's statistics and discuss the qualitative aspects of the pool.

Based on this preliminary review, rating agencies provide a range of subordination levels for each rating category. Once rating agencies are engaged, a more detailed analysis of the pool begins.

First, the rating agencies select a representative sample of loans from the pool to inspect and analyze. For conduit transactions, the sample size depends on the number of loans in the pool and mortgage loan balance. Typically, conduit pools are comprised of a large number of mortgage loans (generally more than 100) with no loan representing more than 5% of the pool balance.

DCR generally samples 50% to 70% of the pool by mortgage loan balance. If the transaction is composed of a small number of large loans (large loan pool), the rating agencies will inspect and analyze the cash flows and values of substantially all of the properties in the pool.

The sample typically includes the 10 largest loans, with the remainder being a representative sample of the rest of the pool based on property type, geographic distribution and loan balance. Small loans are included in the sample to ensure that the same underwriting standards are applied regardless of loan size.

Lastly, if the deal contains loans from more than one contributor, a representative sample is chosen from each. The sample composition will closely mirror that of the total pool.

Site inspections and management meetings

After the sample is chosen, site inspections are performed to provide a better understanding of a property and the market in which it is located. Focus is placed on the quality and competitiveness of the property, the expertise of management, the surrounding neighborhood and new construction or vacant land in the area.

Based on the site inspections, DCR assigns the properties a quality score that ranges in descending order from Class A to D, using the quality score as one factor in determining the capitalization rate that will be applied to the cash flows to derive value. The average of the scores also provides an indication of the property quality of the overall pool, which is an indication of the refinanceability of the loans in the pool.

For large loan transactions, single borrower transactions and significant borrower concentrations within a conduit, DCR conducts meetings with the senior management of the borrower. The purpose of these meetings is to explore management's experience, operating style, business plan for the asset(s) in the pool, historical financial trends for the company and future growth plans.

In addition, the management meetings give rating agencies a better understanding of the current tenant profile, tenant leasing status and strategies, and tenant default issues.

As part of the qualitative aspects of the rating process for a specific transaction, DCR conducts a review of each originator and examines, among other issues, the originator's borrower due diligence, credit reviews, cash flow verification process, lease reviews, policy and procedures manuals, training of employees, third-party selections and review processes and employee incentive compensations.

All rating agencies focus on the level of borrower structuring, diversification and amount of escrows in place for tax, insurance, capital expenditures and leasing costs for each transaction. DCR updates its assessment of each originator for each new transaction to determine whether there have been any changes to the originator's policies and procedures.

Determining net cash flows and values

Once the data gathering/field work is completed, it's time for rating agencies to analyze sample properties' cash flows and values. Net cash flow (NCF) is determined by analyzing the historical performance of each sampled property using underwriting guidelines specific to each rating agency. For properties with short-term leases, such as multifamily and self storage, DCR uses trailing 12-month revenue to determine an appropriate income amount. For properties with longer-term leases (such as office, retail and industrial), the rating agency emphasizes contractual rents in-place for tenants in occupancy and paying rent.

Rents are marked down to market on a lease-by-lease basis. Vacancy deductions are generally the higher of actual, market or minimum vacancy parameters by property type. When warranted, vacancy is further increased to take into account new construction.

Management fees are generally the higher of minimum parameters, market or actual. Leasing commissions and tenant improvement allowances are generally the higher of minimum parameters or market. DCR assumes an average rollover based on the average lease term for the property.

The average NCF variances are then applied to the non-sampled assets by property type and contributor, if applicable. Value is determined by applying an appropriate capitalization rate to the adjusted NCF.

Quantitative analysis

Once a normalized NCF and value are determined for each property in the pool, the cash flows and values are run through the various rating agencies' models. DCR relies on the more constraining of DSCR and LTV for each loan.

For floating-rate transactions, rating agencies typically stress the debt constants on the underlying mortgages up to their interest rate lifetime caps. The level of stress is dependent on the rating category and loan term.

Large loan transactions and micro-loan transactions (i.e., loans less than $1 million) are analyzed differently. Large loan transactions are sized like typical conduits but with adjustments for lower diversification because each loan typically constitutes a greater percentage of the total pool.

The larger the loan concentration, the greater the single-event risk and, therefore, the greater the concentration penalty. Micro-loan transactions benefit from total diversification but are typically penalized due to the reduced level of third-party due diligence, lesser quality of information in the asset summaries and lack of impounds, cash controls and borrower structure.

In addition, the pools are stratified by DSCR, LTV, loan size, geographic location, property type and other relevant statistics. DCR places particular focus on the percentage of the pool that is less than 1.20X DSCR and has a greater than 80% LTV. The stratification analysis results help rating agencies to better evaluate the pool by identifying both positive and negative concentrations.

Rating agencies also review the relevant legal documents for each rated transaction to understand, among other issues, the distribution of cash flow, the relative responsibilities of the parties to the transaction and the strength of the representations and warranties of the mortgage loan seller.

The legal documents typically include the prospectus and/or private placement memorandum, the true sale opinion, the mortgage loan purchase agreement and the pooling and servicing agreement.

Final analysis

Once the pool analysis and legal review are completed, the transaction is presented to the rating agency's credit committee to determine final ratings. The presentation provides an overview of the collateral and the deal structure.

For each transaction, all rating agencies publish pre-sale reports that explain the rating agencies' analysis, list and describe the parties to the transaction, summarize key statistics (such as DSCR and LTV) and the geographic, property type and other relevant concentrations.

It also describes the largest loans in the pool and typically discusses the rating agencies' approach to analyzing them. Lastly, it provides a summary of strengths and weaknesses and risks of the transaction and mitigants to these concerns. Pre-sale reports can be found on each of the rating agencies' Web sites.

Jennifer (Jenny) Perkovic-Story is a group vice president for the Real Estate and Mortgage Group at Duff & Phelps Credit Rating Co. (DCR). She is responsible for the rating analysis of securitized commercial real estate transactions.

This article was previously published in the January 2000 Issue of Commercial Mortgage Insight.