Spotted – a pre-crisis pro-forma CMBS practice

Posted by Tracy Allowayon Jun 29 12:33.

“The steady erosion of loan-to-value requirements and Debt Service Coverage Ratio [DSCR] standards is not as concerning as the reintroduction of pro-forma loans. It is one thing to make a bet on what you know is there, but quite another to make bets on what may or may not be.”

That’s New Oak Capital’s head of commercial real estate, David Eyzenberg.

He’s talking about pro-forma loans in Commercial Mortgage-Backed Securities (CMBS) — and well he might. These loans, last seen in the underwiting excesses just before the crisis, have made something of a comeback. Both IFR and the Wall Street Journal have mentioned their return in recent weeks.

In market terms, pro-forma underwriting is the practice of basing future property cashflows on estimates rather than historical income streams. In non-jargon, it often means picking numbers out of thin air and basing your valuations on them. Even the rating agencies are pretty down on the method. Moody’s says that “almost always pro-forma underwriting is a negative for credit quality.”

Anyway, recent concerns seem to stem from this report from Barclays Capital:

Although CMBS 2.0 deals so far are nowhere close to 2007 vintage in terms of pro-forma underwriting, we start seeing isolated examples where some loans were underwritten using forward looking assumptions … Historically, clean underwriting was traditionally based on the most recent 12-month trailing financials. However, we see that a significant number of loans in CMBS 2.0 were underwritten 1) either significantly higher than 12-month trailing; or 2) historical numbers were not quoted in Annex A, making such comparison impossible. In many instances the lack of historical operating performance was in those cases where relatively new construction (assets built or substantially remodeled within the prior three years and even not fully stabilized) was securitized. In addition, for the recently acquired properties, historical financials might be not available or are just considered less reliable, as the sponsorship changed. Based on our analysis, the combination of these two factors explains most of the instances where the historical financials were missing … On average, about 18% of all CMBS 2.0 loans did not have historical NOIs [net operating income] …

Now, there are all sorts of pro-forma CMBS examples you might cite.

IFR mentions Cantor Fitzgerald’s inaugural CMBS deal, the $635m CFCRE 2011-C1, which is almost 30 per cent backed by loans with early termination clauses. One of the loans is also backed by the Hudson Valley Mall, which makes a rather unwelcome appearance on the website www.DeadMalls.com.

Or take JPMorgan’s JPMCC 2011-C3, where some tenants are in lease payment default or even bankruptcy (in this case, related to the Borders’ bankruptcy) or they’re not actually in place yet.

Luckily, Barclays’ Julia Tcherkassova has provided us with a handy list:

Related links:
S&P identifies troubling trends in recent US CMBS – Investment Edge
Pro forma underwriting not currently prevalent among new loans – Moody’s
Back to the future with CMBS
– FT Alphaville
CMBS hitting the fan – Mock the market, 2008

This entry was posted by Tracy Alloway on Wednesday, June 29th, 2011 at 12:33 and is filed under Capital markets. Tagged with , , , .

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