May 21, 2007

Criteria | Structured Finance | CMBS:

Framework For Credit Analysis In European CMBS Transactions

Primary Credit Analysts: Richard Buckland, London (44) 20-7176-3591; richard_buckland@standardandpoors.com Ronan Fox, London (44) 20-7176-3758; ronan_fox@standardandpoors.com Michelle Weston, London (44) 20-7176-3646; michelle_weston@standardandpoors.com Secondary Credit Analysts: Adam Matejczyk, London (44) 20-7176-3789; adam_matejczyk@standardandpoors.com Andrea Pittaluga, London (44) 20-7176-3590; andrea_pittaluga@standardandpoors.com

Table Of Contents
Real Estate Analysis Rating Through A Recession Real Estate And Loan Interaction And The Importance Of Refinance Risk Assessments Other Loan Level Issues We Consider Consistency, Despite Diversity Related Articles

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Criteria | Structured Finance | CMBS:

Framework For Credit Analysis In European CMBS Transactions

(Editor's Note: This criteria article originally was published on May 21, 2007. We're republishing this article following our periodic review completed on Aug. 31, 2011.) Standard & Poor's Ratings Services' assignment of ratings in European CMBS transactions starts with, and is reliant on, a detailed review of the underlying real estate assets. Significant loan structuring issues and their impact, both positive and negative, also affect the outcome of our real estate analysis. The wide variety of asset types, real estate loans, and transaction structures in European CMBS means that a rigid or prescribed approach to the assessment of credit risk is inappropriate in most situations. A further hurdle is that information availability in European CMBS analysis remains relatively constrained both for the initial rating and its subsequent surveillance. Past performance of the cash flows at the real estate level are often unavailable and general studies of default are also rare. In any event, opportunities to apply this information would be constrained by the lack of diversity seen in European CMBS, as most transactions have one loan that accounts for between 30% and 100% of the Day 1 debt issuance amount. Consequently, the use of stochastic portfolio default models or even a weighted-average foreclosure frequency approach are not suitable for the overwhelming majority of transactions we are asked to rate. However, there are some broad principles of how rating committees in European CMBS transactions consider the credit risks. Our credit evaluation of European CMBS transactions is undertaken by a team of experienced real estate and real estate professionals. This team uses their expertise and applies it to the expected performance of loans and transactions in an evolving real estate and real estate finance landscape. Credit evaluation of real estate debt, particularly transactions backed by a limited number of loans, remains an opinion. However, an informed, differentiated opinion remains of value to market participants. Ultimately, ratings in European CMBS require subjective analysis by a credit committee relying substantially on information provided by issuers and arrangers. Committee members will also draw on their collective real estate experience and knowledge to challenge assumptions where appropriate. Here we provide an overview of the fundamentals of our approach to analyzing European CMBS transactions. Although our focus is on credit analysis, we also consider the impact of other structural and legal issues. For more detail on issues that we consider when reviewing loan level arrangements, see "European CMBS Loan Level Guidelines" in "Related Articles."

Real Estate Analysis

Most real estate loans in European CMBS are non-recourse to their sponsors and the source of payment of interest and repayment of principal is solely the cash flows from the properties securing the loan.

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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions

Consequently, it is critical to analyze these cash flows during the life of the loan and through loan refinance. We make an assessment of cash flows available to meet debt service for each individual loan. This assessment takes into account a number of features of the property, including its location, likely demand from tenants to occupy the property over time, and the appeal of the property to the real estate investment market. This analysis is tailored to the individual asset and is not necessarily exactly the same for all properties within a specific asset class or location. A rigorous assessment of the quality of the real estate and its income-producing potential ultimately shapes our opinion of long-term value. It also determines whether we consider that the real estate has sufficient inherent value to support either a refinancing or a sale to a third party for a sum greater than the remaining outstanding principal balance of the loan before the maturity date of the rated notes that it backs. CMBS analysis is expressly not a CDO of contracted rents from the real estate on long-term leases. This is because although properties leased on long-term leases to investment-grade tenants are generally a positive factor for cash flow evaluation, contracted lease income typically accounts for less than 50% of the investment value of a property over a 10-year period and therefore, on a cumulative basis, is normally less than the total debt amount advanced. In any event, most commercial real estate loans do not provide for significant amortization so the ability to refinance or sell the asset to recover the remaining debt is essential. It is also important to consider that the credit quality of the occupying tenants may evolve over the loan term. It is the quality of the real estate, including its age, condition, configuration, functionality, and location that is often the more significant determinant of risk, rather than the line-up of tenants occupying the assets on Day 1.

Rating Through A Recession

We generally consider environments where cash flows and values are stressed. Transactions where our cash flow assessments exceed in-place cash flows are rare. When considering recession scenarios, we do not default to the recovery levels per square meter seen in previous market downturns. Rather, we make an assessment of the declines in values from current levels both for cash flow and values. Using City of London offices as an example, with recoveries pegged at 1993 levels (the last major recession), would see most investment-grade classes of notes in existing single loan transactions backed by similar real estate suffer a loss, assuming current prevailing subordination levels and a 100% probability of default. In other words, in this scenario, losses would occur further up the capital structure than 'A' rated notes. Although we still assume a recession in our analysis, the calibration of that decline remains a matter of judgment for a rating committee rather than simply looking back at the magnitude of the correction last time. As CMBS tranches take account of recoveries following any default, the probability of default of the loans is generally higher than the probability of default of the lowest-rated tranche.

Real Estate And Loan Interaction And The Importance Of Refinance Risk Assessments
Real estate loans are typically structured to address a series of risks to the debt and to maximize the probability that the loan will be repaid. Interest cover, interest rate hedging, amortization, reserves, and financial covenants, including LTV ratios, are all frequently used to enhance a plain vanilla loan structure.

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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions

Our analysis focuses on how the loan terms mitigate risks. We give credit for loan features that are credit positive, such as well structured and frequently tested LTV ratio covenants. We increase subordination requirements where we consider the absence of these mitigants could have a material impact on recoveries. The declining use of scheduled amortization during the loan term and rise of the five- or seven-year bullet loan has put additional pressure on refinance risk. In forming a view of interest rate risk, we take account of the prevailing interest rate environment and the implied interest rate environment shown by current swap rates as discussed last year in "European CMBS Refinance Risk Part I: Storing Up Trouble For The Future" (see "Related Articles"). An important conclusion that we reached was that investment-grade notes in over 50% of the 44 European CMBS transactions selected for the analysis would experience weak refinance strength and potential losses following a 200 bps upward movement in swap rates to 7.5% without a material rise in property level cash flows. The outcome would be similar in the event of an adverse shift in property yields of the same magnitude (see below). If the same analysis was re-run today using a more recent pool of transactions we think the results could show an even higher proportion of loans would be "at risk" to rising interest rates. This is a function of the continued trend of rising values, increasing overall indebtedness levels, and static underlying cash flows. Consequently, whole-loan exit yields on debt have been under sustained downward pressure and we see no signs of potential refinance issues subsiding. Considering the views of refinance lenders is a key part of the credit analysis of a loan. At refinance, the refinance lender looks at the cash flows over the life of the loan at that point, repeating the work that was done for the initial loan but for a different time period. For example, the initial lender on a seven year loan considers the first seven years and perhaps five years after loan maturity, while the lender at loan maturity looks at cash flows from year eight to year 20, perhaps. In tandem with refinance, a consideration of the then-current market value of the asset is also important. Ultimately, a loan bullet or balloon, as previously mentioned, will be repaid either by financing from another lender or an asset sale, either by the borrower or as a result of an enforcement process. Any analysis of this kind is extremely difficult as it involves judgment. However, there is reasonably good historical property yield data available to enable us to place current performance into a longer-term context. It is important to consider the influence that gilt yields, finance rates, and rental growth prospects could all have on property yields over the life of a loan. At a time of very low yields and correspondingly high capital values, this analysis is as important as ever.

Other Loan Level Issues We Consider

We set out below some of the more pertinent loan level issues that are also considered, which can influence the outcome of our analysis. However, this is not intended to be an exhaustive list.

The impact of the sponsor/borrower

For non-recourse loans, relying on the sponsor to make good cash flow shortfalls in any transaction would not be prudent. Management-intensive assets such as self-storage or shopping malls require motivated sponsors and managers. As a minimum for such assets, we would expect to see an experienced sponsor.

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Our cash flow assessments do not assume that a sponsor funds major capital expenditure at the properties, unless cash reserves have been put in place as part of the initial finance package For transactions where the borrower has material hard cash equity at risk, as opposed to a notional equity stake arising from a favorable revaluation of the real estate, we lower subordination requirements. Wherever appropriate, we expect to see confirmation of purchase price and, if this is lower than the reported property value, it almost certainly becomes our adopted benchmark for calculating the Day 1 LTV ratio as well as the borrower's equity in the transaction. Acquisition costs should not be confused with value as these amounts are always deducted by a potential purchaser when considering an offer. Net purchase price is the figure on which we therefore focus. In certain situations there may be no purchase price information available. Occasionally, however, the assets in question may have appeared more than once before in earlier securitizations, so it is possible to track the degree to which refinancing activity has enabled borrower's equity to have been replaced by debt over time. In limited circumstances, we give enhanced credit for the sponsor. This typically occurs in giving credit for sell-down portfolios, for example.

Enforcement regimes
We evaluate the likely enforcement routes of loans in CMBS transactions. Our CMBS ratings reflect loan probability of default and recoveries thereafter. Efficient enforcement routes require less subordination as the adverse impact on both the amount and timing of recoveries are minimized. The fundamental building block of security in a real estate loan is a first-ranking mortgage. These act as a disincentive for borrowers to fail to comply with the terms of the loans and, ultimately, provide a creditor-friendly path to enforcing security. In some transactions a "springing" mortgage is used. Its purpose is usually to put off significant mortgage registration duties. To avoid contingent perfection and a rating cap on the borrower, these arrangements need to ensure that a mortgage will be put in place when the borrower is solvent, allow for hardening periods, prefund the costs of registration, and allow for the registration of mortgages to be independent of the borrower. Our subordination levels for "springing" mortgage structures are higher than for those with mortgage security on Day 1. While share pledges over borrowers and their holdings companies may be of use in negotiations with a borrower at or around the time of default, these are legally ineffective if exercised over an insolvent entity in the overwhelming majority of European jurisdictions.

Loan flexibility
Where a loan allows substitution of assets, we assume a borrower takes full advantage of this flexibility. Our ratings reflect the weakest potential pool of assets that would be allowed by the terms of the substitution criteria. In particular, the potential to erode interest cover and overcollateralization through substitution have a direct effect on Day 1 subordination levels. Similarly, where borrowers are permitted to undertake development works we would expect, as a minimum, that a borrower can demonstrate before the works commence that they have funds in place equivalent to or, preferably, in excess of, the estimated costs of such works. If there is any concern that the borrower may find itself unable to

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Criteria | Structured Finance | CMBS: Framework For Credit Analysis In European CMBS Transactions

complete the works, we consider the detrimental impact this could have on an asset, its potential cash flow, and its value.

Borrower-level swap agreements

Interest rate hedging is generally considered a positive feature. However, a swap agreement includes a number of termination events that if triggered could lead to unwind costs being paid to the counterparty if the swap is out of the money at that point in time because of lower prevailing interest rates. These costs could be sizeable, particularly if the swap has a long tail. Swaps can terminate, for example, as a result of a loan event of default, non-payment, or loan acceleration. The robustness of the swap is of particular importance when we consider the probability of a loan level default before the maturity date of the swap is relatively high. When this situation arises, we would look to the arrangers to put structural features in place that either help to keep the swap alive or de-prioritize termination payments so they rank junior to the notes.

The ability of the servicer and special servicer

The importance of recoveries in any CMBS credit evaluation means that we carry out a review of all servicers in rated transactions. In Europe, many third-party servicing platforms are evaluated and ranked. Currently, we do not undertake a servicer evaluation where an originator services their own transaction, however, a private assessment is typically carried out in conjunction with any securitization. The track record on servicing and special servicing in Europe is too short to give material credit for these parties' roles in most transactions. However, we do make small adjustments to overall subordination levels, both upward and downward, reflecting our prevailing views of servicing and special servicing. We expect the magnitude of the adjustments to increase over time.

Additional debt and intercreditor agreements

Increasing whole loan indebtedness increases the probability of a borrower default. Even a senior/junior (A/B) structure will still see a borrower having to service and refinance a larger debt stack compared with situations where debt is confined to the senior loan amount alone. Intercreditor agreements in multiple debt level transactions (i.e., A/B or A/B/C) increase the possibility that a dispute between the senior and junior lender could adversely affect recoveries, as the parties may be unable to agree on a course of action following a loan event of default. Any ambiguity that may exist in the agreement could compound disputes and delays. We reduce subordination requirements where intercreditors are considered to be clearly drafted and do not grant embedded control rights to a junior lender once the economic value of their interest is significantly diminished. In agreements where the junior lender has the option to acquire the senior debt at par, a number do not expressly provide for reimbursement of securitization costs such as special servicing and liquidity. Costs not reimbursed generally short the lowest tranche of rated notes, resulting in the rating on them being lowered towards 'D'.

Taking account of CMBS structures

Even when an assessment of loan risks has been concluded, the credit analysis is incomplete without an analysis of the CMBS structure, its priority of payments, and how it treats early repayments of principal. Class X notes for excess spread, pro rata pay, and available funds caps can all affect CMBS tranches. In general, the effect is generally not credit positive at each point in the capital structure.

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Earlier we stated that CMBS tranches take account of recoveries following any default and, therefore, the probability of default of the loans is generally higher than the probability of default of the lowest-rated tranche. However, this outcome presupposes a CMBS structure that facilitates timely payment of interest until, and repayment of debt upon, recovery with no additional shortfall over and above that which we anticipated during our loan level analysis. Class X notes typically extract all excess cash and, in some cases, continue to be paid without any deduction even after a loan event of default has occurred. The additional burden of special servicing fees and liquidity therefore affects the junior notes first and will increase overall losses. Appraisal reduction mechanisms which limit liquidity drawings in a default situation where it has been determined the LTV ratio has breached, say, 90%, also need to be carefully considered in the context of the more highly leveraged loans that we see. If the reduction mechanism is triggered, our ability to rate to timely payment of interest is impaired and the affected notes would be downgraded regardless of the likelihood of eventual recoveries. We also highlighted how a junior lender's purchase option that fails to deliver a "make whole" purchase price would lead to a downgrade of the ratings on the most junior class of notes. Unfortunately, these are all examples of where the credit analysis of the senior debt can be undermined by a structural defect that all too easily shorts what might otherwise be considered investment-grade notes. High prepayment rates in European multiborrower transactions, coupled with pro rata pay, can leave the most senior class of notes exposed to the credit risk of the last remaining loan in the pool. It's not possible to evaluate every prepayment scenario but we consider several possible scenarios and increase subordination levels to take account of many but not all prepayment outcomes. Available funds caps limit the interest coupon to a tranche to that which is available. Its main purpose is to avoid a ratings downgrade where, following prepayment, the margin on the remaining loans is not sufficient to meet the interest coupon on the notes. Available funds caps should only address prepayment risk.

Interaction of legal and credit risks

We rely on issuers and arrangers to structure transactions to take account of prevailing laws in the jurisdictions where collateral is situated, where any borrower has a holding company, and taking account of the domicile of the issuer. Resolving the complexities of tax laws in several European jurisdictions, structuring cash flows to ensure timely payment of interest on rated notes, and avoiding withholding or other taxes is not straightforward. Legal risks at the loan and issuer level are further reflected in our credit analysis. However, we consider that legal risks at the issuer level are somewhat binary in their outcome.

Consistency, Despite Diversity

We have highlighted the importance of anchoring our analysis in the fundamentals of the underlying real estate. This in itself can produce differing outcomes even where assets are broadly similar. No two assets are exactly the same. When one also considers the impact that the loan structuring features referred to can potentially have on the credit analysis, it should become apparent why it is impossible to publish meaningful guidelines on subordination levels in European CMBS transactions.

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Despite the necessary prominence of subjective, qualitative analysis, however, we ensure that the analytical approach adopted for each transaction is consistent.

Related Articles
"European CMBS Loan Level Guidelines" (published on Nov. 15, 2006). "European CMBS Refinance Risk Part I: Storing Up Trouble For The Future" (published on June 15, 2006). All related articles are available on RatingsDirect, the real-time Web-based source for our credit ratings, research, and risk analysis.
Additional Contact: Structured Finance Europe; StructuredFinanceEurope@standardandpoors.com

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