Expected defaults of commercial mortgages: an alternate scenario

RMA Journal, The, May, 2002 by George J. Pappadopoulos

Mixed economic news has heightened uncertainty in all investment markets, leaving many investors trying to discern the downside exposure of their assets. Although many believe the worst may be over and a recovery is not far off, others hold the opinion that a protracted downturn is a very real possibility. Either event warrants an examination of the effects of a more dire scenario, no matter what the asset class.

Certainly, commercial mortgages are no exception. Protracted recessions are bad for real estate. Reduced demand for space drives vacancies upward and NOIs deteriorate. Investors then price those cash flows more conservatively, and values fall. The critical consideration, then, for a portfolio lender or bond buyer is the extent of these declines. Is there sufficient protection in a mortgage structure to weather them?

Obviously, there is no simple answer. The investment's resilience depends not only on the particular loan structure but also on the recession's effects on the specific market and property type collateralizing the loan. Clearly, each market (MSA/property type pair) has a unique level of exposure. Such factors as industry mix, extent of overbuilding, supply/demand response rate, property type, economic drivers, and extent of the recession all play important roles in determining the degree of deterioration. How, then, do these variables affect individual mortgages?

The February 2002 "Real Estate Quantified" used PPR's proprietary methodology for forecasting post-September-11 expected default frequencies and loss given default under a rebound scenario. That is, it assumed a downturn with a deep "V" shape (as opposed to a long "U"), wherein a total of four quarters of negative growth is followed by an economic bounce back as both fiscal and monetary stimuli have their full effects. It assumes that the economy purges its imbalances and that we have a rapid recovery, as has been typical of past recessions.

Instead, we now look at the effects of a more protracted and deeper recession. This scenario is characterized by six quarters of economic contraction followed by a recovery that only returns to prior base case levels of growth. Such an outlook includes a long period of very low levels of consumer confidence, protracted military actions, and a highly uncertain equities market.

The results from this more dire and protracted outlook are compared with the rebound scenario seen at the top of the next page. Obviously, the long "U" scenario exhibits greater default probabilities and loss given default across all categories. The increased stress on the underlying real estate collateral translates into a substantial increase in expected losses (probability of default x loss given default) under both of the tested loan structures, and this holds true for all four major property types.

As expected, apartments exhibit the least deterioration from the more severe economic hit. This property type generally fares better in a recession as the negative impact from reduced household formations is partially mitigated by an accompanying reduction in home ownership rates. That is, although fewer young adults are leaving their parents' homes to rent apartments, there are also fewer families leaving the rental environment to purchase a house. In addition, this safer-haven status attracts a disproportionate amount of investment capital. As a result, apartment values hold up better than the other property types, and less drastic credit migration occurs.

On the other hand, office loans are likely to see the most substantial effects from the poorer economic environment. Business profitability suffers and tenants contract substantially. Landlords must deal with increased vacancy and tenant credit issues. The longer the situation continues, the more vacancy grows as leases roll. The problems are then exacerbated as investment capital flees this most volatile property type. So, even though expected losses for office loans were already the most severe of the group under the deep-V scenario, the increased stress of the more dire long-U pushes collateral beyond its limits at an exponential rate.

The increased severity for retail loans is nearly as bad as for office. Obviously, consumer confidence contracts, and spending dwindles. This decrease in retail sales hurts retailers and, in turn, places more stress on retail property owners. Increased headline risk will exacerbate this already penalized property type, and less capital will depress prices even further. As a result, expected losses would be the second highest next to office.

As the economy goes, so goes warehouse. Warehouse property performance is highly correlated to overall GDP growth, and, as a result, warehouse defaults will certainly increase under the more dire economic scenario. The lack of retail sales and manufacturing activity reduces the need for warehouse space as inventories contract. Fortunately, construction is able to shut down more quickly for warehouses, and the result is less severe than for office or retail.