Download Commercial Real Estate Non-Performing Loan Liquidating Trust

Methodology
Commercial Real Estate
Non-Performing Loan Liquidating Trust
Methodology
october 2010
CONTACT INFORMATION
David Nabwangu
Vice President
CMBS
Tel. +1 312 332 9443
[email protected]
Erin Stafford
Senior Vice President
CMBS
Tel. +1 312 332 3291
[email protected]
Mary Jane Potthoff
Senior Vice President
CMBS
Tel. +1 312 332 0837
[email protected]
DBRS is a full-service credit rating agency
established in 1976. Privately owned and operated
without affiliation to any financial institution,
DBRS is respected for its independent, third-party
evaluations of corporate and government issues,
spanning North America, Europe and Asia.
DBRS’s extensive coverage of securitizations
and structured finance transactions solidifies our
standing as a leading provider of comprehensive,
in-depth credit analysis.
All DBRS ratings and research are available in
hard-copy format and electronically on Bloomberg
and at DBRS.com, our lead delivery tool for
organized, Web-based, up-to-the-minute information. We remain committed to continuously
refining our expertise in the analysis of credit
quality and are dedicated to maintaining
objective and credible opinions within the global
financial marketplace.
Commercial Real Estate Liquidation Trust Methodology
October 2010
Commercial Real Estate Liquidation Trust Methodology
TABLE OF CONTENTS
Introduction
Background
Original RTC and Liquidation Trust Structures
Anticipated Structure of new Liquidation Trusts
Anticipated Cash Flow Waterfall
DBRS Approach to Rating CRE LTs
Pre-Qualifications
Equity
Special Servicer
Servicer Review
Documents and Reporting
Purchase Price
Recent Opinion of Value
Historical Financial Performance
Monthly Cash Flow Remittance
Site Inspections
Rent Rolls
DBRS Data Tape Requirements
Model Overview
Step 1: Initial Value-Driven Credit Enhancement
Observed Market Value
Recent Opinion of Value
Market Comparables Value
Cash Flow Driven Value
Sustainable Cash Flow
Debt Yield and Equity Requirements
Liquidation Expenses & Deferred Maintenance
Initial Value-Driven Enhancement Levels
Step 2: Cash Flow Stress Tests
Cash Flow Volatility
The Timeline of Foreclosure
Cash Flow from Liquidations
Servicer Fee Structure
Land Loans
Cash Flow Test and Bond Losses
Step 3: Loan Correlation Stress Test
Cash flow Decline
Timing of Cash Flow Decline
Loss Severity
Time to Liquidation
Surveillance
Other Considerations
Environmental Risk
4
5
5
6
6
7
7
7
7
7
7
7
7
7
7
8
8
8
9
9
9
9
9
9
10
10
10
11
11
11
12
13
13
13
13
14
15
15
15
16
16
16
16
3
Commercial Real Estate Liquidation Trust Methodology
October 2010
Introduction
As a result of the performance deterioration in the U.S. commercial mortgage sector, lenders and CMBS
special servicers now hold an increasing portfolio of seriously delinquent loans and defaulted loans.
With an imperative need for liquidity, one option available for lenders to finance their portfolios of nonperforming loans (“NPLs”) is to issue notes backed by the liquidation of non-performing mortgage assets.
Such a structure is often called a “liquidating trust” (“LT”). LT note holders are dependent primarily
upon proceeds from the liquidation of mortgaged properties, as opposed to traditional cash securitizations where cash flows from the receipt of monthly borrower remittances.
As of September 1, 2010, a U.S. commercial LT has not been structured containing recent vintages of commercial loans. However, residential mortgage-backed securities (RMBS) LTs secured by non-performing
residential loans have been issued in 2010. A typical RMBS LT includes three classes of notes each rated
investment-grade, with an unrated equity piece. A reserve fund is typically funded upfront to cover any
interest shortfalls that might occur before the liquidations begin to occur.
This methodology is in response to many inquiries received by DBRS and as a result DBRS expects commercial mortgage LT issuance within the next few years to be a viable option to help clear the mounting
volume of commercial NPLs. We expect the main drivers for issuance to be: 1) demand from distressed
investment funds and hedge funds, 2) lenders seeking to obtain financing for non-performing assets in an
effort to ease liquidity pressure through LT securitization.
DBRS is requesting comments on the following methodology by November 30, 2010. Comments can be
sent to [email protected]. Specifically, DBRS is interested in perspectives surrounding the following topics:
1. Should there be a minimum equity requirement on behalf of the loan seller to access this financing?
If so, what is the appropriate threshold? The loan seller is being defined as the entity that holds the
equity (“NR”) tranche and directs the special servicer.
2. Should upfront reserves to guarantee interest also be used to guarantee servicing fees?
3. Should there be a minimum reserve to pay property protection advances, taxes and insurance in order
to protect against adverse selection within the pool? If so, is it appropriate for this to build over time
or should it be established upfront?
4. Should cash flow volatility, and therefore volatility of valuations, increase in states where the foreclosure process is longer?
5. At what minimum interval should servicer visit and inspect the property? Performing loans are typically subject to annual inspections?
6. Should timing and expenses be increased to account for borrower bankruptcy? Alternatively, do foreclosure timelines already consider impact of bankruptcy?
4
Commercial Real Estate Liquidation Trust Methodology
October 2010
Background
As of the second quarter of 2010, there was $3.2 trillion of commercial/multifamily mortgage debt outstanding, according to the Federal Reserve Board of Governors Flow of Funds1. Of that $3.2 trillion,
45% is held by commercial banks and 20% is within CMBS or other structured finance products. As the
overall U.S. economy slowed in 2008 and reached the deepest financial crisis since the Great Depression,
the commercial real estate sector also severely deteriorated. The combination of the difficult economic
environment, a spike in unemployment, and businesses either vacating or renegotiating leases began a
deep slide of commercial real estate values leaving many properties over-levered and unable to cope with
the fluctuations in cash flow and/or unable to refinance the existing debt. As of the third quarter in 2010,
8.8%2 of CMBS fixed-rate mortgages are delinquent compared with less than 1% by YE2007. Banks and
thrifts 90 days or greater delinquencies were reported to be 4.26% as of Q2 2010.3
Properties that are transferred to the special servicer from the master servicers are either in need of a
modification, are more than 60 days delinquent, are non-performing, or are on the verge of imminent
default. Once a mortgage is non-performing, the special servicer of a defaulted mortgage evalutes the
highest and best resolution for the loan which can include foreclosure proceedings on the mortgaged
property or payment modification with the borrower. If the special servicer proceeds with foreclosure,
given the certainty of default of a non-performing mortgage, outside of CMBS the servicer is not obligated
to advance for delinquent monthly remittances of interest and principal. Most non-performing properties
do generate cash flows, although these may be anemic and at worst negative. In addition to this cash flow,
any expenses associated with liquidating an asset are offset by liquidation proceeds received from the sale
of the mortgaged property and any insurance proceeds.
A practical alternative for a lender to fund a portfolio of non-performing loans is a Liquidating Trust
(“LT”) structure, given the expectation of foreclosure or a discounted pay-off (“DPO”) on the mortgage
assets of the trust if no other action is taken. LTs are generally done in the form of an owner trust securitization because of the ineligibility for REMIC status.
The funding of a LT is accomplished by the issuance of notes and represents indebtedness of a trust.
Since a LT may be comprised of one or more pools of non-performing loans, it is expected that cash flow
largely depends on the liquidation timing of the defaulted mortgaged properties, as well as the recoverable proceeds of the defaulted mortgages. The notes can assume a senior-subordinate structure and may
have forms of credit enhancement including (but not limited to) overcollateralization, subordination and
a reserve fund.
ORIGINAL RTC AND LIQUIDATION TRUST STRUCTURES
In the early 1990s, in the wake of the Savings and Loan (“S&L”) crisis and the closure of hundreds of
depository institutions, the U.S. Government initiated the Resolution Trust Corporation (“RTC”) to
oversee the disposal of failed bank real estate loans. The RTC’s mandate was to liquidate S&L defaulted
assets to recover as much money as possible and to limit the impact on the already suffering real estate
markets. One successful structure imposed by the RTC was the formation of commercial real estate securitized liquidation Trusts (Trusts). The Trusts, comprised of commercial real estate loans in various stages
of default, were structured with senior tranches of investment-grade securities available to the public
market and a subordinate equity piece retained by the issuer. A servicer was put in place to coordinate
the collection of monthly property payments as well as facilitating the sale process for any loans within
the Trust. As the loans within the Trust were sold, the most senior certificate holders received interest and
principal until all public certificates were retired.
1. MBA Commercial / Multifamily Mortgage Debt Outstanding Q2 2010
2. Trepp LLC
3. MBA Commercial / Multifamily “Mortgage Delinquency Rates for Major Investor Groups” Q2 2010
5
Commercial Real Estate Liquidation Trust Methodology
October 2010
The initial structure of the investment-grade securities varied, but all Trusts contained a liquidity reserve
to protect the purchasers of the investment-grade securities from a lag in the time lines of the liquidation
of the Trust’s loans. The liquidity reserve provided sufficient cash flow to cover the interest obligations to
the senior certificates. Capital Improvement Reserves were also initially funded by the issuer to provide a
reserve should the safety and integrity of the property securing a particular loan need any repair.
ANTICIPATED STRUCTURE OF NEW LIQUIDATION TRUSTS
Similar to the S&L crisis of the early 1990s, the U.S. is facing a growing number of delinquent or defaulted
loans either on banks’ balance sheets or in various securitization special servicing departments. In order
to facilitate the number of delinquent and defaulted loans, the liquidation trust previously used by the
U.S. government during the early 1990s is a credible solution to allow for public investment and orderly
liquidation of the growing number of impaired commercial real estate loans.
The new NPL securitizations structures are anticipated to incorporate pre-funded liquidity interest
reserves, and capital improvement reserves to provide security for the investment-grade certificate holders.
Additionally, a qualified servicer is expected to be in place to manage the pool of assets as well as the
coordination of liquidations to maximize recovery values for the Trust.
The criterion for a ‘AAA’ rating includes the presence of a dedicated, pre-funded, interest reserve for the
most senior bond in the structure. The interest reserve would need to be sufficient to fund interest owed to
the bond for its estimated weighted-average life. DBRS may rate subordinate bonds in the structure that
do not contain such a reserve if the bonds are subject to available funds cap or payment in kind (PIK). If
the bonds are PIK, the bonds’ principal is anticipated to increase in accordance with any interest shortfall.
ANTICIPATED CASH FLOW WATERFALL
While public certificates are outstanding minimum levels of interest, and capital improvement reserves are
needed in order for the bonds to maintain their original ratings as a result DBRS analyzes the underlying
credit components of the NPLs as it relates to the transaction’s proposed waterfall.
DBRS considers the implications of different structures on a case-by-case basis. Below is an example of a
waterfall structure that may support a AAA rating:
1. Operating cash flows or liquidation proceeds first pay any property protections advances not
supported by individual property cash flows.
2. Remaining cash flows replenish the interest reserves, which are kept in escrow.
3. Remaining cash flows pay pre-determined administrative and servicing fees.
4. Remaining cash flows pay AAA interest.
5. Remaining cash flows pay AAA principal.
6. Remaining cash flows pay rated bond interest.
7. Remaining cash flows pay rated bond principal.
The equity holders do not receive any distributions of interest or principal until all the public certificates
are completely paid-off in full.
Unlike a residential non-performing loan pool, most commercial properties still produce monthly operational cash flow. Assuming a receiver is in place or cash flow is otherwise controlled by the LT, the
monthly property cash flow after payment of operational expenses is contributed to the LT cash flow
waterfall and follows the same path as any liquidated proceeds.
6
Commercial Real Estate Liquidation Trust Methodology
October 2010
DBRS Approach to Rating CRE LTs
PRE-QUALIFICATIONS
In order to qualify for and maintain a DBRS rating, a LT is expected to have certain structural and reporting elements in-place.
Equity
There must be a sufficient amount of equity in the deal to warrant a DBRS investment-grade rating.
“Equity” is defined as the positive difference between the purchase price of the collateral by the loan seller
and the rated-bond principal issued by the trust. The collateral must have been purchased in an armslength transaction by the loan seller, and the loan seller must be able to demonstrate to DBRS why and
how the purchase price represents the correct market value of the collateral.
Special Servicer
The special servicer mandated with the workout of the loans must have incentives that are built into the
deal structure; which ensures their long term concern over the liquidation time and value recovered by
the workouts. The special servicer must maintain an abiding interest to work on behalf of the Trust to
expedite the liquidations while maximizing recovery as opposed to reinvesting in the properties to create
long-term value. This interest is important as the cash flows of the NPL are dependent upon an orderly
and timely liquidation of the assets.
Servicer Review
Prior to contemplating a transaction, DBRS reviews the special servicer’s ability to liquidate the assets
in an efficient manner while maximizing value. DBRS continues to evaluate the servicer’s performance
throughout the life of the LT. For more information on DBRS commercial mortgage servicer evaluations
please refer to the methodology entitled “Commercial Mortgage Servicer Evaluations” available on www.
dbrs.com.
Documents and Reporting
DBRS expects the following documents and reporting to establish and maintain their ratings of the LT.
Purchase Price
DBRS must have access to the actual purchase price that the issuer or loan seller paid for each of the loans
in the pool, and/or documents that demonstrate a real market value for each property in the pool.
Recent Opinion of Value
DBRS expects the Trust to have an independent third-party report which provide an estimate for the
market value of each property. These can be a broker’s opinion of value (BOV); a recent appraised value
(MAI Appraiser); or a recent special servicer asset status report which includes an assessment of value.
DBRS finds benefit in all three forms and does not prefer one over the other. The most important features
are the time frame in which the valuation or assessment was completed and the assumptions used.
Historical Financial Performance
DBRS reviews records of the past monthly and annual financial performance for each asset in the trust.
The past financial statements informs DBRS as to the estimates of the in-place cash flow of each property,
the future potential for performance of each property, as well as the speed of deterioration and cash flow
volatility of each property.
Monthly Cash Flow Remittance
Throughout the life of the transaction, DBRS must have access to monthly cash flow reporting on each
of the properties with detailed delineation of monthly revenues and expenses due to the volatility of the
NPL and LT.
7
Commercial Real Estate Liquidation Trust Methodology
October 2010
Site Inspections
Throughout the life of the transaction, DBRS must have access to periodic site inspections for each of the
properties in the pool. It is expected that the special servicer conducts periodic site visits and relays the
results to DBRS in a timely manner.
Rent Rolls
DBRS must have access to an updated rent roll for each of the properties in the pool, at issuance and
throughout the life of the transaction.
DBRS Data Tape Requirements
DBRS expects a data tape which in some way contained the following data elements on each of the loans
in the pool.
Property Characteristics
Property Type
Detailed Property Type
Address
Net Rentable Area (SF and/or Units)
Year Built
Year Renovated
Issuer Purchase Price of Assets
Latest Appraised Value
Latest Date of Appraisal
Latest Financial Statements (with available history)
Pro Forma Financials
Deferred Maintenance
Loan Characteristics
Original Note Amount
Last Note Amount
Loan Status
Status of Foreclosure Proceedings
Status of Bankruptcy Proceedings
Status of any Outstanding Judgments
Status of Cash Flow Remittance
Status of Receivership
Resolution Strategy
Reserves
8
Commercial Real Estate Liquidation Trust Methodology
October 2010
MODEL OVERVIEW
DBRS uses a three-step approach to rating CRE LTs. The first step is to review proposed credit-enhancement levels for each transaction. This approach relies on estimates of the individual property’s values
which are stressed at successively higher levels at each successively higher rating category.
As DBRS ratings address the timeliness or ultimate repayment of the principal and interest that are
received by investors, a second step is necessary to model and stress the timing of liquidations and other
cash flows. The test stresses the timing of receipt of proceeds by the LT in an effort to gain confidence
that there is sufficient cash flow and reserves available to avoid potential interest shortfalls and principal
losses.
There are innumerable possibilities in terms of the timing and amount of recovered proceeds. DBRS
undertakes another additional step to examine different scenarios that may occur, and observes their
impact on the bond structure. This third and final step aims to ensure that the structure survives under
a variety of stress scenarios that consider the impact of asset correlations and concentrations. This third
and final step acts as a check and balance to the value assumptions and cash flow stress tests applied by
DBRS in the first two steps of its analysis. If challenged, DBRS may revisit the assumptions being used in
the first two steps as these steps serve as the primary rating drivers for a CRE LT.
Step 1: Initial Value-Driven Credit Enhancement
The DBRS model tests the proposed credit enhancement levels by establishing values for each property
which are next subjected to stresses as outlined in Steps 2 and 3 below. The values at the deal’s inception
and at the time of liquidation are critical to the DBRS analysis. DBRS undertakes a variety of approaches,
as described below, in determining value at origination and generally utilizes the most conservative
outcomes.
Observed Market Value
Observed market value is generally the value implied by the purchase price that the loan seller paid for
the collateral. DBRS requests the loan seller to report purchase prices for each of the properties in the
transaction, and provide convincing evidence that these prices are representative of the market value of
each asset.
Recent Opinion of Value
A recent opinion of value must be provided by an independent third-party for each property in the poll
is requested by DBRS,in order to achieve an investment-grade rating. These can be a broker’s opinion
of value (BOV);a recent appraised value (MAI Appraiser); or a recent special servicer asset status report
which includes an assessment of value. As noted earlier, DBRS finds benefit of all three forms and does
not prefer one over the other. The most important features are the time frame in which the valuation or
assessment was completed and the assumptions used.
Market Comparables Value
DBRS collects detailed market value statistics for commercial real estate properties and uses these statistics to build comparable market value per unit estimates for each property based upon certain property
characteristics such as, property type, size, market liquidity, zip code, city, MSA and state. The estimate
of value is derived from these comparable per unit values.
Cash Flow Driven Value
DBRS maintains that the relative value of commercial real estate is in the long run affected most by a
property’s in-place cash flow. DBRS firmly believes that this tenet holds true for both performing and
non-performing properties.
9
Commercial Real Estate Liquidation Trust Methodology
October 2010
Even though the loans are considered non-performing, most properties are generating some level of cash
flow. In order to understand the correct cash flow from which to derive value, DBRS evaluates each
property in order to arrive at a sustainable cash flow. The sustainable cash flow, which is further described
below, differs from the observed in-place cash flows at the property.
Sustainable Cash Flow
The sustainable cash flow that drives the DBRS value estimate is the cash flow that is realistically achievable by a property in its first 12-months after liquidation. It is the cash flow that a buyer may likely
estimate for the short to medium term after purchasing the property and thus the cash flow that would be
a significant driver of the buyers’ conservative assessment of value. DBRS applies its underwriting methodology with the purpose of estimating this cash flow.
DBRS generally samples all of the loans contributed to the CRE LT in some manner including a desktop
review or in-depth file review inclusive of site inspections, as the event risk surrounding any particular
loan is high. DBRS begins with in-place cash flow and relies on the current property financials, third-party
broker information, and special servicer opinions (if applicable) to determine a market sustainable cash
flow. DBRS also performs rent roll analysis to estimate the future expected cash flow volatility, by examining upcoming lease expiration schedules and recent leasing activity, and adjust its estimate for sustainable
cash flow accordingly.
With non-performing loans, recent historical financial performance is an important consideration as it
yields information on the rate of deterioration of a property’s cash flow. DBRS considers recent performance trends for the property and its market and adjust its estimate of sustainable cash flow accordingly.
In an instance where either the observed market value, broker’s opinion of value, and/or market comparable value, is more conservative than the cash flow driven value, DBRS reviews the reasons for the
variance and, if warranted, adjusts its estimate for market sustainable cash flow downward such that the
cash flow driven value reflects the most conservative value estimate.
Debt Yield and Equity Requirements
After determining a sustainable market cash flow, DBRS applies an appropriate debt yield and equity
requirement, primarily based upon property type, and stress the yields throughout the capital structure
to determine an initial recoverable value for each rating level. The debt yield stresses are determined to
capture a variety of potential challenges the properties face, such as illiquid lending environments, more
stringent lending standards requiring increased equity positions, and an overall stressed commercial real
estate environment.
The DBRS debt yield criteria were determined through careful examination of past CRE debt yields
throughout multiple real estate cycles. They begin with a historically relevant level and are stressed
upwards at each successively higher rating category to reflect more stringent environments.
The debt yield criteria were derived from data that does not make a distinction about whether a loan is
performing or non-performing. The added volatility in value provided by the fact that the collateral is
non-performing is adequately captured in the sustainable cash flow assumed by DBRS. The sustainable
cash flow nearly always is below a comparable performing asset, and when coupled with the debt yield
hurdles the implied recoverable value reflects this difference. While CMBS market statistics do not yet
fully reflect the full impact of the recent credit bubble (in large part from 2005-2007), it has been the
experience of DBRS that the debt yield hurdles used accurately reflect the recent observed realized losses
of CMBS loans.
Liquidation Expenses & Deferred Maintenance
The recoverable values previously described are reduced by the estimates of the liquidation expenses and
any actual deferred maintenance cost.
10
Commercial Real Estate Liquidation Trust Methodology
October 2010
Liquidation expenses included in the final valuation are legal and broker closing costs and remediation of deferred maintenance that has occurred at the property during the time the loan was in default.
Liquidation expense estimates were derived from empirical observation of expenses as well as verification
through discussions with knowledgeable market participants. The range of liquidation expenses applied
to the value is 6% to 26%, depending on the size of the subject property and the requested rating level.
Under the premise that the borrower pays its debt service obligations at the expense of not reinvesting
into the property, DBRS expects that most properties have an element of on-going deferred maintenance.
DBRS uses property condition reports, its own site inspections and/or a minimum deferred maintenance
to account for the out-of-pocket expense a buyer would have to invest into the property thus reducing
the value. The minimum deferred maintenance is equivalent to a minimum capital expenditure allowance multiplied by the number of months the loan is delinquent, and the actual deferred maintenance as
provided by the recent property reports.
The sustainable cash flow, debt yield and equity requirements, the deferred maintenance and liquidation
expenses imply a recoverable liquidation value for each asset at each rating category, given by the following formula:
Recoverable Liquidation Value [rating category] =
( Market Sustainable CF / Debt Yield Bench Marks [rating category] + Equity Requirement ) –
Deferred Maintenance - Liquidation Expense
Initial Value-Driven Enhancement Levels
The initial value-driven enhancement levels represent the sum of the recoverable values of each of the
loans at each of the rating categories, divided by the total pool balance. DBRS values are not negative.
The cash flow stress test assumes the negative carry associated with non-cash flow producing properties,
but the recoverable liquidation value assumes there is minimum value to recover liquidation expenses and
therefore is considered zero, but not negative.
Step 2: Cash Flow Stress Tests
DBRS subjects the initial value-driven enhancement levels to stress tests which consider a number of different factors not captured by the value-driven approach.
These factors are:
The timeline of foreclosure
The on-going capital expenditures
Maintenance costs
The in-place cash flow (as opposed to the sustainable cash flow of the property),
The type of resolution strategy
The delinquent loan status
Likelihood of potential cash flow volatility.
The cash flow stress test also considers the structure of the bonds, the available interest reserves based on
stressed liquidation timelines and the administrative and servicing incentive fees.
Cash Flow Volatility
The model ties cash flow volatility to the timing of the loan’s resolution. The longer the loan remains in
the pool the greater the stress applied to each asset’s cash flow. The stresses that govern each cash flow
stress at each rating category are derived from observed volatilities of cash flow across each property type,
as well as an appraisal of the cash flow stability at each subject property. (See January, 2010 DBRS CMBS
Ratings Methodology, page 10).
11
Commercial Real Estate Liquidation Trust Methodology
October 2010
In our view, the practical effect of using cash flow volatility estimates that are derived from observations
of both performing and non-performing loans provides ample volatility estimates across rating categories
for non-performing loans. The potential (and observed) downside volatility in cash flow is often greater
for performing loans, as the cash flow has further to fall. Non-performing loans tend to already have
depressed cash flows with downside that is limited to a minimum possible cash flow reflective of zero
revenues minus involuntary expenses and capital items.
The base model assumption begins with the reported in-place cash flow and assumes a decline of cash
flow over a twelve month period. The twelve month hurdle represents the model’s most severe potential for cash flow loss, especially considering the loans transferred into the CRE LT already present a
distressed cash flow. The rationale behind the decrease in cash flow is rooted in the assumption that the
longer an asset remains in default, the greater the probability of further cash flow decline.
In order to test the proposed credit enhancement levels, DBRS projects this individual loan level cash flow
out on a monthly basis until the property reaches its estimated liquidation date.
DBRS performs a rent roll analysis in order to validate its first broad estimations of cash flow volatility.
The analysis is comprised of examining the tenant lease expiration schedules at each property and the
tenant rental rates with respect to the market rental rate. The aim is derive both the best case and worst
case scenarios of the property’s cash flow volatility during, and slightly beyond, the expected time to
liquidation. DBRS uses the conclusions of the rent roll analysis to drive adjustments of each property’s
estimated cash flow volatility.
The aforementioned cash flows include a projection of the monthly capital expenditures at each property.
The estimate of capital expenditures specifically excludes tenant improvements and leasing commissions,
and/or other items related to stabilizing the asset and leasing vacant space. The capital items included in
the model instead incorporate estimates for expenses that maintain the structural stability and integrity
of the asset during the resolution process. This reflects the broader focus of the LT which attempts to sell
assets as quickly as possible without stabilizing and re-leasing vacant space.
The Timeline of Foreclosure
The timelines of state-foreclosure processes are generally published and depend heavily on the individual
judicial system for each state, as well as the intentions of the special servicer and their chosen approach
to the workout.
An individual loan’s carrying time begins with an estimate of the monthly carrying period for its state,
which considers the length of the process period, the sale publication period and redemption period in
the state.
This baseline estimate may be adjusted to reflect the perspectives of the special servicer. Workout strategies that are deemed to be more expedient reduce the estimate for carrying period applied. For example,
a loan for which the servicer is pursuing a discounted pay-off strategy is given credit (once verified by
DBRS) over a loan for which the servicer is pursuing a foreclosure strategy, all else being equal. The credit
for the workout strategy is applied to a loan’s estimated liquidation time. The investment-grade rating
categories begin with the baseline assumption that the workout strategy is foreclosure.
DBRS then stresses this carrying period across each rating category to capture the wide range of potential
resolution outcomes within each particular state. For example, the State of Tennessee has a two-year
redemption period available to foreclosed borrowers included in the liquidation process. Therefore, loans
within the State of Tennessee have a longer modeled liquidation time than a property located in Texas as
Texas has a median liquidation period of one month. In general, states with a judicial foreclosure process
have longer liquidation timelines than non-judicial states and these circumstances are taken into consid12
Commercial Real Estate Liquidation Trust Methodology
October 2010
eration when modeling the pool’s liquidation scenarios.4
DBRS adds an additional time allotment for the marketing and sale of the REO asset. This additional time
varies by rating category from anywhere between six and twelve months.
Under this methodology, the median expected time to liquidation (before DBRS adjustment) is 13 months
and values across properties can range from seven to 32 months. The AAA stressed carrying periods
(before DBRS adjustment) can range from a minimum of 27 to a maximum of 52 months.
Based on the treatment of cash flows described above, a longer liquidation timeline has the following
ramifications. First, the longer the period, the more carrying costs and interest expenses are included in
the cash flow waterfall. Second, the greater the carrying period, the greater the cash flow decline applied
to the monthly cash flow of the asset. Finally, the longer the carrying period, the less servicer fees due to
the incentivized servicer fee structure.
Cash Flow from Liquidations
At the end of the estimated carrying period, DBRS recognizes the cash flow from the liquidation of a
given property and applies it to the cash flow waterfall. The liquidation values differ across rating categories and accord to the estimated recoverable values and expenses that were established by the process
described in Step 1 of this methodology (see Step 1: Initial Value- Driven Credit Enhancement)
Servicer Fee Structure
DBRS views the alignment of servicer incentives as an essential part of its rating process and the intended
operation of the LT. DBRS does not rate transactions that lack a strong incentive for the servicers to liquidate the loans in a timely manner. Balancing the need for rapid liquidation of the loan is the need for
enough recoverable proceeds to repay the bond principal and any outstanding interest obligation.
To deter servicers from only focusing on the speed of liquidations and ignoring the maximization recoverable value, DBRS critically reviews the servicer’s fee structure to determine if it promotes both quick
liquidation and sufficient recoveries for the trust.
Land Loans
By nature, land does not produce cash flow and requires significant capital investments to transform it
into a cash flowing asset. Land loans have a negative carrying value due to taxes owed. The DBRS model
gives zero value to land loans and implements a selling expense attributed to these loans. Because of the
uncertainty of purchase prices, negative carry values and liquidation values, DBRS uses a conservative
analysis and models each land loan with 100% loss severity throughout the loan’s capital structure.
Cash Flow Test and Bond Losses
The DBRS methodology tests the capital structure for two distinct possibilities. First, the estimated cash
flows are applied to the waterfall to see whether the structure incurs a reserve shortfall on any given
month before all loans have been liquidated from the trust. Second, the estimated cash flows are applied
to the waterfall to see whether the structure incurs a loss to rated bond principal.
The tests are run for each rating category of the structure. The tests for each category apply the related
stress level for each of the model inputs. For example, the AAA bond must be able to withstand AAA
level stresses to the aggregate pool’s loans cash flow volatility, speed of cash flow deterioration, speed of
liquidation, and recoverable values.
4. Guided by http://www.realtytrac.com/foreclosure-laws
13
Commercial Real Estate Liquidation Trust Methodology
October 2010
An example of a cash flow test would be as follows:
On any given month the estimates for the current period loan level cash flows are summed and represent
the cash flow that are applied to the structure. These cash flows are first applied to any outstanding obligation to the capital expenditure reserves. The capital items required on any given month represent the
DBRS estimate for capital items on the outstanding loans. The beginning balance of the month’s reserves
equates to the prior month’s ending balance or the initial reserves funded at the closing of the trust (for
the 1st month). Where appropriate, any excess reserve balance over the required existing reserve amount
is added to the available cash and released down the waterfall.
The remaining available cash flows are then applied to any outstanding obligation to the interest reserves.
Where appropriate, any excess reserve balance over the required existing reserve amount is added to the
available cash and released down the waterfall.
Administrative servicing fees are removed from the available cash flows, in accordance with the contractual obligations. Potential servicer incentive fees are also removed from the available cash flows, in
accordance with the contractual obligations. Any remaining cash flow is used to pay the interest of the
AAA rated bonds or the investment grade bonds (if the AAA outstanding balance is zero).
Once all of the loans have left the pool, any outstanding reserves are used to pay down the potential
remaining bond balances; after which the remaining bond balances represent a loss to the corresponding
bond. At no point does the equity piece of the transaction receive proceeds before any outstanding principal, interest or reserve obligation of the rated bonds, and outstanding fees are satisfied.
Step 3: Loan Correlation Stress Test
When times are good, all properties tend to be supported by the market, and losses are fewer and less
severe. In times of restricted liquidity, tighter lending standards, and general risk aversion, nearly all properties have a greater probability of default and severity given default. The fact that property performance
is correlated and that the amount of correlation both changes over time and reflects the current economic
environment is especially relevant for NPL pools. NPL pools are sensitive to concentrations of cash flow
(or negative cash flow) that might break their reserve structure.
The third step is a stress of the structure that is meant to test its sensitivity to the added element of uncertain timing. It is a test simply used to indicate whether or not the reserves, structural features, and/or
credit enhancement, are sufficient to achieve the proposed rating level.
The fact that this step does not drive or define enhancement levels is necessary because of the difficulties
involved in estimating the correlation between assets. LT asset correlations are particularly difficult to
estimate: There was no body of research that measured the correlation between assets facing liquidation
at the disposal of DBRS. Additionally, it proved difficult to accumulate a reliable data set with which to
observe correlation of losses and cash flow declines over time, empirically. Finally, the added element of
the special servicer human intent and behavior makes it especially difficult to reliably estimate.
The correlations that DBRS used at each of the rating categories are therefore just our collective best
conservative estimate, and are not backed by exhaustive research or data analysis. We know that the
assets are already highly correlated given that they all face a default and liquidation scenario at generally the same time, under the same economic conditions. Our correlation assumptions aim to make our
model capture the worst case scenarios in terms of the timing and severity inputs. With that goal in mind,
DBRS feels that the correlations it uses are adequate for our purposes. The correlations that we used are
illustrated in the schedule below:
14
Commercial Real Estate Liquidation Trust Methodology
October 2010
Rating Category
Correlation
AAA
90%
A
50%
BBB
25%
The key model inputs affected by our correlation test are: cash flow, the speed of cash flow deterioration,
time to liquidation, and loss severity at liquidation.
DBRS examines thousands of possible outcomes for each of these four inputs for each loan in the pool.
It measures the resulting outcomes against the structure of the bonds and the reserves. If the structure
breaks more than permitted by the DBRS criteria for each rating category, DBRS may revisits and revise
its assumptions of sustainable cash flow in Step 1.
A structure is determined to have ‘broken’ if/when: 1) there is a principal loss to the bond, 2) the reserve
balances are negative, or 3) there is an interest shortfall to the bond.
The results of the this test are used to indicate whether the structure is robust enough under extreme circumstances, and therefore suggest whether or not DBRS need to revisit or revise its assumptions in Steps
1 or 2, given the proposed reserves, structural features, and/or credit enhancement.
DBRS proposes its structure breaking at the frequencies denoted below:
Rating Category
Frequency of Failure
(per 1,000 observations)
AAA
none
AA
6
A
20
BBB
41
BB
73
B
177
Cash flow Decline
With each scenario test, a property’s cash flow would be permitted to vary by a random amount downwards from its ‘B’ expected value, according to the downward tail of a normal distribution, and assuming
a volatility defined by DBRS. Each property’s cash flow decline is assumed to be correlated to a certain
degree. The degree of correlation increases across each rating category varying between 14 and 90%. A
‘AAA’ stress test would therefore assume that a property’s decline in cash flow is 90% correlated with the
other properties in the pool.
Timing of Cash Flow Decline
Timing always plays a key role in NPL cash flow analysis. DBRS assumes that a loan reaches its lowest
estimated cash flow after a certain number of months. The timing of cash flow decline varies between zero
and twenty four months. As the causes of cash flow declines often reflect the broader market, the estimate
of the timing of cash flow decline for any given loan is correlated with the rest of the pool. Additionally
the timing of cash flow decline can be overridden by an analysis to reflect the conservative scenarios of
their rent roll analysis.
Loss Severity
With each scenario test a property’s loss severity would be permitted to vary by a random amount downwards from its ‘B’ expected value, according to the downward tail of a normal distribution, assuming
15
Commercial Real Estate Liquidation Trust Methodology
October 2010
the volatility implied by the DBRS debt yield hurdles, as well as the empirical volatility in CMBS liquidation expenses. The recoverable values of the loans depend upon many factors which are often related to
each other; the servicer’s ability, the economy, and lending practices, are some examples. The recoverable values are therefore estimated to be correlated with each other. The correlation varies across rating
category from 14 to 90%.
Time to Liquidation
The timing of the liquidation also has an important impact on the reserves and bonds. DBRS allows the
time to liquidation to vary. The liquidation time varies around the estimate for a property’s expected foreclosure timeline. The expected timeline is based upon the workout strategy of the loan, as well as the state
where it is located, and that state’s judicial procedures. DBRS does not permit the timeline to be shorter
than three months under any circumstances. The actual time to liquidation is often influenced by factors
that are shared by all the loans in the pool, such as the abilities of the servicer or the economic environment. Estimates of the time to liquidation are therefore correlated with each other. The correlation varies
across rating category from 14 to 90%.
SURVEILLANCE
DBRS undertakes, at a minimum, quarterly reviews of the collateral and bond structure, to confirm (or
change) the ratings of the bonds. The process of each review follows this methodology. In addition, the
on-going surveillance also measures the performance of the servicer in terms of their liquidation times
and their recovered liquidation proceeds. Performance in terms of these two metrics is used to recalibrate,
and reassess the DBRS NPL model to provide more realistic views of the structure’s future performance.
Additionally, the review focuses on the performance of the remaining assets. DBRS expects the collateral
level performance to be much more volatile than regular performing loans, and measures whether cash
flow may be deteriorating faster than assumed at issuance. It is also possible that cash flow increases at
some of the properties. On-going loan performance is used to recalibrate and reassess the DBRS NPL
model to provide a more realistic view of the future performance of the structure.
Surveillance activities provide a continuous feedback loop to DBRS rating methodologies. Performance
metrics revealed in the surveillance process that may impact or challenge the premise of this methodology
will be considered and evaluated in a timely manner.
OTHER CONSIDERATIONS
Environmental Risk
Environmental contamination at a property can be expensive to remediate and when discovered, it can
completely erode the property value in addition to causing liability issues. DBRS anticipates that the
environmental risk is mitigated to best extent possible by the trust’s mortgage loan seller providing the
following:
A) Original environmental reports from the loan’s origination in conjunction with updated servicer
property inspections
1) If there has been no change in use, DBRS can gain a certain level of comfort surrounding
environmental risk
2) If there has been damage at the property, as reported in the property inspection report, an update
may be required.
B) The mortgage loan seller may hire a due diligence firm that may update the environmental and provide
an overall assessment of the property. There also may be some reliance upon diligence performed by
the servicer that was originally handling the defaulted loan file if updated reports were mandated and
received.
C) The mortgage loan seller may choose to purchase an environmental insurance policy for the Trust.
DBRS reviews the policy to determine the level of coverage provided for in the insurance policy.
D) The mortgage loan seller may choose to cover any costs associated with environmental defects within
16
Commercial Real Estate Liquidation Trust Methodology
October 201
their representations and warranties.
E) If none of the above are available as options to mitigate the environmental risk associated with the
loans in the LT, then DBRS takes that into account in its ratings of the pool. Absent sufficient coverage
of this risk, the highest ratings is difficult to achieve.
Copyright © 2010, DBRS Limited, DBRS, Inc. and DBRS Ratings Limited (collectively, DBRS). All rights reserved. The information upon which DBRS ratings and reports are based is obtained by DBRS from sources DBRS believes to be accurate and reliable. DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance. The extent of any factual investigation or independent verification depends on facts and circumstances. DBRS ratings,
reports and any other information provided by DBRS are provided “as is” and without representation or warranty of any kind. DBRS hereby disclaims any representation or warranty,
express or implied, as to the accuracy, timeliness, completeness, merchantability, fitness for any particular purpose or non-infringement of any of such information. In no event shall
DBRS or its directors, officers, employees, independent contractors, agents and representatives (collectively, DBRS Representatives) be liable (1) for any inaccuracy, delay, loss of data, interruption in service, error or omission or for any damages resulting therefrom, or (2) for any direct, indirect, incidental, special, compensatory or consequential damages arising from
any use of ratings and rating reports or arising from any error (negligent or otherwise) or other circumstance or contingency within or outside the control of DBRS or any DBRS Representative, in connection with or related to obtaining, collecting, compiling, analyzing, interpreting, communicating, publishing or delivering any such information. Ratings and other
opinions issued by DBRS are, and must be construed solely as, statements of opinion and not statements of fact as to credit worthiness or recommendations to purchase, sell or hold
any securities. A report providing a DBRS rating is neither a prospectus nor a substitute for the information assembled, verified and presented to investors by the issuer and its agents
in connection with the sale of the securities. DBRS receives compensation for its rating activities from issuers, insurers, guarantors and/or underwriters of debt securities for assigning
ratings and from subscribers to its website. DBRS is not responsible for the content or operation of third party websites accessed through hypertext or other computer links and DBRS
shall have no liability to any person or entity for the use of such third party websites. This publication may not be reproduced, retransmitted or distributed in any form without the
prior written consent of DBRS. ALL DBRS RATINGS ARE SUBJECT TO DISCLAIMERS AND CERTAIN LIMITATIONS. PLEASE READ THESE DISCLAIMERS AND LIMITATIONS AT http://www.dbrs.
com/about/disclaimer. ADDITIONAL INFORMATION REGARDING DBRS RATINGS, INCLUDING DEFINITIONS, POLICIES AND METHODOLOGIES, ARE AVAILABLE ON http://www.dbrs.com.
www.dbrs.com
Corporate Headquarters
DBRS Tower
181 University Avenue
Suite 700
Toronto, ON M5H 3M7
TEL +1 416 593 5577