Properties backed by CMBS loans that have undergone an appraisal reduction may be a financial fortune cookie for investors. Ordering an updated appraisal is just one of the steps required after a loan has been transferred to special servicing.

In the current environment, most appraisals have been reduced from their original value at securitization, especially loans underwritten during the boom for commercial mortgage-backed securities. “Appraisal reduction is a forward-looking measure of potential future losses,” explains Paul Mancuso, a vice president with commercial real estate data and analytics firm Trepp LLC.

The New York-based researcher mined its database to extract distressed CMBS loans that had at least one appraisal reduction and carried an unpaid loan balance through February.

The key metric Trepp studied was the realized loss rate, or the liquidation balance less net liquidation proceeds received from a troubled loan. Trepp wanted to determine whether commercial real estate values bottomed in 2009 when the realized loss rate skyrocketed to 47%, and whether the loss rate of 33% over the first two months of 2010 was a momentary blip.

“Looking at the $33.3 billion universe of loans that have had at least one appraisal reduction through the end of February, our analysis indicates a potential loss rate of just over 40%, or $13.4 billion,” explains Mancuso. “This is 22% higher than the current year-to-date loss rate of 33%.”

There is significant variability in loss rates by property type based on multiple factors, not the least of which is the economy, says Mancuso. The office sector, for instance, has had the lowest delinquency rate at 4.33% through the end of February 2010.

The total dollar volume of CMBS office loans with appraisal reductions is $5.1 billion. Of that total, $2.4 billion evaporated through appraisal reduction, for a loss rate of 46.1%, the highest among the five major property types.

“I don't think we have seen the tip of the iceberg yet for office properties, which continue to struggle with lower rents, tenant concessions and decreased occupancy levels,” says Mancuso. “These factors will continue to negatively impact property fundamentals in the near term.”

The greatest realized losses by origination year occurred in the lax underwriting years of 2005, 2006 and 2007 vintage CMBS loans. Across all property types, these years have total realized losses of 44%, 61% and 56.7% respectively.

Reflecting its size, Texas recorded the highest realized loss measured by number of loans and dollar volume from June 2001 through February 2010. New York, California and Georgia had loss rates below the overall average.

Nationally, the commercial real estate pain is likely to intensify through the end of this year. “A strong possibility exists that loss severity rates will continue to rise through at least the end of 2010,” says Mancuso. “Due diligence remains key for investors in this environment.”