With the CMBS market reaching its highest point yet, rating agencies are keeping a sharp eye on the whole process. The question is, who is keeping an eye on them? Loan servicers and others return the favor by examining those who examine them.
Back in the early 1980s, Carl Kane undertook the initial study for Standard & Poor's as it devised the first criteria for rating commercial mortgage-backed securities.
Kane, now with KPMG Peat Marwick in New York, owns a 13-year perspective on CMBS and the rating processes that are necessary to bring these issues to market. "The rating agencies have done a good job even though it is not a standard of perfection since one does not expect perfection in capital markets," says Kane. "In a disciplined way, the rating agencies have steered a steady ship. They are doing the right thing in maintaining a steady course based on their perception and not upon the need to get deals done, which is the driver in the rest of the world."
One may argue that the basic CMBS format hasn't changed much since the early 1980s or, on the other hand, the opposite hypothesis can be made that while the structure is the same, the individual issues have become more complex. What can't be argued is the fact that, since the early 1990s, CMBS has risen to become a major factor in the real estate capital marketplace. In February, CMBS surpassed the $100 billion mark in total issues. Also, the CMBS market in the first quarter of 1996 experienced a volume of $6.9 billion, a 243% rise over the same period last year. At this pace, the market could easily surpass the record $20.33 billion of CMBS issued in 1994.
The rating agencies are "critical" to the CMBS process because, as Gail Davis, a senior director at the Mortgage Bankers Association in Washington, D.C., succinctly notes, "They assign the rating which effectively determines price."
Basically, a rating agency assigns ratings to CMBS and all their tranches. The structures are usually bond-type securities in which a mortgage and note on a cross-collateralized package of loans are pledged as collateral, or pass-through certificates in which the rated securities represent ownership in a trust that, in turn, owns certain mortgage loans.
Does a rating mean anything specific? At Standard & Poor's, a debt rated "B" means greater vulnerability to default but currently has the capacity to meet interest payments and principal repayments. Adverse business, financial or economic conditions will likely impair capacity or willingness to pay interest and repay principal. Not much different from Fitch, where the definition of a "B" rating is: bonds currently are meeting debt service requirements, but the probability of continued timely payment of principal and interest reflects the obligor's limited margin of safety and the need for reasonable business and economic activity throughout the life of the issue.
Approving loan servicers
Rating agencies are also involved in the real estate process in other ways as well. With CMBS, the agencies also rate (perhaps "rank" is a better word) the companies that service loans. In addition, the rating agencies rate the debt of the real estate investment trusts.
In the case of commercial mortgage loan servicers, the rating agencies are essentially approving the companies, which gives investors and securities underwriters a qualitative measure of the servicer's performance and also pre-approves the servicers to do transactions. A master servicer, for example, is responsible for servicing performing loans, and in some cases, nonperforming loans. While a special servicer takes on the job of restructuring and liquidating nonperforming loans.
"Each of the rating agencies handles the servicer's approval a little differently," says Keith Locker at Bear Stearns in New York. "Standard & Poor's and Duff & Phelps do very comprehensive reviews of the servicers and rank them on a qualitative bases. Fitch basically finds master servicers either acceptable or unacceptable and then ranks special servicers. Moody's ranks servicers on a transaction by transaction basis."
Have the rating agencies done a good job? The servicers seem to think so.
Midland Loan Services L.P. in Kansas City and Dallas-based Amresco Inc. not only originate loans specifically for securitization but also service loans and others and are, in fact, two of the biggest servicers in the country. "Early on there was very little discrimination between the quality of servicers, and that has changed significantly over time as the transactions have gotten more seasoned and as investor demand for information dramatically increased," says Stacey Berger, executive vice president at Midland.
To which Michael Maberry, president of Amresco Capital Corp., a subsidiary of Amresco Inc., adds: "The rating agencies are interested in our capabilities. In other words, we are rated as a servicer, and the pools (of loans) that we service are held in higher esteem by the rating agencies than pools that would be handled by a servicer that was not rated. We feel the rating agencies have treated us fairly."
Going beyond CMBS
Outside of the CMBS world, rating agencies are called on to assign ratings to REIT debt issues.
In order to have ready access to capital and in response to competitive interest rates, many REITs have turned to the issuance of debt instead of secondary equity offerings. The debt is then rated which, in a general sense, is different from rating CMBS, because the latter is a set portfolio that doesn't change over time. However, when looking at REIT debt, the rating agencies are really looking at the company as it adds and disposes of properties.
For example, in a review of a REIT's unsecured creditworthiness, Fitch will consider three principal factors: an evaluation of the REIT's management team; a review of its property portfolio; and a review of its financial structure, including determining the extent to which the REIT's unencumbered assets can mitigate refinancing risk.
To perform an appropriate review and to reach an accurate rating judgment, Fitch believes it is essential to have access to, and the cooperation of, a REIT's management. Without such access, Fitch says, an evaluation of the quality and depth of a REIT's management and a determination of the appropriateness of a strategic direction is not possible. In addition, it's important for management to supply information pertaining to property cashflow and to allow site inspections.
"When Moody's looks at a REIT, it tries to get a sense of where it came from, what it does, what kind of franchise it has, what products it offers," says Thierry Perrin, vice president-financial institutions at Moody's Investors Service. "Moody's tries to get a sense of senior management, trends on properties, what kind of risks are associated with the different product types and makes sure the company has a proven track record in adding value to real estate."
Perrin adds: "This is a more dynamic process than rating CMBS. We look at management and how the company manages property over a period of time as compared to assets in a CMBS which basically don't move."
Nevertheless, CMBS is certainly the most visible arena where rating agencies become involved in the processes of capitalizing real estate.
Rating agencies are not all the same
The general perception is that fundamentally the four rating agencies -- Standard & Poor's, Moody's, Fitch and Duff & Phelps -- use the same analysis processes and have the same objectives, which is to evaluate risk, but there are differences in terms of priorities, approach and use of technology.
"There are certainly common themes among the rating agencies," says Allan Baum, a director at CS First Boston in New York. "But they have different approaches to analyzing real estate, different preferences, and it is done somewhat uniquely. Clearly, there are certain agencies that have more experience on the single-asset stuff, as there are certain agencies with more experience on subperforming loans."
"The (rating agencies) all have a different way of looking at things," says Ray Mikulich, a managing director at Lehman Brothers in New York. "On a single-asset deal, one rating agency can ascribe aggressive rating levels because it likes the property, and another will be much more conservative. Agencies look at pools differently and, if you look at the universe of pooled transactions, you will see that different rating agencies have rated different tranches. This creates the opportunity for some ratings arbitrage. In other words, you may want to get one agency on the senior tranches and use others for the subordinated tranches."
What Mikulich calls "arbitrage" others call "rating shopping."
"There's a tremendous amount of rating shopping," says Sheridan Schechner, a vice president at Goldman Sachs in New York. "Typically, investors want to see two rating agencies in these transactions, so you get all four for initial feedback."
Prudential Securities gives its clients feedback about each rating agency, their preferences, and depending on the product, advises the clients as to how each of the four agencies would approach the product, says Peter Riemenschneider, a director of investment banking in Prudential Securities' real estate department. "We typically approach a number, if not all, the rating agencies to get preliminary feedback. If there is a point of discussion, we help the client prepare supporting materials to overcome the objections."
Investment bankers try to get the lowest possible credit enhancements and, to do that, they will find the rating agency most favorable to their product.
"We see all sorts of proposals," says Tad Philipp, a managing director at Moody's in New York. "Then typically there is an initial meeting to review the proposals and get a preliminary of what the rating levels will be." If Moody's is then engaged, there is a more extensive review period including such tasks as engineering and environmental appraisals, on-site inspections of the properties and cashflow determinations.
The model that Moody's uses has two major components: property and portfolio characteristics. "We assess each and every property on its loan to value ratio, debt service coverage, the quality of the property and inherent riskiness of the asset class," says Philipp. "We first assign a credit enhancement to each individual property in the pool based on property level characteristics. We then take that number and adjust it by a separate model which deals with portfolio characteristics."
At Duff & Phelps, the rating process is comprised of four steps:
* preliminary assessment of the transaction based on a term sheet, financial statements and other relevant data;
* site visits, cashflow analysis and review of other outside due diligence information;
* review of deal structure, legal documents and legal opinions; and
* Credit Rating Committee review and assignment of rating.
Fitch performs a risk analysis that incorporates two measures of commercial mortgage loan performance: default probability and loss severity. It also performs a qualitative review of the loan or loan pool, looking at geographic diversity, property type, loan diversity, borrower concentration, property operating statements, amortization and balloon risk, rates, collateral quality, basis risk, spread, environmental risk, underwriting standards and the servicers.
"We have benchmarks for each property type, for the different types of transactions," says James Titus, a director at Standard & Poor's. "We have our own way of evaluating financial statements, of looking at properties. We seek detailed information regarding condition of properties and environmental issues and, in such property types as malls, we evaluate the credit quality of the stores. We try to figure out who is strong and who is likely to go under. We also evaluate the marketplace to determine how the competition is doing and, if a few tenants are lost, what is the likelihood those tenants will be replaced." Standard & Poor's uses specific property condition criteria including assessments of construction quality, structural and mechanical integrity and physical condition. The company examines the impact of local zoning regulations, building codes and any special hazard that may affect the income stability of the property.
All the rating agencies have a process of monitoring properties after issuance. Standard & Poor's boasts a group of seven analysts that are part of what it calls its surveillance group, and they are responsible for collecting periodic financial information as well as getting background on the properties and borrowers in all deals that the company rated. The surveillance group's job is to analyze the information, bring it back to the credit committee, make a decision as to whether the credit has improved, stabilized or deteriorated and finally to make a decision as to what needs to be done.
Fitch works with a three-man surveillance team, which does quarterly reports on how the properties are doing. Once a year there is a full review and a decision is then made to keep the ratings, upgrade or downgrade.
The fairness factor
From investors to investment bankers, the general feeling is that the rating agencies have done a good job understanding the real estate asset and have been fair in assessing ratings -- although everything is subject to debate when it comes to a rating. As KPMG's Kane says, "One doesn't expect perfection in capital markets." In relative terms, the CMBS is only 10 years old, so it is still in a growth and adjustment phase. "You can look at it broadly and see there have been a few hiccups in deals, and there are delays in getting ratings done," Kane says. "But the rating agencies are growing up, learning, developing and becoming more service oriented."
The biggest problem with rating agencies, says Prudential Securities' Riemenschneider, is that most of the people came from an institutional background and had this real estate snobbism that every property under a certain dollar amount was an accident waiting to happen. "But there has been noticeable difference over time, and they now have a knowledge as to how real estate works," he says.
Again, the industry is very young, and new developments, such as the increasing investment interest in lower tranches, continue to demand adjustments. Stephen Roth, president of Los Angeles-based Secured Capital Corp., a company that has helped develop a secondary market for nonperforming loans, says the credit agencies have done a good job rating single assets and senior classes of multiple-asset securitizations, but their ability to rate the lowest rated tranches in conduit deals involving better than 50 assets is limited by the resources that can be committed.
"Whereas you might have a high degree of confidence in their rating ability on the senior classes in conduit deals, you have got to take their rating with a grain of salt on the lowest rated classes because it needs and demands full underwriting asset by asset," says Roth, "and they cannot commit the people or the time to that, so it is done on a sampling basis."
It is important to understand both what you're dealing with and how to deal with it when it comes to working with rating agencies. "In analyzing the risks inherent in a particular structure or transaction," says Paul H. McDowell, vice president and general counsel of Capital Lease Funding L.P., New York, "it is important to differentiate between the `actual' risks -- those that would drive an underwriting decision -- and `agency' risks -- those risks that the agencies view as important. You ignore either at your peril."
McDowell adds that it is critical to first understand why they are concerned about a specific issue before you devote time in telling the agencies why they are wrong in their analysis. "We have also found that it is not necessary to bang them on the head about every little issue. Indeed, to do so invites a negative reaction," he says. "Instead, once their primary areas of concern have been identified and discussed, then the focus necessarily shifts for the issuer to work on the subtle trade-off between what the rating agencies want -- bullet-proof bank leases -- and the realities of originating and underwriting loans in the real world."
Staffing up: CMBS firms keeping up with demand
Because the commercial mortgage-backed security business started ramping up in the early 1990s, rating agencies have scrambled to keep up with the high volume of business.
Complicating any staffing arrangements has been the coincidental growth of the real estate investment trust sector and its turn from equity financing to debt financing, which also requires the services of the rating agencies.
Duff & Phelps
Early '90s: 10 working with CMBS
1996: 20 working with CMBS and REITs
1993: 6 total working real estate
1996: 23 total working real estate
Staffed up but difficult to total
Standard & Poor's
1990: 15 or 16
By and large, the investment bankers and commercial mortgage servicing companies would agree the agencies have done a good job of getting staffed up, but this year's recent uptick in CMBS business after a three-year plateau has created some backlogs, which is one reason why most of the agencies are continuing to build staff levels.
"There is a backlog," says Sheridan Schechner, a vice president at Goldman Sachs in New York. "The rating agencies were unprepared for the increase in CMBS volume that we are currently seeing, so they are now trying to staff up."
However, despite the increase in CMBS volume, the amount of staff that has to be added may not be as great as when the agencies were first gearing up.
"All the rating agencies have added significant staff, but what is helping is that they are seeing a number of repeat issuers," says Stacey Berger, executive vice president with Kansas City-based Midland Loan Services L.P. "So the amount of start-up work that has to be done in terms of reviews, structures associated with the deals, underwriting groundwork, etc. is lessened. To the extent they are seeing more repeat issuers really makes the process much more efficient."
Duff & Phelps began rating CMBS transactions in 1986 but, by the early 1990s, it only had 10 people dealing with the sector. Today, the company boasts 20 people working CMBS and REITs.
"We are still adding, but not as dramatically, because we think the volume is getting to a level that will be steady," says Joseph Franzetti, a director at Duff & Phelps.
When John Bonfiglio, a senior director at Fitch, joined the firm three years ago, the total staff working with real estate numbered six. Now employee numbers are up to 23. "We are interviewing like crazy, so the answer to the question of adding staff is yes!"
Back in 1990, Standard & Poor's could boast a fairly large staff rating real estate issues, probably about 15 or 16 people.
"We have expanded quite dramatically," says James Titus, a director at Standard & Poor's. "This year alone we will be adding three folks so that we will be up to 40 people, and we will continue to look at beefing up our staff where necessary."
Moody's has staffed up as well, but people who work with real estate are in at least three different departments so it was difficult to get a total of the staff doing this work.
The importance of the rating agencies to the capitalization of real estate is really a reflection of the changes in the industry over the past half-decade, as Wall Street has become increasingly involved in the property business. Has the change been good for real estate? John Bonfiglio, a senior director at Fitch, thinks so. "The capital market is a great place to raise money efficiently, and it is a good allocator of capital. Clearly, Wall Street has added a lot of liquidity where there was none, and that has to be good."