Upgrades in the commercial mortgage-backed securities (CMBS) market should vastly outweigh downgrades this year. But a recent report by Fitch Ratings cautions that an elevated number of interest-only loans could lower ratio of upgrades to downgrades over the long-term.
"Deals issued last year averaged 70% of full or partial interest-only terms in a CMBS pool, compared with 60% in 2005," says Britt Johnson, a senior director at Manhattan-based Fitch Ratings.
"As these deals will amortize [slower] than more seasoned transactions, the number of upgrades will drop unless the low interest rate environment lasts and there continues to be a significant amount of defeasance," adds Johnson. Defeasance of a securitized commercial mortgage is a process whereby a borrower substitutes other income-producing collateral for a piece of property in order to remove an existing lien without pre-paying the existing note.
Still, it would take a lot of downgrades to reverse this trend anytime soon: U.S. CMBS upgrades reached record highs in 2006. Fitch Ratings upgraded 1,781 tranches while downgrading only 52 among approximately 500 CMBS deals. That's a 34:1 upgrade-to-downgrade ratio, compared to 11:1 in 2005.
"Defeasance continues to be a major factor in upgrades, and the amount of loan defeasance continues to rise," says Johnson. "Other contributors will include the continued strong performance of underlying real estate, collateral prepayments and scheduled amortization."