S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.
As the COVID-19-related economic dislocation unfolds, we have received numerous questions concerning the impact on European commercial mortgage backed securities (CMBS). Here we answer the most common questions we have received and give our views regarding the potential credit effects on this sector, following our earlier article (see "European CMBS: Assessing The Credit Effects Of COVID-19," published on March 24, 2020).
Frequently Asked Questions
Which structural features are coming to the fore in light of COVID-19's effects on credit performance?
Liquidity facilities, reserve fund notes (RFNs), and similar liquidity features:
Notwithstanding any long-term impact that COVID-19 may have, many European CMBS transactions have liquidity facilities, RFNs, or similar liquidity features that mitigate the risk of temporary interest shortfalls. At each interest payment date (IPD), the cash manager can draw from this liquidity support to fund issuer expense shortfalls, property protection shortfalls, and note interest shortfalls for most investment-grade (and some speculative-grade) notes.
Liquidity facilities are lines of credit provided by rated banks, with the size determined at closing. These facilities generally include appraisal reduction mechanisms and drawstop events, which reduce the commitment's size and availability to what is viewed as recoverable. This is typically based on updated market values relative to the outstanding loan amount. All payments due to the liquidity facility will rank ahead of interest payments and principal repayments on the notes.
RFNs and other notes issued for liquidity purposes operate similarly to liquidity facilities in their use and are senior ranking in the issuer waterfall. The cash from issuing RFNs is used to fund a liquidity reserve.
Class X diversion trigger events:
Given the current events related to the COVID-19 pandemic, loans may breach debt yield and loan-to-value (LTV) ratio requirements. To help mitigate the effects of this, most transactions are structured with class X diversion triggers that divert excess spread, which would otherwise leak out of the structure, to a diversion ledger. If these ratios are not cured, this excess would be held and, in turn, flow through the transaction waterfall for the benefit of the noteholders.
Servicing, operating advisors, and tail periods:
With an elevated risk of loan defaults that may materialize from the impact of COVID-19, the role of the servicer and special servicer becomes increasingly important. In European CMBS, a loan is typically transferred to special servicing following a loan event of default that, in the servicer's opinion, is unlikely to be cured within 21 days. The special servicer, acting on behalf of the issuer, has significant discretion but is ultimately guided by the servicing standard, which is to maximize recoveries before the final note maturity date. European CMBS transactions are typically structured with a five-year "tail period" (i.e., the period between the maturity date for the last loan underlying a transaction and the transaction's legal final maturity date), which prevents the need for the special servicer to hold a fire sale of the property and crystallize losses.
Although the special servicer has significant discretion in the workout of a defaulted loan, it may be required to consult the operating advisor (if one is appointed by the controlling class) with regard to the servicing and enforcement of the loan. The appointment of the special servicer can be terminated at any time at the direction of the noteholders. In addition, it can also be terminated at the direction of the operating advisor.
How do we treat interest shortfalls and when might we lower ratings?
With some CMBS borrowers growing increasingly cash-strapped as their revenue dries up in the current environment, some of them may fail to pay their interest due under the loan. As already discussed in this article, transactions are typically structured with liquidity facilities or another form of liquidity support to mitigate these risks. However, long periods of insufficient income can lead to liquidity support being depleted. Moreover, in some transactions the more junior classes do not benefit from liquidity support. Absent liquidity support, this may lead to interest shortfalls on the CMBS notes. When a European CMBS class of notes experiences an interest shortfall, we look to assess whether we believe the interest shortfalls to be permanent or temporary, with repayment occurring on subsequent payment dates.
When we consider the interest shortfall to be permanent, a monetary default under the terms of the transaction, or we expect repayment to take longer than 12 months, we would typically consider the interest shortfall to be a default.
However, in cases where we determine that an interest shortfall is temporary, we believe that an immediate downgrade to a 'D' rating may not be the most appropriate indicator of credit risk. We would look to understand the likely duration of the outstanding interest shortfall. As per the framework set out in our temporary interest shortfall criteria and given that the majority of European CMBS deals pay on a quarterly basis, we would expect any interest shortfall on a class rated 'AA-' and above to repay at the next IPD (see "Structured Finance Temporary Interest Shortfall Methodology," published on Dec. 15, 2015). Classes of notes rated in the 'A' category ('A+', 'A', and 'A-') and 'BBB' category are expected to repay any periodic interest shortfall within six and nine months, respectively. Those classes rated in the 'BB' and 'B' categories are expected to repay periodic interest shortfalls within 12 months.
Should we believe that there is a high likelihood that any reimbursement from interest shortfalls is going to take longer than its rating-specific time horizon, we may adjust the ratings accordingly.
We use both qualitative and quantitative considerations to assess temporary interest shortfalls and the ability of the issuer to reimburse the interest amounts due. Among other factors, we primarily seek to understand the cause of the interest shortfall, the underlying collateral performance and projections, as well as the transaction's supporting liquidity features.
Furthermore, where there is an interest shortfall on a European CMBS class of notes and the interest is being deferred, we would expect the noteholders to receive some form of economic compensation for the delayed interest payment. The most common form of this in European CMBS is additional interest being charged on the deferred interest due.
How does sovereign downgrade risk affect European CMBS ratings?
In accordance with our criteria on incorporating sovereign risk in rating structured finance securities, we can rate European CMBS notes up to four notches above the rating on the sovereign country where the assets are located, subject to certain conditions (see "Incorporating Sovereign Risk In Rating Structured Finance Securities," published on Jan. 30, 2019). In other words, as long as the relevant sovereign has a rating of at least 'A+', the European CMBS notes can be rated up to 'AAA'. Should our sovereign rating on the relevant country be lowered below that threshold, we will lower the affected CMBS ratings, regardless of our view on the underlying collateral. For instance, our highest rating on European CMBS notes backed by real estate collateral in Italy would currently be 'A+'.
Countries prominent in European CMBS transactions and our sovereign ratings and outlooks on them are:
- United Kingdom: (Unsolicited) AA/Stable
- Germany: (Unsolicited) AAA/Stable
- The Netherlands: (Unsolicited) AAA/Stable
- Italy: (Unsolicited) BBB/Negative
- Finland: AA+/Stable
- France: (Unsolicited) AA/Stable
- Ireland: AA-/Stable
What counterparty risk is prominent in European CMBS?
The main counterparties in European CMBS are banks and other financial institutions. The typical type of support that they provide is in the form of issuer bank accounts, liquidity support, and derivatives such as interest rate caps and swaps.
The default of a bank providing a bank account or a liquidity facility would not in and of itself lead to an interest shortfall on European CMBS notes because multiple events would have to coincide. If a bank that holds the quarterly interest payment were to default, the issuer could still use the liquidity facility or any reserve to cover the shortfall, at least for the classes that benefit from such support. Conversely, if a liquidity facility provider were to become unable to meet its obligations, this would only lead to a shortfall if the relevant borrower in the transaction at the same time also failed to pay its interest in full. Currently, very few of the liquidity facilities in European CMBS transactions have outstanding drawings.
However, should there be a period where a large number of borrowers were to fail to meet their interest obligations and liquidity providers also come under pressure, shortfalls could arise. To mitigate this risk, all of the European CMBS transactions that we monitor are structured with mechanisms that would require the account bank or the liquidity provider to replace itself within a specific timeframe if our rating on them falls below a trigger level. Under our counterparty criteria, in order to maintain a 'AAA' rating on a European CMBS class of notes, the minimum rating for an issuer account bank is generally 'BBB' and for the liquidity facility provider it is 'A' (see "Counterparty Risk Framework: Methodology And Assumptions," published on March 8, 2019). Some transactions are structured with higher triggers.
Finally, the floating interest rate risk in European CMBS loans is typically hedged via interest rate caps, and, in rare instances, swaps. The strike rates of the caps and the swap rates are typically set much higher than the current reference rates under the loan agreements. Given the existing low interest rate environment and the low likelihood that rates may rise substantially in the short term, we do not expect European CMBS transactions to depend on payments to be made by these counterparties. However, even if they were, these derivative contracts are also structured with mechanisms to mitigate the counterparty risk, such as collateral posting or replacement.
Will insurance cover anything?
Property insurance is usually there to cover risks such as fire, flooding, and general liability. The contracts typically also protect the borrowers against loss of rent and business interruption, generally for up to 24 months. These business interruption clauses are designed for when the borrower can't collect the revenue under its leases or its operation because the building has been physically damaged. For example, if a building burns down, the borrower can collect the replacement costs from the insurance, but until then the business interruption insurance will cover the lost revenue and allow the borrower to maintain its interest payments.
The question that we have been receiving is whether the lockdowns in many countries and the social distancing guidelines qualify as business interruption. Our current understanding is that they do not.
What is our view on possible refinancing risk over the next 12 months?
In the European CMBS transactions that we currently rate, only four loans are due to mature over the next 12 months (see table 1). These loans span different jurisdictions and asset types.
|Refinancing Risk That May Occur Over The Next 12 Months|
|Transaction Name||Loan Name||Jurisdiction||Asset type||Loan Maturity Date *||Note Maturity||Securitized Loan Balance||LTV ratio (%)||Refinancing Status|
Patrimonio Uno CMBS S.r.l.
|Patrimonio Uno||Italy||Mixed use||December 2020||December 2021||€45,962,925||18.8||Loan maturity has previously been extended|
Libra (European Loan Conduit No. 31) DAC
|Senior Loan||Germany and the Netherlands||Light industrial/logistics||January 2021||October 2028||€223,947,917||63.3||-|
Elizabeth Finance 2018 DAC
|Maroon loan||U.K.||Retail||January 2021||July 2028||£66,417,016||73.9||-|
Scorpio (European Loan Conduit No. 34) DAC
|Project Scorpio||U.K.||Office||November 2020||May 2029||£286,382,517||66.8||-|
|*Loan maturities may be extended to a future date if they meet certain requirements. LTV--Loan to value.|
Given the current uncertainty in the commercial real estate market and debt capital markets, loans due to mature within the next 12 months are likely to face elevated refinancing risk. In these cases, sponsors may be unable to raise sufficient funds to refinance the loans or, where relevant, loans with extension options may not meet the required conditions. This would result in a loan event of default, where the special servicer would take over with a view to maximizing recoveries for the noteholders. Exit strategies may include asset sales to repay the debt. In the current environment, and given the long time left until the notes legal final maturity date (as indicated in table 1), we believe it would be more likely that the special servicers will sit out the current crisis by providing loan extensions or entering into standstill agreements, provided that the borrowers are able to make interest payments in full.
In the context of our ratings, a loan failing to refinance will not in and of itself lead to us taking a rating action on the related CMBS transaction, given that we rate to the full repayment of principal by note maturity, and not loan maturity. Where a transaction has a note maturity in the next 24 months, such as Patrimonio Uno CMBS S.r.l., we believe the risk of failure to repay by this date is already incorporated in our assigned ratings.
What questions are S&P Global Ratings asking?
Like everybody else, we are asking ourselves the same questions, such as: How long will the COVID-19 pandemic last? When will markets open again? When will real estate performance stabilize? How resilient are the individual subsectors? How much will property values decline? How will structural support mechanisms work in practice?
While it is extremely challenging to provide answers with complete confidence at this time, our focus is on making informed credit decisions based on the available information, such as transaction specific performance data in combination with broader market intelligence and trends.
In the short and medium term, while we are reviewing all the key levers to credit risk, given the "economic stop" currently being experienced through the European real estate markets, our focus is primarily on the strength of individual transaction's cash flow expectations and supporting structural features. More specifically, we are considering the likely rental receipts available to the sponsors, the extent to which borrowers are likely to come out of pocket to support the performance of their loans, and ultimately the available liquidity support (and the financial strength of the providers) to meet the debt payment requirements due on the CMBS notes. The responses in this article aim to address some of these considerations.
Looking at European CMBS transactions through a "longer-term" lens, we seek to understand where there might be a systemic shift, if any, in the performance of individual property types. The spotlight will inevitably be on the hotel, retail and leisure, student housing, and office co-working sectors, but there is the potential for other property sectors to experience some form of structural adjustment, whether it be through operational factors such as how space is used, achievable rents, vacancy levels, flexibility of lease terms, or investment and financing sentiment driving capital values. At this point, however, it's too early to opine on with any conviction.
This report does not constitute a rating action.
|Primary Credit Analyst:||Edward C Twort, London (44) 20-7176-3992;|
|Secondary Contacts:||Mathias Herzog, Frankfurt (49) 69-33-999-112;|
|Carenn K Chu, London (44) 20-7176-3854;|
|Oliver Thomas, London + 44 20 7176 8589;|
|Amisha Unnadkat, London + 44 20 7176 3826;|
No content (including ratings, credit-related analyses and data, valuations, model, software or other application or output therefrom) or any part thereof (Content) may be modified, reverse engineered, reproduced or distributed in any form by any means, or stored in a database or retrieval system, without the prior written permission of Standard & Poor’s Financial Services LLC or its affiliates (collectively, S&P). The Content shall not be used for any unlawful or unauthorized purposes. S&P and any third-party providers, as well as their directors, officers, shareholders, employees or agents (collectively S&P Parties) do not guarantee the accuracy, completeness, timeliness or availability of the Content. S&P Parties are not responsible for any errors or omissions (negligent or otherwise), regardless of the cause, for the results obtained from the use of the Content, or for the security or maintenance of any data input by the user. The Content is provided on an “as is” basis. S&P PARTIES DISCLAIM ANY AND ALL EXPRESS OR IMPLIED WARRANTIES, INCLUDING, BUT NOT LIMITED TO, ANY WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE OR USE, FREEDOM FROM BUGS, SOFTWARE ERRORS OR DEFECTS, THAT THE CONTENT’S FUNCTIONING WILL BE UNINTERRUPTED OR THAT THE CONTENT WILL OPERATE WITH ANY SOFTWARE OR HARDWARE CONFIGURATION. In no event shall S&P Parties be liable to any party for any direct, indirect, incidental, exemplary, compensatory, punitive, special or consequential damages, costs, expenses, legal fees, or losses (including, without limitation, lost income or lost profits and opportunity costs or losses caused by negligence) in connection with any use of the Content even if advised of the possibility of such damages.
Credit-related and other analyses, including ratings, and statements in the Content are statements of opinion as of the date they are expressed and not statements of fact. S&P’s opinions, analyses and rating acknowledgment decisions (described below) are not recommendations to purchase, hold, or sell any securities or to make any investment decisions, and do not address the suitability of any security. S&P assumes no obligation to update the Content following publication in any form or format. The Content should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors and/or clients when making investment and other business decisions. S&P does not act as a fiduciary or an investment advisor except where registered as such. While S&P has obtained information from sources it believes to be reliable, S&P does not perform an audit and undertakes no duty of due diligence or independent verification of any information it receives. Rating-related publications may be published for a variety of reasons that are not necessarily dependent on action by rating committees, including, but not limited to, the publication of a periodic update on a credit rating and related analyses.
To the extent that regulatory authorities allow a rating agency to acknowledge in one jurisdiction a rating issued in another jurisdiction for certain regulatory purposes, S&P reserves the right to assign, withdraw or suspend such acknowledgment at any time and in its sole discretion. S&P Parties disclaim any duty whatsoever arising out of the assignment, withdrawal or suspension of an acknowledgment as well as any liability for any damage alleged to have been suffered on account thereof.
S&P keeps certain activities of its business units separate from each other in order to preserve the independence and objectivity of their respective activities. As a result, certain business units of S&P may have information that is not available to other S&P business units. S&P has established policies and procedures to maintain the confidentiality of certain non-public information received in connection with each analytical process.
S&P may receive compensation for its ratings and certain analyses, normally from issuers or underwriters of securities or from obligors. S&P reserves the right to disseminate its opinions and analyses. S&P's public ratings and analyses are made available on its Web sites, www.standardandpoors.com (free of charge), and www.ratingsdirect.com and www.globalcreditportal.com (subscription), and may be distributed through other means, including via S&P publications and third-party redistributors. Additional information about our ratings fees is available at www.standardandpoors.com/usratingsfees.
Any Passwords/user IDs issued by S&P to users are single user-dedicated and may ONLY be used by the individual to whom they have been assigned. No sharing of passwords/user IDs and no simultaneous access via the same password/user ID is permitted. To reprint, translate, or use the data or information other than as provided herein, contact S&P Global Ratings, Client Services, 55 Water Street, New York, NY 10041; (1) 212-438-7280 or by e-mail to: firstname.lastname@example.org.