Standard & Poor's warns of loose standards in commercial lending

Deteriorating underwriting standards, high loan-to-value ratios and interest-only loans aren’t issues confined to residential mortgage lending.

Analysts at Standard & Poor’s Ratings Service say they are concerned about those trends and others in commercial mortgage-backed securities (CMBS) and collateralized debt obligations (CDOs).

The “vast majority” of loans in commercial MBS and CDOs are interest-only for part or all of the loan term, which greatly increases refinancing risks if interest rates rise or property values are not sustained, Standard & Poor’s warned.

Lenders are also seeking to make more loans secured by esoteric collateral and construction loans, and relaxing requirements for capital expenditures, tenant improvement, and leasing commission reserves.

“While these trends were more exceptions to the rules in the past, they have now become standard practice,” Kim Diamond, managing director in Standard & Poor’s Global Real Estate Finance Group, said in a statement.

Lenders have used the run-up in property value to justify loans with higher loan-to-value ratios on the theory that they can be refinanced with little or no amortization if property values continue to appreciate, the statement said.

Despite those concerns, Standard & Poor’s expects commercial MBS issuance volume to remain stable this year, unless there’s a major increase in interest rates or an “unforeseen shock” to capital markets.

Some Wall Street investors have become wary of residential MBS backed by subprime loans because of a recent increase in delinquencies and defaults.

Standard & Poor’s believes the commercial MBS market “has positive momentum and an encouraging outlook in terms of delinquencies, investor demand and liquidity.”

But the company’s analysts warn that a “flood of liquidity” into commercial MBS and CDOs makes it harder for investors to demand prudent underwriting.

“Many of the deals brought to market these days are several times oversubscribed,” Diamond said. “Investor demand has increased to the point that if one investor doesn’t purchase a particular CMBS transaction … another is ready to step in and buy it instead, making it harder for investors to exert pressure on issuers by voting with their wallets.”

Full-leverage loans based on the speculative future value of transitional properties are becoming increasingly common, Standard & Poor’s reports, as are loans with debt service coverage of less than one. Unexpected changes in real estate fundamentals could undermine assumptions about growth of rental and occupancy rates, making it more difficult for borrowers to refinance those loans.

To maintain volume in the competitive loan origination market, commercial real estate lenders are branching out into “esoteric asset types” such as health care, amusement parks, casinos and cell towers, Standard & Poor’s analysts said. The volatility of such businesses makes those loans more risky.

Construction loans are risky because projects may not be completed and leased on schedule or at all, making refinancing impossible. The flood of money into construction loans, analysts warned, “could ultimately cause a rash of speculative new building that could upset the balance of supply and demand in certain real estate markets and ultimately erode fundamentals.”

Standard & Poor’s says its ratings take into account the possibility of a downturn in commercial real estate or an increase in interest rates. But investors should expect the ratio of upgrades to downgrades to slow, Diamond said, noting the company has begun requiring higher credit-enhancement levels on some deals.