Loan metrics for U.S. commercial mortgage-backed securities (CMBS) conduit transactions were mixed in the fourth quarter of 2019. Debt service coverage ratios continued to rise largely due to lower long-term interest rates and a higher percentage of full-term interest-only (IO) loans. Leverage increased about two percentage points, effective loan counts remained stable, and lodging and retail exposures declined. Notably, weighted average coupons declined throughout the year, falling to annual lows in the fourth quarter. But they appear to have stabilized at these lower levels for now. In 2020, S&P Global Ratings expects private label new issuance volume to reach $100 billion amid stable credit performance, assuming our base case of moderate economic growth, low unemployment, and relatively low interest rates holds.

Our Required Credit Enhancement Levels Remain Wide At 'BBB-'

Our 'AAA' credit enhancement level was slightly less than 23% in the fourth quarter, compared to the market average of 21.1%; and our 'BBB-' credit enhancement level was approximately 11%, compared to the market average of about 7%. We believe conduit deals with 'BBB-' credit enhancement levels could prove vulnerable if even a few of the top 10 loans default and incur moderate losses due to the relatively more concentrated nature of CMBS 2.0 conduit pools (i.e., deals issued after the financial crisis).

We rated 14 of the 17 U.S. CMBS conduit deals priced in fourth-quarter 2019 and 36 of the 52 deals issued in 2019 (see table 1). The 17 transactions that priced in the fourth quarter each had an average of 49 loans, with top 10 loan concentration averaging 51%. We continue to see transactions where the largest loan exposure is greater in percentage terms than the 'BBB-' credit enhancement level. Of the 14 deals we rated in the fourth quarter, only one contained a principal and interest class that was assigned a 'BBB- (sf)' rating (CF 2019-CF3 Mortgage Trust).

Table 1

Conduit deals priced during fourth-quarter 2019 had higher loan-to-value (LTV) ratios and higher DSCs on a quarterly basis. The average LTV was 95.1%--a 210 basis points (bps) increase quarter over quarter. Average DSC increased 0.11x to 2.12x in the fourth quarter, maintaining the trend from previous quarters in the year. This likely reflects two factors: lower interest rates and more full-term IO loans (for the purposes of our DSC analysis regarding partial IOs periods, we utilize the figure after the IO period ends, but partial IO percentages have been declining).

Overall IO percentage rose to 84% in the fourth quarter from 82% in the third quarter. Full-term IO loans now make up 67% of the collateral pools, a 500 bps increase quarter over quarter, while partial term IO exposures fell 250 bps to 17.5%. The average annual percentage of full-term IO loans have surpassed the pre-crisis vintage levels. Although this poses a risk, these loans, like their amortizing counterparts, exhibit lower leverage on average than their pre-crisis forebears.

In our review, we make negative adjustments to our loan-level recovery assumptions for all IO loans. In some conduit transactions, we make additional pool-level adjustments when we see very high IO loan concentrations or when an IO loan bucket has no discernible difference in LTV (i.e., it is not pre-amortized). The average LTV for the full-term IO loans issued in the fourth quarter was 93.5%, about 160 bps below the overall average.

Effective loan counts, or Herfindahl-Hirschman Index scores, which measure concentration or diversification by loan size, remained stable at just over 28. We consider this level to be well diversified, meaning that additional increases in the measure would result in only small marginal benefits to credit enhancement. The average deal size fell by about $40 million to $957 million in the third quarter, while the average number of loans decreased to 49 from 53.

A trend we witnessed throughout 2019 is the decline in transaction-level weighted average coupons, concurrent with the declining benchmark interest rates (see chart 1). The average has plummeted 123 bps since first-quarter 2019, with the greatest drop occurring between second and third quarters. Prudence dictates an awareness that prevailing low interest rates might not be present at refinance.

Chart 1

Fee/Leasehold Splits: An Area To Watch

We have seen an uptick in fee/leasehold splits, where a borrower both owns the interests and allocates debt accordingly. We believe this financial engineering could create a situation where the sum of the parts is greater than the original whole. In instances where we are not provided all of the relevant facts (i.e., the original fee purchase price and the subsequent leased fee and leasehold interest values) or have concerns about the "non-arm's length" nature of the transaction, we increased our stressed refinance rates on the ground fee interest or the cap rates on the leasehold interest.

Property Type Exposures: Multifamily And Suburban Office Rise, While Retail/Lodging Falls

Lodging exposure declined to 8% in the fourth quarter from 12% in the third quarter, well below the quarterly range of 12%-17% since the beginning of 2013. The sector's presence, as a percent of standalone deals, also fell to about 25% in 2019 from over 40% in 2018. This may have partly resulted from declining revenue per available room (RevPAR) growth and some reversal in top markets. Annual RevPAR grew 0.8% year over year as of November 2019, according to STR, compared with an approximately 3% growth in 2018. Twelve of the top 25 markets, including many of the largest markets (e.g., New York, Chicago, and Miami), have experienced year-over-year declines through November 2019.

The percentage of loans collateralized by suburban office that we reviewed increased to 56% in the fourth quarter from 53%, 50%, and 44% in the third, second, and first quarters, respectively. We consider suburban offices to be more risky, based on re-tenanting risk, which can be exacerbated by single-tenant exposures or when one tenant accounts for most of the rental income. In some cases, these risks are mitigated by structures such as reserves, triggers, and hyper-amortization via anticipated repayment date provisions. However, in many cases, we are seeing coterminous leases and loans and other concerning trends.

Retail exposure dropped to 18% in the fourth quarter--the lowest level we have seen in CMBS 2.0 transactions. Meanwhile, multifamily exposure jumped to 22% in the fourth quarter from 12% in the third quarter. This is likely due to the government-sponsored enterprises (GSEs) reducing their exposures after reaching their annual caps (if this is the case, the percentage of multifamily exposure may eventually fall back to prior levels because GSE volume caps have been renewed through the end of 2020).

Office continues to have the highest exposure, at 31% (down slightly from 33% in the third quarter), while mixed-use properties rose to 8% from 7% (part of the "other" category in chart 2 below) and industrial fell modestly to about 5%.

Chart 2

New Issuance Volume To Reach $100 Billion

We expect U.S. private label CMBS new issuance volume to reach $100 billion in 2020, not including commercial real estate (CRE) collateralized loan obligations (CLOs). In 2019, private label CMBS new issuance volume increased about 25% year over year to $96 billion.

We expect the single-asset single-borrower (SASB) sector to account for slightly less than 50% of transaction volume--similar to the 2019 split (about 45%). The trend of financing large loans either through the SASB sector or in the ever-growing portion of large pari passu loans within conduit pools has been one of the hallmarks of CMBS 2.0, and we expect this trend to continue for the foreseeable future.

The Credit Outlook Remains Favorable

We expect stable overall credit quality in 2020 as property-specific events, rather than any systemic change, continue to drive negative rating actions in CMBS 2.0 transactions. Nevertheless, on the credit side, we see several risks to the status quo, which was characterized by stable underlying CRE performance and, until recently, positive rating activity (as measured by an upgrade to downgrade ratio of 1.7 to 1.0 in 2018 and even higher figures in 2016-2017 when maturing volume was much greater) (see table 2). In 2019, the upgrade to downgrade ratio fell below 1.0, primarily due to negative rating actions on pre-crisis legacy deals as performing loans pay down and special servicing assets liquidate.

We also note that our economics team currently forecasts a 25%-30% probability of recession occurring during the next 12 months. In the event of a recession, we would expect most conduit rating transitions to be in the speculative-grade rating category ('BB+' and below), among other risks. S&P Global Ratings views the lower rated classes as more risky than the market and has generally required higher levels of credit enhancement to achieve an equivalent rating (for more details, see "When The Cycle Turns: How Would Global Structured Finance Fare In A Downturn," published Sept. 4, 2019).

Table 2

Related Criteria

• CMBS Global Property Evaluation Methodology, Sept. 5, 2012
• Rating Methodology And Assumptions For U.S. And Canadian CMBS, Sept. 5, 2012

Related Research

• When The Cycle Turns: How Would Global Structured Finance Fare In A Downturn, Sept. 4, 2019
• U.S. CMBS Conduit Update Q3 2019: Debt Service Coverages On The Rise, Oct. 9, 2019
• U.S. CMBS Conduit Update Q2 2019: 'BBB-' Levels Remain Too Low, July 10, 2019
• U.S. CMBS Conduit Update Q1 2019: Loan Metrics Improve As Steady Conditions Prevail, April 4, 2019
• U.S. CMBS Conduit Update Q4 2018: Metrics Deteriorated A Bit, Stable Ratings Expected In 2019 With Some Caveats, Jan. 9, 2019
• U.S. CMBS Conduit Update Q3 2018: Metrics Mostly Improve Although Deal Dispersion Widens Again, Oct. 4, 2018
• U.S. CMBS Conduit Update Q2 2018: Credit Quality Variances Are On The Rise As Loan Structural Features Weaken, July 5, 2018
• U.S. CMBS Conduit Update Q1 2018: Interest-Only Loan Volume And LTVs Remain High, April 2, 2018