Rising interest rates affect commercial real estate (CRE) loans in different ways. They make new loans or inadequately hedged floating-rate loans more expensive for the borrowers because the interest burden rises. Higher interest rates also tend to lead to lower CRE values, which increases leverage in the loans and requires borrowers to drum up more equity.

However, because most loans that we monitor in European CMBS are either on a fixed interest rate or are hedged against rising rates, we believe that the current environment is affecting refinance risk much more than term risk. In this article, we look at the loans that are due to refinance over the next 12 months and the loan maturity profile for CMBS overall.

We currently monitor CRE loans in CMBS transactions from a variety of countries and property types, although the U.K. now accounts for the vast majority of the loans.

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Shifting Risks

While the COVID-19 pandemic led to a temporary decline in rental collections for many properties, it mainly posed a cash flow risk to the loans in our surveillance book. This new environment has moved the focus away from the question of whether borrowers will be able to pay their interest and toward "will they actually be able to repay principal?".

Amplifying the situation is that 2018 and 2019 were among the most active years recently for CMBS issuance and these securitizations typically had a five-year term (including loan extensions). Consequently, these are all coming up for refinancing in 2023 and 2024.

In the following two charts, we show the upcoming maturities for the euro and British pound sterling-denominated loans that we monitor in rated CMBS transactions and the reported loan-to-value (LTV) ratios for each loan.

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Loan Maturities

While the bulk of our loans is now in the U.K., continental European loans also show a concentration in maturities. In the below tables, we look closer at those loans that are about to mature. We assess default risk using a variety of qualitative and quantitative inputs, such as the current (estimated) leverage, interest coverage with and without hedging, the nature of the loan collateral, and the stability of the underlying property income.

Elizabeth Finance 2018 DAC (Maroon Loan)

The Maroon loan is in default already and has been with the special servicer since April 2020. Its upcoming maturity date is therefore less relevant. The 92.0% LTV ratio is based on a January 2020 valuation, which has caused the default. Currently, the loan's collateral still produces enough cash to pay interest and slowly amortize so the debt burden reduces every quarter and the issuer does not need to draw on the liquidity facility. However, rising interest rates have caused the interest burden to increase and have diminished the debt service coverage ratio to 1.0x. Per the investor report, the special servicer is pursuing a longer-term management strategy, which includes the conversion of one of the assets to student housing. The special servicer has until July 2028 to complete the workout of the loan, which is when the notes mature.

Taurus 2021-5 UK DAC

This loan is a vertical slice of a larger senior loan (11%) and the above-stated property value is apportioned accordingly. It has been extended once already and there are two more contractual extension options left for one year each. The interest-only loan is secured by a portfolio of student accommodation properties and its current LTV ratio of 59.4% is based on a June 2021 valuation. The operator has been able to gradually increase occupancy at the properties and based on the latest reported net rental income, the interest coverage ratio is 1.8x. We believe it is likely that the loan will be extended again in May 2023.

Taurus 2018-2 UK DAC

This loan is secured by the Devonshire Square office property in Central London and has a large exposure to WeWork. The loan has already been extended twice and cannot be extended again when it matures in May this year. The borrower repaid a large portion of the loan while the collateral remained unchanged. Therefore, the LTV ratio, based on a valuation from April 2022, is only 21.6%. We believe that even with a current valuation, the LTV ratio would still be very low and the loan will fully repay at or before its maturity date.

Agora Securities UK 2021 DAC

The retail warehouse loan backing this transaction is nearing its initial maturity date. It then has three extension options of one year each. The servicer reports a strong debt yield at 19.3%. The LTV ratio is 50.5%, although this is based on a valuation from April 2021. The weighted-average lease term to break is 5.9 years and occupancy at the properties has steadily increased since closing. The annual contractual rental income covers the interest due by more than 4x (the servicer does not report a net operating income). We believe the loan will likely be extended.

Highways 2021 PLC

This was the first transaction backed by U.K. motorway service stations that we have rated. The loan is nearing its initial maturity date, two years after closing, and can be extended three times by one year each. The properties are all leased to a single tenant, Welcome Break, which is reporting an EBITDAR that covers their rent by 1.7x. Rent, in turn, covers the interest by 1.6x based on the most recent period. However, the current interest due is protected by an interest rate swap, which expires together with the loan at its initial maturity date. To extend the loan, the borrower will need to get a new interest rate swap or cap. Using current Sterling Overnight Index Average (SONIA) rates plus the loan margin (2.2%), the interest coverage ratio would decline to 1.4x. A mitigating factor is that there is a contractual rental increase later this year (+2.3%), which would bring the interest coverage ratio back to about 1.5x. Given the stable performance of the underlying tenant and the EBITDAR to interest coverage ratio, we believe the loan will likely be extended. A new valuation of the underlying properties is not available.

Salus (European Loan Conduit No. 33) DAC

The loan's initial maturity date was in January 2022 and it has been extended twice (by one year each time) in line with the loan agreement. It cannot be extended again. Based on the most recent valuation, which is from September 2021, the loan's LTV ratio is 49.7%. Given changes in the CRE markets since then, the value is now likely lower and the LTV ratio consequently higher, as we also stated when we lowered our ratings on the two most junior classes of notes in this transaction in October 2022. The property still struggles with an above-market vacancy rate of about 20%, but the weighted-average lease term to break for the remaining tenants extends more than five years past the loan maturity date. The collateral is a well-located, good-quality office property in central London, and the current interest burden of 4.0% is covered by the net rental income by 1.9x. We therefore believe the refinancing prospects for the loan are good.

EOS (European Loan Conduit No. 35) DAC

The loan has amortized significantly through property sales and a sequential payment trigger has been breached at the transaction level. The LTV ratio is now so low that a full repayment at the April maturity is likely.

Oranje (European Loan Conduit No. 32) DAC (Phoenix loan)

The last remaining loan is in its final extension period and cannot be extended again. Despite high structural vacancy in the underlying property collateral, the LTV ratio is 44.5% based on a valuation from February 2022. Refinance prospects are good, in our opinion.

Kanaal CMBS Finance 2019 DAC (Big 6 loan)

Due to the deteriorating performance of the underlying collateral, we have previously taken negative rating action in this transaction. Over the last four quarters, the servicer reported a steadily increasing debt yield, which now stands at 11.8%. A recent valuation revealed a 5% decline in value in the third quarter of 2022 and the LTV ratio is now 60.7%. Continuously high vacancy at about 20% is a challenge for the properties as is the upcoming expiry of the interest rate cap. Nevertheless, even without this protection, the interest coverage ratio will still be 1.8x. We believe the leverage is still moderate.

Taurus 2019-4 FIN DAC

A third-quarter 2022 valuation showed a small increase in value for the remaining properties after one was sold. The loan is in its second of two extension periods. The larger of the two remaining assets is a shopping center in Finland, which has recently struggled with increasing vacancy. The weighted-average lease term to break is short at 3.3 years, but the debt yield is over 10%. We believe this loan is in a good position to refinance.

Starz Mortgage Securities 2021-1 DAC (Node loan)

The loan was removed from the servicer's watchlist after net operating income stabilized. However, a low interest coverage ratio of 1.32x is a concern, with maturity coming up later this year, because a replacement loan may require a higher interest burden., This could lead to interest exceeding the income from the property as the debt yield is only 5.8%. The LTV ratio of 68.1% is based on a valuation from 2021. The collateral is a multifamily property in Dublin, which is a notoriously competitive market given the scarcity of residential supply, which may help with the refinancing.

Pearl Finance 2020 DAC

The loan is in the first of three potential extension periods and currently meets the requirements for further loan extensions. The final extended maturity date is in November 2025. The granular property portfolio has benefited from low vacancy below 5% and the loan's debt yield is 12%. We believe it is likely that the loan will be extended again later this year.

Berg Finance 2021 DAC (Sirocco loan)

Just one loan remains in this transaction, backed by a single property (the Vienna property), after two were sold. We affirmed our 'BB- (sf)' rating on the lowest class in the transaction in November 2022, citing as a concern the low interest coverage ratio of 1.46x. The loan benefits from a low interest burden based on a 1.75% interest rate cap. There is a risk that the loan will not be able to secure a new interest rate cap at its initial maturity in April 2024 and so not qualify for the first of its two extension options. It may then default. However, the recent sale of the Dutch property in January has likely led to a further deleveraging in the loan and it is possible that the borrower will also dispose of the last remaining property before the loan maturity date.

Refinance Risk

On the continent, almost all loans in our surveillance book mature over the next 12 months, (except three that expire within 18 months), disregarding loan extension options. The weighted-average LTV ratio for continental European loans is 57.3%, while for the U.K. loans it is 51.8%. The highest current LTV ratio that we are recording in the eurozone is 68.1% for one of the loans in Starz Mortgage Securities 2021-1 DAC.

Generally, we believe that office and retail loans will be harder to refinance in the current environment than industrial/warehouse or residential property loans given the outlook on the property market fundamentals for these property types. For office collateral, the uncertainty surrounding future office needs, in the face of an increasing trend toward work from home, leaves real estate investors and lenders concerned about the extent of possible cash flow and value declines. Retail property values seem to have stabilized after many years of continuing decline. Nevertheless, the trend toward more online shopping continues, so many properties continue to be under pressure regarding declining rents and occupancy rates.

The last time the CRE markets went through a similar decline in values was during the global financial crisis (GFC). The markets experienced similar loan maturity walls but the leverage on CRE loans was much higher then. Most of the loans were then originated at 80% leverage or more, leaving borrowers little incentive to participate in a workout and the loans with little room to withstand market value declines. We believe that the situation is fundamentally different today.

Overall, we believe that the majority of the loans that are due to mature over the next 12 months are in a good position to refinance. Even if they default, most of them should be able to fully repay the debt during a workout process.

There are three large loans that were due to mature this year but for which we have already received notice that they will fully repay: Ribbon Finance 2018 PLC, Taurus 2019-3 UK DAC, and Student Finance PLC.

Structural Changes

Another noteworthy difference is that CMBS structures are now very different from the 2005-2007 vintages. In particular, these pre-GFC transactions featured very short tail periods. Oftentimes, the special servicers only had two years between the loan maturity and the note maturity to resolve a loan, which led to many of these collateral properties being sold in fire sales at significant discounts to already depressed values. Tail periods are now more than double in length, with a minimum of five years, which structurers designed to avoid panic selling.

But What If A Loan Does Default?

When a loan defaults, it is typically transferred to the special servicer. The default gives the special servicer more powers to put pressure on the borrower and they can also often replace the property manager. Should the borrower not cooperate in an orderly workout, the special servicer can enforce on the security and take control of the property. At the height of the COVID-19 pandemic, when a number of loans breached performance thresholds that led to loan defaults, we observed that the special servicers often agreed to plans with the borrowers that included requirements for the borrowers to provide more equity or give up on excess cash flow in the loan, if any.

According to the servicing standard, which is written up in the servicing agreement between the issuer, the servicer, and the special servicer, the special servicer needs to act in the best interest of all the noteholders. We have heard concerns from investors that the special servicers tend to act more in the interest of the borrower rather than the noteholders. However, we believe that this frustration stems from the fact that different noteholders have different interests. The interests of the junior noteholders often conflict with those of the senior noteholders and the servicer and special servicer need to satisfy both.

For example, when a loan with a 90% LTV ratio defaults, the junior noteholders may want a quick exit before the situation can deteriorate further and they might suffer a loss. On the other end of the spectrum, the senior noteholders may be getting a good return and can withstand a significant decline in value so they may be more in favor of a stabilization of the underlying assets. From our perspective, we rely on the special servicer to maximize the recovery for all the noteholders. Matters of bond yield and duration are not in scope for our ratings.

From a ratings perspective, our analysis assumes a 100% probability of default so the loan default in and of itself does not result in any rating action. Where loans have performed below our expectations, we have taken rating actions to reflect the increased risk that the issuer may suffer losses in stressed environments. We do not assess the strength of the borrower's sponsor as part of our analysis because the loans are non-recourse and there is no obligation for any of these sponsors to support the rated bonds. Moreover, these borrower sponsors are typically not rated.

Conclusion

While this concentration of maturities during the current macroeconomic uncertainty is far from ideal, we believe that the more prudent loan underwriting compared with older vintage CMBS loans is now going to pay off. Some loan defaults are likely unavoidable, and a small number of them may even end up in a workout with a principal loss, but we believe that those loans maturing in the near term are largely well positioned for successful refinancing.

Although there may be some negative rating actions, we believe we have incorporated these risks in our 2022-2023 rating actions and that structural features, most notably longer tail periods, will help mitigate losses on the rated notes.

A note on our data

As we mentioned above, we exclude the Land Securities Capital Markets PLC, Ribbon Finance 2018 PLC, Student Finance PLC, and Taurus 2019-3 UK DAC loans from our data. We also exclude the loans in our granular pool transactions, because of their size, and the loans in the credit tenant lease transactions, because they do not feature refinance risk.

As we cease monitoring loans once they prepay, our analysis does not include the loans that would still be outstanding had they not prepaid earlier than scheduled.