In 2018, new issuance in the European commercial mortgage-backed securities (CMBS) sector began to increase, after several years of subdued activity. However, most outstanding transactions in S&P Global Ratings' rated universe were issued before 2007: the so-called CMBS 1.0 generation. Many of these transactions have already redeemed or been otherwise terminated, but the sector remains a focus of our surveillance analysis, given the degree of credit distress that CMBS experienced over the past 10 years. This report looks back at two decades of European CMBS issuance and how the transactions that we rated have performed. In particular, we look beyond the number of tranche defaults and quantify the losses actually realized to date.

As well as addressing repayment of principal no later than the legal final maturity date, our ratings also address timely payment of interest. We may therefore lower a CMBS rating to 'D' if a coupon payment is delayed, even if all interest and principal payments are later fully made. This means that CMBS investors in some tranches whose ratings we lowered to 'D' may ultimately have suffered no losses. Additionally, even in cases where defaults were due to incomplete principal repayment, the ultimate loss to investors may still vary widely. This is because we would lower a rating to 'D' on a failure to fully repay principal by a certain date, regardless of whether the shortfall or loss rate on the tranche is 5%, 50%, or 100% of the original balance.

Since the tranches began defaulting in 2007, we lowered a total of 300 ratings to 'D' from 1,617 euro- and pound sterling-denominated European CMBS tranches included in this study. Here, we analyze the actual loss experience of European CMBS across the rating and vintage spectrum, over a 20-year horizon. All reported figures are as of first-quarter 2018, unless otherwise noted. For further detail on how we have calculated these losses, please refer to the Appendix.

CMBS 1.0 And 2.0: Two Generations Of Varying Defaults

Over the last two decades, we rated £86 billion of pound sterling-denominated and €134 billion of euro-denominated CMBS notes, with the peak of this rated issuance occurring between 2005 and 2007 (see chart 1). Total issuance in what we call CMBS 2.0 (issued in 2008 and beyond) was comparably small--11.3% of the total pound sterling issuance since 1998 and 4.4% of euro issuance--although this cohort covers almost half the time period in this study.

Chart 1

CMBS 1.0 transactions (from the 2007 vintages and earlier) typically consisted of one or more 'AAA'-rated senior tranches, followed by junior ranking tranches rated in the investment-grade range (see charts 2 and 3). Speculative-grade rated tranches were relatively rare, comprising less than 1% of the issuance that we rated.

By contrast, a large amount of post-crisis CMBS 2.0 issuance comprised transactions with no 'AAA' tranches, primarily driven by credit tenant lease (CTL) structures and tap issuances from existing programs.

Chart 2

Chart 3

CMBS Defaults Started In 2007

Of the European CMBS transactions that we rated, HOTELoc PLC was the first to default. We lowered our ratings on the class E1, E2, and E3 notes to 'D' in May 2007 when the issuer failed to fully repay principal at the legal final maturity date. These three tranches were the most junior in the transaction's seven-tranche structure and carried 'BB' ratings when we first rated it in 2002. The pound sterling-denominated class E1 and E2 notes had a combined initial balance of £43 million and ultimately suffered a principal loss of just under £9 million, representing 21% of the tranches' principal balance but less than 1% of the overall transaction's capital structure.

The wider European economic and real estate downturn that ultimately led to most of the losses in the CMBS sector began in 2008, as liquidity dried up and capitalization rates began to increase. However, CMBS defaults did not spike until the 2011-2013 period.

Chart 4 shows the losses experienced up to first quarter 2018, segmented by the year in which we lowered the respective notes' ratings to 'D'. Some of the losses were crystallized much later, but we lower our ratings to 'D' as soon as an issuer fails to maintain timely interest payments. Special servicers often delay the sale of a real estate asset because they plan to first improve its marketability by increasing occupancy or renewing lease contracts. Moreover, during the 2008-2010 period, many special servicers thought that it was not the right time to sell properties securing defaulted loans because they perceived market values to be at the bottom of their cycle. Consequently, asset sales were delayed and where the borrower was not able to make interest payments on the loan, issuers often kept coupon payments on the CMBS notes current by drawing on the liquidity facility.

Chart 4

2006-2007 Vintages Suffered Most Defaults And Losses

The vast majority of tranches whose ratings we have lowered to 'D' were originally issued in the years when real estate markets approached their peak, CMBS issuance was strong, and competition among originators for loans was fiercest. The highest default rates to date have been in the 2006 and 2007 transaction vintages (see chart 5). By contrast, many pre-2005 loans were successfully prepaid during the years when the market was performing well, so didn't experience a period of stress.

Chart 5

The cumulative losses that we have recorded to date amount to £2.9 billion and €5.3 billion, of which 97% and 95%, respectively, were lost principal, with the remainder being lost interest. As a proportion of the total issuance balance, these losses equate to 3.4% for pound sterling-denominated and 3.9% for euro-denominated tranches.

Both the pound sterling- and euro-denominated tranches issued in 2006 and 2007 had high losses (see chart 6). In addition, the 2008 vintage of euro-denominated transactions also had high losses, although this is attributable to a single, unusually large tranche in a year of very limited issuance overall--Excalibur Funding No. 1 PLC's class A notes.

Chart 6

We originally assigned 263 ratings to pound sterling-denominated tranches and 426 to euro-denominated tranches issued in 2006-2007. Of these, we subsequently lowered 85 and 173 ratings to 'D', respectively. That said, 22 of these tranches did not experience a principal loss, but rather resulted from the issuers' failure to make timely interest payments. Also, the issuers subsequently repaid interest shortfalls on six of these tranches.

Table 1

Losses in these transactions--including lost interest--were as low as 0.1% of the original principal balance in some cases but as high as 76% in one (see table 2). The 10 largest transactions from the 2006 and 2007 vintages, which were all euro-denominated, experienced an average loss rate of 3.7%, while for the smallest transactions it was 7.0%. While this may suggest that larger, more diversified transactions show smaller losses, we found that of the 10 transactions with the largest losses, six were backed by multiple loans and the four single loan transactions were all backed by portfolios of properties rather than individual real estate assets (see table 2). Diversification on its own does not appear to have led to lower losses. Instead, in our opinion, the high loss rates in these transactions were due to high leverage, aggressive underwriting, and geographic and property type concentration.

For example, commercial real estate loans originated in 2006 and 2007 oftentimes had a 70%-80% loan to value (LTV) ratio on the first mortgage portion with the remaining property price financed by subordinate debt. Consequently, borrowers frequently had little or no equity in their transactions. At the same time, property valuations that originators used as a foundation for their lending were often based on special assumptions of future rental growth, which then didn't materialize, thereby exacerbating the losses.

In contrast, CMBS loans originated in 2018 typically carry LTV ratios in the 60%-65% range, with little or no subordinate debt.

Table 2

20-Year Loss History Similar Between The U.K. And Eurozone

On average, pound sterling-denominated tranches experienced a 3.4% loss rate over the past 20 years--roughly the same as for euro-denominated tranches (3.9%; see tables 3 and 4). For tranches originally rated 'AAA', loss rates appear to be much smaller in the eurozone than in the U.K., but this is skewed by a small number of very large German multifamily housing transactions that increased the euro-denominated issuance volumes--but not the losses--for the investment-grade rating categories.

Moreover, for the low speculative-grade rating categories, average loss rates per vintage in some cases have exceeded 100%, because we include lost interest.

Table 3

Table 4

Another transaction feature that has influenced the recorded loss rates is the use of pro rata payments on the notes. This has led to lower loss rates in the speculative-grade rating categories--particularly in the 2006 and 2007 vintages--as loan amortization partially repaid subordinated tranches prior to the occurrence of a trigger event (typically a loan event of default). In return, this has exacerbated losses in the higher rating categories. Nevertheless, pro rata pay ultimately only changed the distribution of losses between the rating categories within the transactions and did not lead to higher losses overall.

Also notable is the sharp increase in losses as the rating categories move to the speculative-grade range from the investment-grade range (see chart 7). This effect is primarily driven by structural subordination, but is also because more junior ranking tranches are generally smaller and typically absorb lost interest.

Chart 7

Peak In Defaults About Seven Years After Issuance

Of the 300 tranches we downgraded to 'D' since defaults began in 2007, many followed a failure to repay at note maturity. It is therefore not surprising that the ratings defaults seem to be concentrated around the seventh year after issuance, as many transactions were structured with a five-year expected maturity, followed by a two-year tail period (the period between the maturity date of the latest maturing loan and the final maturity date of the transaction; see chart 8). CMBS 2.0 transactions are now usually structured with a five-year tail period or longer.

Defaults earlier in the term have usually been due to a failure to pay timely interest. This would typically follow property-level cash flow declines combined with appraisal reduction, which led to a limitation on the drawings available under the liquidity facility. Principal losses in the first three years of a transaction have been rare.

Chart 8

Despite Brighter Outlook, Issuance Is Nowhere Near A Turning Point

Our stated loss numbers may increase over the next two to four years as more CMBS 1.0 tranches move beyond their legal final maturity dates. Particularly at risk are the 27 tranches currently rated in the 'CCC' and 'CC' rating categories. However, given that most CMBS 1.0 deals have been repaid or worked out, we do not expect the actual final total loss numbers to be substantially higher than stated in this article, especially since our underlying assumptions for this analysis are relatively conservative (see Appendix for further details).

Even assuming that all classes currently rated 'CCC' or 'CC' default and all of their currently outstanding principal is lost, our loss rates would only increase to 3.7% for pound sterling-denominated notes and to 4.3% for euro-denominated notes.

European CMBS 2.0 issuance volumes have remained subdued relative to the peak period of CMBS 1.0 issuance, although real estate markets are now in a similar situation to pre-crisis. Cap rates are now as low as--if not lower than--at the peak of the previous cycle, and rental growth and market vacancies in the main sectors and the key markets are stable.

As of end August 2018, we have recorded €1.7 billion and £1.1 billion of new European CMBS issuance across nine transactions, of which we rated five. The transactions typically include one to three loans in some of the same jurisdictions that we had seen most prominent over the last 20 years: the U.K., Germany, the Netherlands, and Italy. That said, one of the newly issued transactions, FROSN-2018 DAC, includes properties in Finland, a country previously not popular among CMBS issuers. On the other hand, France, which used to be a frequent home to CMBS properties, is notably absent among new issuances.

Despite increased new issuance activity in 2018, however, CMBS volumes are still nowhere near their previous peaks. This may be partly due to the historical losses described in this study, but also due to the post-crisis regulatory response, which significantly increased the capital charges that some types of investors are required to hold against CMBS exposures.

So far, CMBS 2.0 transactions have been few in number and have also not experienced the type of economic and real estate market downturn that CMBS 1.0 transactions did. However, structural enhancements have been made to the product, such as longer tail periods and more subordination, with less leverage in the securitized portions. We expect these enhancements to lead to lower losses in the recent vintage transactions if they were to experience a similar stress as their CMBS 1.0 counterparts.

RELATED CRITERIA AND RESEARCH

• 2017 Annual European Structured Finance Default Study And Rating Transitions, Aug. 22, 2018
• European CMBS Monthly Bulletin (August 2018), Aug. 21, 2018
• Application Of Property Evaluation Methodology In European CMBS Transactions, April 28, 2017
• CMBS Global Property Evaluation Methodology, Sept. 5, 2012
• European CMBS Methodology And Assumptions, Nov. 7, 2012

Appendix: Data Selection And Calculation Approaches

In this study, we reviewed 325 CMBS transactions that we rated between 1998 and end-March 2018. Our dataset includes 1,617 rated euro- and pound sterling-denominated tranches from these transactions, but we have excluded interest-only certificates--such as class X notes--because these only have a nominal principal balance (which prevents meaningful calculation of a loss rate), and because their repayment is not linked to the transaction's performance. Our regular default and ratings transition studies do include these tranches in the European CMBS sector, as well as tranches denominated in other currencies.

There are a number of transactions in this study where we lowered the ratings on some tranches to 'D' and then subsequently raised the rating. If, for example, a transaction is restructured, we may lower some ratings to 'D', subsequently withdraw them, and then assign new ratings to the tranches of the restructured transaction. We have included these cases in our counts of ratings moving to 'D', but have attributed no losses.

Among the 325 transactions in this study, 57 are still outstanding, meaning we are still rating one or more tranches. Of this subset, we count 19 transactions with at least one class of notes rated 'D'. For these classes we have assumed that:

• The entire principal amount outstanding will be lost;
• Any accrued and non-capitalized interest outstanding will not be recovered and will instead increase the principal loss, potentially above 100% of the tranche balance; and
• Outstanding liquidity drawings will increase the loss of the transaction's highest ranking class currently rated 'D'.

Moreover, there are tranches that are still outstanding but which we do not rate anymore, mostly because they have failed to repay at their legal final maturity date. Because we have ceased monitoring these classes, we have assumed that the entire principal amount and the accrued but unpaid interest, as of the date that we last received information on these classes, was or will be lost.

We recognize that the losses we assume for these tranches may overstate the eventual loss experience, given that recoveries can (and in many cases will) still be received by the special servicers, sometimes even after the tranches' legal final maturity dates, which is when we typically stop monitoring transactions.

This study only focusses on the tranches that we currently rate 'D' or where our last rating prior to withdrawal was 'D'. There may be future losses on outstanding tranches with a higher rating--for example, in the 'CCC' rating category--but we have not included a loss assumption for these tranches in this study.