The Financial Patterns of Distressed CommercialProperties and the Borrower BehaviorPresented at Moody’s Analytics Risk Pra...
Agenda1. Market update2. Motivation to study distressed properties3. Case studies4. Typical patterns of distressed propert...
1   Market Update                    Distressed CRE Properties and Borrower Behavior   3
CRE Credit Problem Has Abated» While the storm has passed, this cycle has left ~$380 billion troubled CRE assets in total ...
Commercial Banks’ CRE Portfolios Have Improved» Both construction loans and permanent loans saw improved credit performanc...
The Default “Pipeline” Has Significantly Reduced» The delinquency (30-89 days past due) rate has come back to that of norm...
Again, Let’s Not Forget the Pains» Commercial banks have charged off over $120 billion CRE losses over the last 5 years   ...
2   Motivation to Study Distressed    Properties                     Distressed CRE Properties and Borrower Behavior   8
Why Study Distressed Properties?» Commercial mortgage credit risks are almost certainly caused by borrowers defaulting  on...
3   Case Studies                   Distressed CRE Properties and Borrower Behavior   10
Two California Plaza» Property Type: Office  – Class: A» Submarket: Downtown Los Angeles  – Neighborhood: Bunker Hill» Siz...
Two California Plaza: Property Characteristics» Occupancy: 90.5% (as of UW Mar 2007), with major tenants:  – Deloitte & To...
Two California Plaza: Loan Characteristics» Securitized loan amount:  – $470 millions  – Coupon rate: 5.5%. Annual debt se...
Two California Plaza: Financial Performance Time-series» Expected underwritten NOI growth did not happen                  ...
Two California Plaza: 2009 Performancethe property is in goodshape as it is 93.5% leased.          Occupancy: 83%         ...
Two California Plaza: 2010                                        Occupancy: 83% Deloitte … will be vacating floors 19 and...
Two California Plaza: 2011-2012Borrower to    The loan remains            The property is                  The property is...
Two California Plaza: MPG Gave UpMPG Office Trust Announces Agreement with Two California Plaza Special ServicerLOS ANGELE...
Two California Plaza: Still Developing Story…Two California Plaza Goes into ReceivershipLOS ANGELES – William Howell has b...
Lessons Learned from Two California Plaza» Over-leveraged to begin with» “Hope” was the strategy in 2007 loan underwriting...
Angel Park Office» Property Type: Office» Market: Las Vegas  – Northwest suburban» Size: 18,245 square feet» Year built: 1...
Angel Park Office: Strong Underwriting Ratios in 2004» Property financials as of 2004 securitization  – Occupancy:        ...
Angel Park Office: Took A Hit After 2009» The property’s financial performance took a significant hit from the recession  ...
And Yet, the Loan Is Still Performing» The loan has remained current so far despite the woes of its collateral            ...
Lessons Learned from Angel Park Office» Strong financial ratios to begin with» Conservative underwriting in 2004» Many bor...
3   Typical Patterns of Distressed    Properties’ Financial Performance                     Distressed CRE Properties and ...
Summary of Empirical Data» 4 Office markets used in study: New York, Los Angeles, San Francisco, Chicago                  ...
Distressed Properties Had “Better” Financial Performance» Post-distress, distressed properties perform better than non-dis...
NOI Growth Rates of Distressed Properties» Post-distress, roughly 75% of distressed properties saw positive NOI growth rat...
NOI Growth Rates of Non-Distressed Properties» There was no upward bias in the NOI growth rates for non-distressed propert...
How To Explain This Empirical Phenomenon?» Simply put, commercial properties benefited from their being “hard assets”  – A...
That’s Why We Do Not Observe 100% Default RatesEven for the Most Distressed Properties                         10x differe...
4   New Ways to Analyze Distressed    Properties in A Credit Risk Model                      Distressed CRE Properties and...
New Methodology in NOI Simulation» NOI = Revenue - Expense  – Many market participants consider Revenue and Expense separa...
The Math Part: Decompose NOI into Revenue and Expense                                 Distressed CRE Properties and Borrow...
Implementation Flowchart                                    Input:                             Initial DSCR Level         ...
New model simulation» Calibrated with office property type data containing 4 MSA’s» 10,000 NOI paths were simulated over 1...
Results on Non-Distressed Properties: Initial DSCR = 1.5» New and existing models match almost perfectly       New Model N...
PD for Non-Distressed Loans: Initial DSCR = 1.5» New and existing models match almost perfectly                           ...
Results on Distressed Properties: Initial DSCR = 0.5» New model provides more upside movements and better reflect actual d...
PD for Distressed Loans: Initial DSCR = 0.5» New model produces lower PD for distressed loans                             ...
Concluding Remarks» Distressed properties do not necessarily lead to defaults  – Collateral distress is a necessary, but n...
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The Financial Patterns of Distressed Commercial Properties

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The presentation agenda includes:
-Market update
-Motivation to study distressed properties
-Case studies
-Typical patterns of distressed properties’ financial performance
-New ways to analyze distressed properties in a credit risk model

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The Financial Patterns of Distressed Commercial Properties

  1. 1. The Financial Patterns of Distressed CommercialProperties and the Borrower BehaviorPresented at Moody’s Analytics Risk Practitioner Conference; Chicago | October 15-18, 2012Jun Chen, Senior Director October 17, 2012
  2. 2. Agenda1. Market update2. Motivation to study distressed properties3. Case studies4. Typical patterns of distressed properties’ financial performance5. New ways to analyze distressed properties in a credit risk model Distressed CRE Properties and Borrower Behavior 2
  3. 3. 1 Market Update Distressed CRE Properties and Borrower Behavior 3
  4. 4. CRE Credit Problem Has Abated» While the storm has passed, this cycle has left ~$380 billion troubled CRE assets in total $ billions Newly Troubled CRE Assets $80 $70 $60 $50 $40 $30 $20 $10 $0 07H1 07H2 08H1 08H2 09H1 09H2 10H1 10H2 11H1 11H2 12H1 12H2 EstimateSource: Real Capital Analytics Distressed CRE Properties and Borrower Behavior 4
  5. 5. Commercial Banks’ CRE Portfolios Have Improved» Both construction loans and permanent loans saw improved credit performance Total CRE Nonaccrual % Construction Nonaccrual % Perm Nonaccrual % 16% 14% 12% 10% 8% 6% 4% 2% 0% Jun-98 Jun-93 Jun-94 Jun-95 Jun-96 Jun-97 Jun-99 Jun-00 Jun-01 Jun-02 Jun-03 Jun-04 Jun-05 Jun-06 Jun-07 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Dec-08 Dec-92 Dec-93 Dec-94 Dec-95 Dec-96 Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-09 Dec-10 Dec-11 Source: FDIC Distressed CRE Properties and Borrower Behavior 5
  6. 6. The Default “Pipeline” Has Significantly Reduced» The delinquency (30-89 days past due) rate has come back to that of normal periods 2.5% Total CRE 30-89 Days Delinquency % 2.0% 1.5% 1.0% 0.5% 0.0% Source: FDIC Distressed CRE Properties and Borrower Behavior 6
  7. 7. Again, Let’s Not Forget the Pains» Commercial banks have charged off over $120 billion CRE losses over the last 5 years $ billions 90 80 70 60 50 40 30 20 10 0 2007 2008 2009 2010 2011 2012 Construction Cumulative Net Charge-offs Perm Cumulative Net Charge-offs Source: FDIC Distressed CRE Properties and Borrower Behavior 7
  8. 8. 2 Motivation to Study Distressed Properties Distressed CRE Properties and Borrower Behavior 8
  9. 9. Why Study Distressed Properties?» Commercial mortgage credit risks are almost certainly caused by borrowers defaulting on distressed properties – The financial performance of distressed properties has key influence on credit risks» However, distressed properties do not necessarily lead to defaults – Collateral distress is a necessary, but not a sufficient, condition on default event – Understanding the relationship between “distress” and “default” is critical for credit risk analysis» Recent economic recession has left behind very rich datasets for meaningful updated analysis on this subject Distressed CRE Properties and Borrower Behavior 9
  10. 10. 3 Case Studies Distressed CRE Properties and Borrower Behavior 10
  11. 11. Two California Plaza» Property Type: Office – Class: A» Submarket: Downtown Los Angeles – Neighborhood: Bunker Hill» Size: 1.33 million square feet, including – An atrium, three-levels of retail (~52,000 sq.ft) – A five-level subterranean parking garage» Year built: 1992» Stories: 54 Distressed CRE Properties and Borrower Behavior 11
  12. 12. Two California Plaza: Property Characteristics» Occupancy: 90.5% (as of UW Mar 2007), with major tenants: – Deloitte & Touche (25.7% NRA) – Aames Financial Corp (11.4% NRA) – PricewaterhouseCoopers (12.1% NRA)» Per UW, in-place rents at the property avg $17.80 NNN, while the current market rent in excess of $23.00 NNN.» Securitization property financials: – Revenue: $ 53,847,418 – Expense: $ 21,110,399 – NOI: $ 32,737,019 (pro forma) – Appraisal value: $ 638,000,000 Distressed CRE Properties and Borrower Behavior 12
  13. 13. Two California Plaza: Loan Characteristics» Securitized loan amount: – $470 millions – Coupon rate: 5.5%. Annual debt service: $ 25,850,000 – IO periods: 10 years – Origination date: 4/24/2007» UW DSCR is 1.20x (assumes forward looking rents)» At closing a $12 MM leasing reserve and $3 MM debt service reserve was collected.» Included in GG10 CMBS deal (2007)» Maguire Properties is the loan sponsor. Distressed CRE Properties and Borrower Behavior 13
  14. 14. Two California Plaza: Financial Performance Time-series» Expected underwritten NOI growth did not happen Actual NOI Debt Service UW Pro Forma NOI $35,000,000 $30,000,000 $25,000,000 $20,000,000 $15,000,000 $10,000,000 $5,000,000 $- 2007 2008 2009 2010 2011 2012 Distressed CRE Properties and Borrower Behavior 14
  15. 15. Two California Plaza: 2009 Performancethe property is in goodshape as it is 93.5% leased. Occupancy: 83% 83% 84%the Downtown LA market does Leasing reserve:not have the exposure to the $5.9 MM $4.1 MM $3.7 MMfinancial sector that most Debt servicemajor cities do. reserve: $0 $0 $0 01/09 05/09 07/09 02/10 Occupancy has declined As of As of As of due to Accredited Home 1Q09, DSCR is Lenders declaring 09/09, DSCR YE09, DSCR 0.94x bankruptcy in April 2009. is 0.86x is 0.87x Distressed CRE Properties and Borrower Behavior 15
  16. 16. Two California Plaza: 2010 Occupancy: 83% Deloitte … will be vacating floors 19 and 20 effective 8/2010. Without Deloitte, occupancy will They will be paying a termination be 80% Loan transferred to fee ~$2.2 mm, which will be held special servicing by Lender. effective 12/20/10 Leasing reserve: for imminent Leasing reserve: $ 3.3 MM $5.7 MM monetary default. Debt service reserve: $ 0 Debt service reserve: $0 08/10 10/10 12/10 As of 6/30/10, DSCR is 0.92x Distressed CRE Properties and Borrower Behavior 16
  17. 17. Two California Plaza: 2011-2012Borrower to The loan remains The property is The property ispropose loan current while in currently 78% currently 75%modification technical default. occupied. occupied.terms. SS dual tracking Receiver was Appraisal value:PNA executed loan modification / appointed $ 350 MM3/10/11. foreclosure. 3/23/2012. 4/11 7/11 4/12 7/12 “We no longer believe we will be able to successfully modify the Two California Plaza mortgage loan and retain an ownership interest in the asset,” MPG (the landlord formerly known as Maguire Properties) said in a filing with SEC. March 15, 2012 Distressed CRE Properties and Borrower Behavior 17
  18. 18. Two California Plaza: MPG Gave UpMPG Office Trust Announces Agreement with Two California Plaza Special ServicerLOS ANGELES--(BUSINESS WIRE)--May. 24, 2012-- MPG Office Trust, Inc. (NYSE:MPG), a Southern California-focused real estate investment trust, today announced thatthe Company and the special servicer for Two California Plaza, a property that is currentlyin receivership, entered into an agreement dated as of May 23, 2012.Pursuant to this agreement, the receiver will continue to manage the property. TheCompany will temporarily remain the title holder of the asset until Two California Plaza istransferred to another party or there is a completed foreclosure, with a definitive outsidedate of December 31, 2012, at which time the Company will cease to own the asset. Weare not obligated to pay any amounts and are not subject to any liability or obligation inconnection with our exit from the asset, other than to cooperate in the sale or otherdisposition. Also pursuant to this agreement, we are released of nearly all potential claimsunder the loan documents, except for certain environmental claims and other very limitedpotential claims that we consider immaterial. The agreement also obligates the Company topay approximately $1 million related to certain historical operational liabilities. Source: MPG Office Trust, Inc., May 24, 2012 Distressed CRE Properties and Borrower Behavior 18
  19. 19. Two California Plaza: Still Developing Story…Two California Plaza Goes into ReceivershipLOS ANGELES – William Howell has been named as receiver for Two CaliforniaPlaza, …Californias largest single asset real estate receivership in 2012.Howell has appointed Cushman and Wakefield as exclusive leasing agent for the Towerand Ocean West Management Services as property manager…“I am confident that the tower can be returned to immediate success in the leasing andtenant community,” Howell says……Two Cal Plaza To Get Improvements… CW Capital, the entity managing the debt on the building, plans to invest in the propertyand hold on to it…… Source: GlobeSt.com and LADowntownNews.com, Mar 28, 2012 Distressed CRE Properties and Borrower Behavior 19
  20. 20. Lessons Learned from Two California Plaza» Over-leveraged to begin with» “Hope” was the strategy in 2007 loan underwriting» …» “Strong” sponsors may not be there to help when you need them the most» Good news: There remains high residual option value to hold onto the property after receivership Distressed CRE Properties and Borrower Behavior 20
  21. 21. Angel Park Office» Property Type: Office» Market: Las Vegas – Northwest suburban» Size: 18,245 square feet» Year built: 1997» Stories: 1 Distressed CRE Properties and Borrower Behavior 21
  22. 22. Angel Park Office: Strong Underwriting Ratios in 2004» Property financials as of 2004 securitization – Occupancy: 93% – NOI: ~$ 225,000 – DSCR: 1.91 – LTV: 57%» Included in BSCMS 2004-T16 CMBS deal» Current tenants (2012): – LV Bible School (5,120 sq.ft) – Douglas Prince, DMD (2,095 sq.ft) – OGI Environmental, LLC (2,000 sq.ft) Distressed CRE Properties and Borrower Behavior 22
  23. 23. Angel Park Office: Took A Hit After 2009» The property’s financial performance took a significant hit from the recession NOI NOI Debt Service DSCR DSCR $300,000 2.50 $250,000 2.00 $200,000 1.50 $150,000 1.00 $100,000 0.50 $50,000 $- 0.00 2004 2005 2006 2007 2008 2009 2010 2011 2012 Distressed CRE Properties and Borrower Behavior 23
  24. 24. And Yet, the Loan Is Still Performing» The loan has remained current so far despite the woes of its collateral Distressed CRE Properties and Borrower Behavior 24
  25. 25. Lessons Learned from Angel Park Office» Strong financial ratios to begin with» Conservative underwriting in 2004» Many borrowers hold onto distressed properties instead of choosing to default – Among many reasons, the option value of an equity ownership is always positive, meaning there is always a possibility that the property will come back strongly. And it is not easy for a borrower to give up that option. Distressed CRE Properties and Borrower Behavior 25
  26. 26. 3 Typical Patterns of Distressed Properties’ Financial Performance Distressed CRE Properties and Borrower Behavior 26
  27. 27. Summary of Empirical Data» 4 Office markets used in study: New York, Los Angeles, San Francisco, Chicago Distribution of DSCR - Office 4 MSAs DSCR # Obs Total # Obs = 18,060 < 0.0 49 3500 0.0-0.5 215 0.5-1.0 855 3000 1.0-1.5 4,902 1.5-2.0 6,653 2500 2.0-2.5 2,802 Frequency 2.5-3.0 1,064 2000 3.0-3.5 573 3.5-4.0 307 1500 > 4.0 640 1000 Total 18,060 500 0“Distressed” Properties DSCR Bin Majority of loans for Office property type has DSCR level between 1.0 and 3.0. We define “distressed” properties as those with DSCR level below 1.0 Distressed CRE Properties and Borrower Behavior 27
  28. 28. Distressed Properties Had “Better” Financial Performance» Post-distress, distressed properties perform better than non-distressed properties Median 1-Year NOI % Change by Starting DSCR 100% DSCR 0.0-1.0 80% DSCR 1.0-2.0 60% 40% 20% 0% -20% 2001 2002 2003 2004 2005 2006 2007 2008 2009 Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 DSCR 0.0-1.0 14 31 33 51 54 61 66 65 79 DSCR 1.0-2.0 439 584 699 769 764 753 899 1087 1195 Distressed CRE Properties and Borrower Behavior 28
  29. 29. NOI Growth Rates of Distressed Properties» Post-distress, roughly 75% of distressed properties saw positive NOI growth rates – In other words, only 25% of distressed properties saw continued declines in NOI – This happened even during the financial crisis 1-Year NOI % Change - Starting DSCR 0.0-1.0 500% 400% 300% Median 200% 95th Percentile 100% 75th Percentile 0% 25th Percentile 5th Percentile -100% 2001 2002 2003 2004 2005 2006 2007 2008 2009 Distressed CRE Properties and Borrower Behavior 29
  30. 30. NOI Growth Rates of Non-Distressed Properties» There was no upward bias in the NOI growth rates for non-distressed properties – Except their median growth rates appeared to follow the market trends 1-Year NOI % Change by Ending Years - Starting DSCR 1.0-2.0 40% 30% 1-Year NOI % Change 20% Median 10% 95th Percentile 0% 75th Percentile -10% 25th Percentile -20% 5th Percentile -30% -40% 2001 2002 2003 2004 2005 2006 2007 2008 2009 Distressed CRE Properties and Borrower Behavior 30
  31. 31. How To Explain This Empirical Phenomenon?» Simply put, commercial properties benefited from their being “hard assets” – As long as physical space still exists, empty buildings can be leased to the businesses or people who are in the market for space – There have always been some level of space demand continuously, at least due to the turnovers of existing leases regardless of economic cycles» The majority of real estate assets can indeed be turned around by skilled owners – The last few years saw enormous investor demand for foreclosed properties in both residential and commercial real estate Distressed CRE Properties and Borrower Behavior 31
  32. 32. That’s Why We Do Not Observe 100% Default RatesEven for the Most Distressed Properties 10x differences in actual default rates given the same DSCR, reflecting differential option value equity ownership Actual Default at different phases of the cycle Rate 25% Observation Year: 2006 Observation Year: 2007 Observation Year: 2008 Observation Year: 2009 20% 15% 10% 5% 0% up to 0.25 0.25 ~ 0.55 0.50 ~ 0.85 0.75 ~ 1.05 DSCR Range Distressed CRE Properties and Borrower Behavior 32
  33. 33. 4 New Ways to Analyze Distressed Properties in A Credit Risk Model Distressed CRE Properties and Borrower Behavior 33
  34. 34. New Methodology in NOI Simulation» NOI = Revenue - Expense – Many market participants consider Revenue and Expense separately instead of modeling NOI directly» The interaction between Revenue and Expense has not been captured in existing model» Separating revenue and expense modeling may lead to more accurate models on the evolution of NOI for distressed properties Distressed CRE Properties and Borrower Behavior 34
  35. 35. The Math Part: Decompose NOI into Revenue and Expense Distressed CRE Properties and Borrower Behavior 35
  36. 36. Implementation Flowchart Input: Initial DSCR Level Initial Exp/Rev Ratio, φt-1 Simulate (φt - φt-1) Process Simulate Revt / Revt-1 Process Derive φt from φt-1 Obtain NOIt / NOIt-1 Update DSCR Level Simulate Next Year Distressed CRE Properties and Borrower Behavior 36
  37. 37. New model simulation» Calibrated with office property type data containing 4 MSA’s» 10,000 NOI paths were simulated over 10 year horizon» Implemented in Matlab» Volatility parameters are taken directly from the CMM model» Market drift (trend) component is set to zero Distressed CRE Properties and Borrower Behavior 37
  38. 38. Results on Non-Distressed Properties: Initial DSCR = 1.5» New and existing models match almost perfectly New Model NOI Path Starting DSCR = 1.5 # of Negative NOI Paths = 48 / 10000 Cross-Sectional Distribution at Year 5 1000 35 New Model 30 Existing Model 25 500 Percentage NOI Level 20 15 0 10 5 -500 0 0 2 4 6 8 10 -100 0 100 200 300 400 Year NOI Level Existing Model NOI Path Starting DSCR = 1.5 # of Negative NOI Paths = 0 / 10000 Cross-Sectional Distribution at Year 10 1000 35 New Model 30 Existing Model 25 500 Percentage NOI Level 20 15 0 10 5 -500 0 0 2 4 6 8 10 -100 0 100 200 300 400 Year NOI Level Distressed CRE Properties and Borrower Behavior 38
  39. 39. PD for Non-Distressed Loans: Initial DSCR = 1.5» New and existing models match almost perfectly Annual PD Starting DSCR = 1.5 Cumulative PD Starting DSCR = 1.5 6 40 New Model New Model Existing Model Existing Model 35 5 30 4 25 Cumulative PD (%) Annual PD (%) 3 20 15 2 10 1 5 0 0 0 2 4 6 8 10 0 2 4 6 8 10 Year Year Distressed CRE Properties and Borrower Behavior 39
  40. 40. Results on Distressed Properties: Initial DSCR = 0.5» New model provides more upside movements and better reflect actual data New Model NOI Path Starting DSCR = 0.5 # of Negative NOI Paths = 364 / 10000 Cross-Sectional Distribution at Year 5 1000 35 New Model 30 Existing Model 25 500 Percentage NOI Level 20 15 0 10 5 -500 0 0 2 4 6 8 10 -100 0 100 200 300 400 Year NOI Level Existing Model NOI Path Starting DSCR = 0.5 # of Negative NOI Paths = 0 / 10000 Cross-Sectional Distribution at Year 10 1000 35 New Model 30 Existing Model 25 500 Percentage NOI Level 20 15 0 10 5 -500 0 0 2 4 6 8 10 -100 0 100 200 300 400 Year NOI Level Distressed CRE Properties and Borrower Behavior 40
  41. 41. PD for Distressed Loans: Initial DSCR = 0.5» New model produces lower PD for distressed loans Annual PD Starting DSCR = 0.5 Cumulative PD Starting DSCR = 0.5 6 40 New Model New Model Existing Model Existing Model 35 5 30 4 25 Cumulative PD (%) Annual PD (%) 3 20 15 2 10 1 5 0 0 0 2 4 6 8 10 0 2 4 6 8 10 Year Year Distressed CRE Properties and Borrower Behavior 41
  42. 42. Concluding Remarks» Distressed properties do not necessarily lead to defaults – Collateral distress is a necessary, but not a sufficient, condition on default event – Understanding the relationship between “distress” and “default” is critical for credit risk analysis» Borrowers did not “ruthlessly” default simply because of financial troubles in the underlying collateral» Empirical data from the recent downturn provided meaningful empirical evidence supporting the notion that distressed commercial properties did grow more in terms of operating income than non-distressed ones» The new modeling method that separates revenue and expense leads to more accurate results in collateral performance simulation and credit risk measures Distressed CRE Properties and Borrower Behavior 42

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