The Financial Patterns of Distressed Commercial Properties and the Borrower Behavior Jun Chen, Senior Director October 17, 2012
Agenda 1. Market update 2. Motivation to study distressed properties 3. Case studies 4. Typical patterns of distressed properties financial performance 5. New ways to analyze distressed properties in a credit risk model 2
1 Market Update 3
CRE Credit Problem Has Abated» While the storm has passed, this cycle has left ~$380 billion troubled CRE assets in total $80 $ billions Newly Troubled CRE Assets $70 $60 $50 $40 $30 $20 $10 $0 07H1 07H2 08H1 08H2 09H1 09H2 10H1 10H2 11H1 11H2 12H1 12H2 Estimate Source: Real Capital Analytics 4
Commercial Banks CRE Portfolios Have Improved» Both construction loans and permanent loans saw improved credit performance 16% Total CRE Nonaccrual % Construction Nonaccrual % Perm Nonaccrual % 14% 12% 10% 8% 6% 4% 2% 0% Dec-92 Jun-93 Dec-93 Jun-94 Dec-94 Jun-95 Dec-95 Jun-96 Dec-96 Jun-97 Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03 Jun-04 Dec-04 Jun-05 Dec-05 Jun-06 Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12 Source: FDIC 5
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 6
Again, Let s Not Forget the Pains» Commercial banks have charged off over $120 billion CRE losses over the last 5 years 90 $ billions 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 7
2 Motivation to Study Distressed Properties 8
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 9
3 Case Studies 10
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 11
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 12
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. 13
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 14
Two California Plaza: 2009 Performance the property is in good shape as it is 93.5% leased. Occupancy: 83% 83% 84% the Downtown LA market does not have the exposure to the financial sector that most major cities do. Leasing reserve: $5.9 MM Debt service reserve: $0 $4.1 MM $0 $3.7 MM $0 01/09 05/09 07/09 02/10 As of 1Q09, DSCR is 0.94x Occupancy has declined due to Accredited Home Lenders declaring bankruptcy in April 2009. As of 09/09, DSCR is 0.86x As of YE09, DSCR is 0.87x 15
Two California Plaza: 2010 Deloitte will be vacating floors 19 and 20 effective 8/2010. They will be paying a termination fee ~$2.2 mm, which will be held by Lender. Leasing reserve: Debt service reserve: $ 0 $ 3.3 MM Occupancy: 83% Without Deloitte, occupancy will be 80% Leasing reserve: $5.7 MM Debt service reserve: $0 Loan transferred to special servicing effective 12/20/10 for imminent monetary default. 08/10 10/10 12/10 As of 6/30/10, DSCR is 0.92x 16
Two California Plaza: 2011-2012 Borrower to propose loan modification terms. The loan remains current while in technical default. The property is currently 78% occupied. The property is currently 75% occupied. PNA executed 3/10/11. SS dual tracking loan modification / foreclosure. Receiver was appointed 3/23/2012. Appraisal value: $ 350 MM 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 17
Two California Plaza: MPG Gave Up MPG Office Trust Announces Agreement with Two California Plaza Special Servicer LOS ANGELES--(BUSINESS WIRE)--May. 24, 2012-- MPG Office Trust, Inc. (NYSE: MPG), a Southern California-focused real estate investment trust, today announced that the Company and the special servicer for Two California Plaza, a property that is currently in receivership, entered into an agreement dated as of May 23, 2012. Pursuant to this agreement, the receiver will continue to manage the property. The Company will temporarily remain the title holder of the asset until Two California Plaza is transferred to another party or there is a completed foreclosure, with a definitive outside date of December 31, 2012, at which time the Company will cease to own the asset. We are not obligated to pay any amounts and are not subject to any liability or obligation in connection with our exit from the asset, other than to cooperate in the sale or other disposition. Also pursuant to this agreement, we are released of nearly all potential claims under the loan documents, except for certain environmental claims and other very limited potential claims that we consider immaterial. The agreement also obligates the Company to pay approximately $1 million related to certain historical operational liabilities. Source: MPG Office Trust, Inc., May 24, 2012 18
Two California Plaza: Still Developing Story Two California Plaza Goes into Receivership LOS ANGELES William Howell has been named as receiver for Two California Plaza, California's largest single asset real estate receivership in 2012. Howell has appointed Cushman and Wakefield as exclusive leasing agent for the Tower and Ocean West Management Services as property manager I am confident that the tower can be returned to immediate success in the leasing and tenant community, Howell says Two Cal Plaza To Get Improvements CW Capital, the entity managing the debt on the building, plans to invest in the property and hold on to it Source: GlobeSt.com and LADowntownNews.com, Mar 28, 2012 19
Lessons Learned from Two California Plaza» Over-leveraged to begin with» Hope was the strategy in 2007 loan underwriting»» Strong sponsors may not be there to help when you need them the most» Good news: There remains high residual option value to hold onto the property after receivership 20
Angel Park Office» Property Type: Office» Market: Las Vegas Northwest suburban» Size: 18,245 square feet» Year built: 1997» Stories: 1 21
Angel Park Office: Strong Underwriting Ratios in 2004» Property financials as of 2004 securitization Occupancy: 93% NOI: ~$ 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) 22
Angel Park Office: Took A Hit After 2009» The property s financial performance took a significant hit from the recession $300,000 NOI NOI Debt Service DSCR DSCR 2.50 $250,000 $200,000 $150,000 $100,000 $50,000 2.00 1.50 1.00 0.50 $- 2004 2005 2006 2007 2008 2009 2010 2011 2012 0.00 23
And Yet, the Loan Is Still Performing» The loan has remained current so far despite the woes of its collateral 24
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. 25
3 Typical Patterns of Distressed Properties Financial Performance 26
Summary of Empirical Data» 4 Office markets used in study: New York, Los Angeles, San Francisco, Chicago Frequency 3500 3000 2500 2000 1500 1000 Distribution of DSCR - Office 4 MSA's Total # Obs = 18,060 DSCR # Obs < 0.0 49 0.0-0.5 215 0.5-1.0 855 1.0-1.5 4,902 1.5-2.0 6,653 2.0-2.5 2,802 2.5-3.0 1,064 3.0-3.5 573 3.5-4.0 307 > 4.0 640 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 27
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% 80% DSCR 0.0-1.0 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 28
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 500% 1-Year NOI % Change - Starting DSCR 0.0-1.0 400% 300% 200% Median 95th Percentile 100% 75th Percentile 0% -100% 2001 2002 2003 2004 2005 2006 2007 2008 2009 25th Percentile 5th Percentile 29
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 40% 1-Year NOI % Change by Ending Years - Starting DSCR 1.0-2.0 1-Year NOI % Change 30% 20% 10% 0% -10% -20% -30% Median 95th Percentile 75th Percentile 25th Percentile 5th Percentile -40% 2001 2002 2003 2004 2005 2006 2007 2008 2009 30
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 31
That s Why We Do Not Observe 100% Default Rates Even for the Most Distressed Properties Actual Default Rate 25% 20% 10x differences in actual default rates given the same DSCR, reflecting differential option value equity ownership at different phases of the cycle Observation Year: 2006 Observation Year: 2007 Observation Year: 2008 Observation Year: 2009 15% 10% 5% 0% up to 0.25 0.25 ~ 0.55 0.50 ~ 0.85 0.75 ~ 1.05 DSCR Range 32
4 New Ways to Analyze Distressed Properties in A Credit Risk Model 33
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 34
The Math Part: Decompose NOI into Revenue and Expense 35
Implementation Flowchart Simulate (φ t - φ t-1 ) Process Input: Initial DSCR Level Initial Exp/Rev Ratio, φ t-1 Simulate Rev t / Rev t-1 Process Derive φ t from φ t-1 Obtain NOI t / NOI t-1 Update DSCR Level Simulate Next Year 36
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 37
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 1000 NOI Level 500 0 Percentage 35 30 25 20 15 10 5 Cross-Sectional Distribution at Year 5 New Model Existing Model -500 0 2 4 6 8 10 Year 0-100 0 100 200 300 400 NOI Level Existing Model NOI Path Starting DSCR = 1.5 # of Negative NOI Paths = 0 / 10000 1000 NOI Level 500 0 Percentage 35 30 25 20 15 10 Cross-Sectional Distribution at Year 10 New Model Existing Model 5-500 0 2 4 6 8 10 Year 0-100 0 100 200 300 400 NOI Level 38
PD for Non-Distressed Loans: Initial DSCR = 1.5» New and existing models match almost perfectly 6 Annual PD Starting DSCR = 1.5 New Model Existing Model 40 Cumulative PD Starting DSCR = 1.5 New Model Existing Model 35 5 30 4 25 Annual PD (%) 3 Cumulative PD (%) 20 15 2 10 1 5 0 0 2 4 6 8 10 Year 0 0 2 4 6 8 10 Year 39
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 1000 NOI Level 500 0 Percentage 35 30 25 20 15 10 5 Cross-Sectional Distribution at Year 5 New Model Existing Model -500 0 2 4 6 8 10 Year 0-100 0 100 200 300 400 NOI Level Existing Model NOI Path Starting DSCR = 0.5 # of Negative NOI Paths = 0 / 10000 1000 NOI Level 500 0 Percentage 35 30 25 20 15 10 Cross-Sectional Distribution at Year 10 New Model Existing Model 5-500 0 2 4 6 8 10 Year 0-100 0 100 200 300 400 NOI Level 40
PD for Distressed Loans: Initial DSCR = 0.5» New model produces lower PD for distressed loans 6 Annual PD Starting DSCR = 0.5 New Model Existing Model 40 Cumulative PD Starting DSCR = 0.5 New Model Existing Model 35 5 30 4 25 Annual PD (%) 3 Cumulative PD (%) 20 15 2 10 1 5 0 0 2 4 6 8 10 Year 0 0 2 4 6 8 10 Year 41
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 42
moodysanalytics.com Jun Chen, Ph.D. Senior Director Quantitative Research Group 415.874.6218 tel jun.chen@moodys.com Moody's Analytics 405 Howard Street Suite 300 San Francisco, CA 94105 43
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