the financial patterns of distressed commercial properties

The Financial Patterns of Distressed Commercial Properties and the Borrower Behavior

October 17, 2012Jun Chen, Senior Director

Presented at Moody’s Analytics Risk Practitioner Conference; Chicago | October 15-18, 2012

2Distressed CRE Properties and Borrower Behavior

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


Market Update1


CRE Credit Problem Has Abated

Source: Real Capital Analytics

07H1 07H2 08H1 08H2 09H1 09H2 10H1 10H2 11H1 11H2 12H1 12H2$0

$10

$20

$30

$40

$50

$60

$70

$80 Newly Troubled CRE Assets$ billions

Estimate

» While the storm has passed, this cycle has left ~$380 billion troubled CRE assets in total


Commercial Banks’ CRE Portfolios Have Improved

Source: FDIC

» Both construction loans and permanent loans saw improved credit performance

Dec-9

2

Dec-9

3

Dec-9

4

Dec-9

5

Dec-9

6

Dec-9

7

Dec-9

8

Dec-9

9

Dec-0

0

Dec-0

1

Dec-0

2

Dec-0

3

Dec-0

4

Dec-0

5

Dec-0

6

Dec-0

7

Dec-0

8

Dec-0

9

Dec-1

0

Dec-1

10%

2%

4%

6%

8%

10%

12%

14%

16%

Total CRE Nonaccrual % Construction Nonaccrual % Perm Nonaccrual %


The Default “Pipeline” Has Significantly Reduced

Source: FDIC

» The delinquency (30-89 days past due) rate has come back to that of normal periods

Dec-0

1

Jun-

02

Dec-0

2

Jun-

03

Dec-0

3

Jun-

04

Dec-0

4

Jun-

05

Dec-0

5

Jun-

06

Dec-0

6

Jun-

07

Dec-0

7

Jun-

08

Dec-0

8

Jun-

09

Dec-0

9

Jun-

10

Dec-1

0

Jun-

11

Dec-1

1

Jun-

120.0%

0.5%

1.0%

1.5%

2.0%

2.5% Total CRE 30-89 Days Delinquency %


Again, Let’s Not Forget the Pains

Source: FDIC

» Commercial banks have charged off over $120 billion CRE losses over the last 5 years

2007 2008 2009 2010 2011 20120

10

20

30

40

50

60

70

80

90

Construction Cumulative Net Charge-offs Perm Cumulative Net Charge-offs

$ billions


Motivation to Study Distressed Properties2


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


Case Studies3


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


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


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.


Two California Plaza: Financial Performance Time-series

2007 2008 2009 2010 2011 2012 $-

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

Actual NOI Debt Service UW Pro Forma NOI

» Expected underwritten NOI growth did not happen


Two California Plaza: 2009 Performance

01/09

the property is in good shape as it is 93.5% leased.

the Downtown LA market does not have the exposure to the financial sector that most major cities do.

05/09

Occupancy: 83%

Leasing reserve: $5.9 MM

Debt service reserve: $0

As of 1Q09, DSCR is 0.94x

07/09

83%

$4.1

MM

$0

Occupancy has declined due to Accredited Home Lenders declaring bankruptcy in April 2009.

As of 09/09, DSCR is 0.86x

02/10

84%

$3.7

MM

$0

As of YE09, DSCR is 0.87x


Two California Plaza: 2010

08/10

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: $ 3.3 MM

Debt service reserve: $ 0

10/10

As of 6/30/10, DSCR is 0.92x

Occupancy: 83%

Without Deloitte, occupancy will be 80%

Leasing reserve: $5.7 MM

Debt service reserve: $0

12/10

Loan transferred to special servicing effective 12/20/10 for imminent monetary default.


Two California Plaza: 2011-2012

4/11

Borrower to propose loan modification terms.

PNA executed 3/10/11.

The loan remains current while in technical default.

SS dual tracking loan modification / foreclosure.

7/11 4/12

The property is currently 78% occupied.

Receiver was appointed 3/23/2012.

The property is currently 75% occupied.

Appraisal value: $ 350 MM

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


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


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…

…

Source: GlobeSt.com and LADowntownNews.com, Mar 28, 2012

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…

…


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


Angel Park Office

» Property Type: Office

» Market: Las Vegas– Northwest suburban

» Size: 18,245 square feet

» Year built: 1997

» Stories: 1


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)


Angel Park Office: Took A Hit After 2009

» The property’s financial performance took a significant hit from the recession

2004 2005 2006 2007 2008 2009 2010 2011 2012 $-

$50,000

$100,000

$150,000

$200,000

$250,000

$300,000

0.00

0.50

1.00

1.50

2.00

2.50

NOI Debt ServiceDSCR

NOI DSCR


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 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.


Typical Patterns of Distressed Properties’ Financial Performance3


Summary of Empirical Data

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

0 0.1 0.3 0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9 2.1 2.3 2.5 2.7 2.9 3.1 3.3 3.5 3.7 3.9 4.1 4.3 4.5 4.7 4.9 More0

500

1000

1500

2000

2500

3000

3500

Distribution of DSCR - Office 4 MSA'sTotal # Obs = 18,060

DSCR Bin

Fre

qu

en

cy

DSCR # Obs< 0.0 49

0.0-0.5 2150.5-1.0 8551.0-1.5 4,9021.5-2.0 6,6532.0-2.5 2,8022.5-3.0 1,0643.0-3.5 5733.5-4.0 307> 4.0 640Total 18,060

“Distressed” Properties

» 4 Office markets used in study: New York, Los Angeles, San Francisco, Chicago


Distressed Properties Had “Better” Financial Performance

Year 2001 2002 2003 2004 2005 2006 2007 2008 2009DSCR 0.0-1.0 14 31 33 51 54 61 66 65 79DSCR 1.0-2.0 439 584 699 769 764 753 899 1087 1195

2001 2002 2003 2004 2005 2006 2007 2008 2009-20%

0%

20%

40%

60%

80%

100%

Median 1-Year NOI % Change by Starting DSCR

DSCR 0.0-1.0DSCR 1.0-2.0

» Post-distress, distressed properties perform better than non-distressed properties


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

2001 2002 2003 2004 2005 2006 2007 2008 2009-100%

0%

100%

200%

300%

400%

500%1-Year NOI % Change - Starting DSCR 0.0-1.0

Median

95th Percentile

75th Percentile

25th Percentile

5th Percentile


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

2001 2002 2003 2004 2005 2006 2007 2008 2009-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

1-Year NOI % Change by Ending Years - Starting DSCR 1.0-2.0

Median

95th Percentile

75th Percentile

25th Percentile

5th Percentile

1-Y

ea

r N

OI %

Ch

an

ge


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


That’s Why We Do Not Observe 100% Default Rates Even for the Most Distressed Properties

up to 0.25 0.25 ~ 0.55 0.50 ~ 0.85 0.75 ~ 1.050%

5%

10%

15%

20%

25%Observation Year: 2006 Observation Year: 2007

Observation Year: 2008 Observation Year: 2009

DSCR Range

Actual Default Rate

10x differences in actual default rates given the same DSCR, reflecting differential option value equity ownership at different phases of the cycle


New Ways to Analyze Distressed Properties in A Credit Risk Model4


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


The Math Part: Decompose NOI into Revenue and Expense


Implementation Flowchart

Input:

Initial DSCR Level

Initial Exp/Rev Ratio, φt-1

Simulate Revt / Revt-1 Process

Simulate (φt - φt-1) Process

Derive φt from φt-1

Obtain NOIt / NOIt-1

Update DSCR Level

Simulate Next Year


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


Results on Non-Distressed Properties: Initial DSCR = 1.5

0 2 4 6 8 10-500

0

500

1000New Model NOI Path Starting DSCR = 1.5 # of Negative NOI Paths = 48 / 10000

Year

NO

I Le

vel

0 2 4 6 8 10-500

0

500

1000Existing Model NOI Path Starting DSCR = 1.5 # of Negative NOI Paths = 0 / 10000

Year

NO

I Le

vel

-100 0 100 200 300 4000

5

10

15

20

25

30

35Cross-Sectional Distribution at Year 5

NOI Level

Per

cent

age

New Model

Existing Model

-100 0 100 200 300 4000

5

10

15

20

25

30


NOI Level

Per

cent

age

New Model

Existing Model

» New and existing models match almost perfectly


PD for Non-Distressed Loans: Initial DSCR = 1.5

0 2 4 6 8 100

1

2

3

4

5

6Annual PD Starting DSCR = 1.5

Year

Ann

ual P

D (

%)

New Model

Existing Model

0 2 4 6 8 100

5

10

15

20

25

30

35

40Cumulative PD Starting DSCR = 1.5

Year

Cum

ulat

ive

PD

(%

)

New Model

Existing Model

» New and existing models match almost perfectly


0 2 4 6 8 10-500

0

500

1000New Model NOI Path Starting DSCR = 0.5 # of Negative NOI Paths = 364 / 10000

Year

NO

I Lev

el

0 2 4 6 8 10-500

0

500

1000Existing Model NOI Path Starting DSCR = 0.5 # of Negative NOI Paths = 0 / 10000

Year

NO

I Lev

el

-100 0 100 200 300 4000

5

10

15

20

25

30


NOI Level

Per

cent

age

New Model

Existing Model

-100 0 100 200 300 4000

5

10

15

20

25

30


NOI Level

Per

cent

age

New Model

Existing Model

Results on Distressed Properties: Initial DSCR = 0.5

» New model provides more upside movements and better reflect actual data


PD for Distressed Loans: Initial DSCR = 0.5

0 2 4 6 8 100

1

2

3

4

5

6Annual PD Starting DSCR = 0.5

Year

Ann

ual P

D (

%)

New Model

Existing Model

0 2 4 6 8 100

5

10

15

20

25

30

35

40Cumulative PD Starting DSCR = 0.5

Year

Cum

ulat

ive

PD

(%

)

New Model

Existing Model

» New model produces lower PD for distressed loans


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

the financial patterns of distressed commercial properties

Economy & Finance

fdic distressed cre

maguire properties

cre losses

distressed properties3

cre credit problem

troubled cre assets

borrower behaviorpresented

california plaza property