Analysing default risk of tenants in commercial real estate (CRE) portfolios is poorly understood and could have knock-on effects for European CMBS transactions as the continent heads towards a recession, risk analytics firm Income Analytics has told GlobalCapital.
Matt Richardson, CEO and co-founder of Income Analytics, said there were a number of problems stemming from the way data is compiled on CRE portfolios’ tenants. This could create what he called a dangerous situation in what is, globally, a market that feeds institutional investors about $1.5tr per year in rent.
He argued that the property sector focuses too much on the equity and not enough on the cashflow of a commercial property.
According to data from MSCI, a minority shareholder in Income Analytics, 65%-70% of UK investment returns in CRE portfolios comes from cashflow. Meanwhile, the long-term return on UK CRE property is 9.8% — but 6.5% of that comes from cashflow and only 3% comes from capital growth.
In addition, capital growth has a volatility of plus or minus 10%, while cashflow volatility is closer to 1%.
“Cashflow is what pays cash cover on the debt. It’s what pays dividend distribution yields, it’s what pays fund distribution yields and, most importantly, it’s what pays everyone’s fees across the market,” Richardson said.
“And yet, when you look at how people approach property, they nearly always come at it from the capital side, which strikes me as fundamentally quite nuts.”
Despite this, it is normal to analyse CRE portfolios, which can then feed into CMBS transactions, by looking at lease data on only the top 10 or 20 tenants.
However, Will Robson, global head of real estate solutions research at MSCI, told GlobalCapital this could become problematic.
“By looking just at the biggest tenants, you are often missing a lot of the income in total and within that there is a significant amount of those tenants that are higher risk,” he said.
“Big companies don’t fail very often,” Richardson added. “Companies that are under three years old fail 50% of the time. Once a company gets beyond three years, its failure probabilities start to fall away.”
Data not up to scratch
Part of the problem in analysing default risk for smaller tenants is the data those companies provide is not very useful, Richardson said.
He said tenants must produce company credit reports but they provide only a “point in time” analysis of creditworthiness and provide no insight into the term risk associated with a lease, while having the added caveat of being confusing.
“They say things like ‘your tenant is 3a2’ or ‘your tenant is low risk’ — and you’ve got no idea what that means,” Richardson said.
Meanwhile, working out probabilities of default is also difficult because defaults are quite rare.
“It tends to be the very last thing that companies fail to pay,” Richardson said — in the same way that a mortgage is often the final thing a consumer fails to pay.
Mathias Herzog, director, structured finance at S&P Global Ratings, told GlobalCapital having this level of detail was often something CRE portfolio managers would not spend a lot of time on. However, the impact on CMBS transactions and ratings was likely to be limited.
“Even the most sophisticated real estate owner probably won’t spend a lot of time analysing the credit quality of a tenant that is 0.01% of their revenue,” he said.
“But it’s definitely a valid point. We do acknowledge that we don’t have information on the credit quality of many of the smaller underlying tenants in CMBS loans, but that is something that is baked into our methodology.”
Herzog said rating agencies typically look at the long-term capability of a property to generate cashflow, rather than the ability of a certain tenant to continue paying rent.
He added that they take “the more conservative view from the start” because smaller tenants don’t have to update information in the same way.
Pressure rising
With major European economies such as the UK and Germany expecting to go into (or be in) a recession, Robson said there were a lot of “stresses” appearing.
“Many specific types of businesses are struggling. There is significant pressure on their business models, and therefore on their ability to pay rent,” Herzog added.
He believed that pressure was coming, defaults would rise and ratings in CMBS would start to assume higher vacancy rates.
However, Richardson thought there was a bigger problem looming because leases are not considered a loan obligation or debt instruments.
With institutional investors collecting about $1.5tr per year in rent “and little or none of it is regularly marked to market”, he was concerned there wasn’t sufficient focus on the quality of data.
“No one seems to think this is a problem,” he added.
Portfolio holders often argue that because they have potentially thousands of leases, they are therefore diversified.
“Of course, it doesn’t work that way, as we discovered in 2007 — because when the markets go down, you get correlation of one,” Richardson added.
As a result, there was an increasingly pressing need to begin pricing property not from a value point of view but from a value of cashflow point of view, he said.
“People aren’t pricing their cashflows effectively. They are spending way too much time looking at the equity.
“No one’s doing any of this. No one is looking under the bonnet.”