Morningstar DBRS Takes Rating Actions on North American Single-Asset/Single-Borrower Transactions Backed by Office Properties

DBRS Inc. (Morningstar DBRS) has concluded its review of transactions secured by office properties within its North American Commercial Mortgage Backed Securities Single-Asset/Single-Borrower (NA CMBS SASB) portfolio that were placed Under Review with Negative Implications on January 9, 2024 (see the press release titled ”Morningstar DBRS Places North American Single-Asset/Single-Borrower Transactions Backed by Office Properties Under Review With Negative Implications”). The review was prompted by Morningstar DBRS’ view that a shift in the use and demand for office space has been observed in the last few years, with tenants placing even more emphasis on the quality of the buildings they are leasing, the amenities offered, and the overall desirability of their locations, with greater preference for proximity to highly coveted transportation nodes and vibrant neighborhoods with many food and retail options. These trends are expected to be sustained as the need for and use of office space have shifted for many industries amid a greater preference and allowance for remote/hybrid work schedules, as outlined in the Morningstar DBRS commentary, “Differentiating North American Office Properties Amid Sector-Specific Pressures,” released in conjunction with the January 2024 rating action. While these shifts are expected to affect the office market as a whole, it is Morningstar DBRS’ view that there is incremental risk within these shifts, which highlights the need for greater differentiation between buildings and across markets to reflect both the cyclical and secular risk of the asset class to properly assess the permanent implications for property values and other determinants of credit risk.

Morningstar DBRS takes a longer-term, rating-through-the-cycle view that assesses the performance of an asset class in the longer run and avoids changing ratings with each phase of an economic cycle; therefore, there is generally less reaction to cyclical movements, such as increases in the cost of capital or changes in unemployment. However, as previously noted, the factors driving the subject rating actions include a reflection of a secular shift in the factors that determine the credit risks for the office sector as a whole. Morningstar DBRS considers these types of secular shifts, when observed, during the surveillance process and may update its credit ratings in accordance with its rating methodology, as warranted. For more about Morningstar DBRS’ rating philosophy, please see Understanding Ratings at dbrs.morningstar.com.

As part of its review, Morningstar DBRS reviewed its approach to deriving the Morningstar DBRS value for the underlying office properties, with an evaluation of the capitalization (cap) rates and the performance of property cash flows relative to the most recently derived Morningstar DBRS net cash flow (NCF). In addition, any qualitative adjustments applied in the analysis to account for property quality, market fundamentals and/or cash flow stability, were also assessed. The analysis considered how each factor applied relative to the collateral office property or office portfolio’s position within the market. Where market conditions are expected to remain the most stressed compared with pre-pandemic levels, the qualitative adjustments for market fundamentals were typically moved downward to reduce the benefit in the loan-to-value (LTV) sizing. Similarly, where investor demand is expected to remain the most depressed and/or the collateral building’s quality and/or location was deemed a disadvantage amid the secular shifts described above, the cap rates were moved wider and qualitative adjustments for property quality were dampened. Qualitative adjustments for cash flow volatility were evaluated by looking at the scheduled rollover for the collateral properties, as well as the demand dynamics in the market—if these factors suggested increased credit risks, those adjustments were moved downward to again reduce the benefit in the LTV sizing.

The credit rating actions following this review include 288 credit rating confirmations and 230 credit rating downgrades across 87 transactions. The credit rating actions taken by Morningstar DBRS consider the analysis as outlined above and the credit support of each class within the structure of the specific transaction. Of the classes downgraded, 133 were downgraded by one or two notches; in general, these downgrades reflected relatively moderate changes in the cap rates and qualitative factors, particularly market fundamentals and property quality, or a combination of those changes coupled with a relatively moderate deterioration in the performance of the underlying asset that is expected to be sustained for the longer term. In instances where downgrades exceeded two notches (in total, 78 classes were downgraded between three and six notches), there was a trend of more pronounced declines in property performance, typically combined with more significant upward adjustments to cap rates and/or the consideration of a stressed DBRS Morningstar NCF as compared with the figures previously derived. In addition, these transactions typically had less benefit applied in the qualitative adjustments for property quality, market fundamentals, and/or cash flow volatility.

Nineteen classes across four transactions were downgraded between seven and 10 notches; in the case of two of those transactions, the underlying loans are currently in default and with the special servicers. In the remaining two transactions, the collateral properties are located in less desirable submarkets, and suffer from older construction ages and limited recent capital investment. Five classes within one transaction were upgraded based on significantly improved, sustained performance. Additionally, a subset of 15 transactions comprising 88 classes remains Under Review with Negative Implications following this review as more information is yet to be received and/or additional reviews are expected to be incorporated into the analysis. In some cases, sufficient information was available to resolve the Under Review with Negative Implications status, but concerns about evolving or emerging risks remain. In those cases, Morningstar DBRS placed Negative trends on the classes (60 classes in 16 transactions) deemed to have exposure to those risks.

As part of the analysis for these credit rating actions, Morningstar DBRS reviewed quarterly broker and investor surveys of cap rates to gain an understanding of the market’s view on both the incremental and market specific risk. Overall, these surveys revealed that cap rates have increased an average of 1.0% to 1.25%. It should be noted that Morningstar DBRS cap rates in the past 10 years have traditionally been significantly higher than the prevailing market cap rates used by the appraiser or observed in acquisition financing. However, as interest rates rose dramatically over the last year, it was Morningstar DBRS’ expectation that the delta between those values would shrink. In addition, Morningstar DBRS believes that some of that increase in cap rates across broker and investor surveys is a direct reflection of the cyclical increase in interest rates.

With this review, Morningstar DBRS generally applied a 25 to 50 basis point premium to its existing cap rates as a baseline reflection of the secular shift that view office loans as a riskier property type compared with previous cycles. As a result, there may be a limit to future cash flow growth in the sector. Additionally, Morningstar DBRS looked at each property, considering its age, build-out, its current leasing and vacancy rates, upcoming tenant rollover, and its position within the market to determine if an additional cap rate adjustment was warranted. Particularly noteworthy factors such as the stickiness of current tenancy (long term leases); current vacancy at the property compared with market vacancy; concentration of upcoming lease expiries; proximity to employment centers and primary transportation nodes; quality of the building, including year built and/or extent of last renovation; and market dynamics (net absorption) were considered. Where warranted, those considerations resulted in increased cap rates that ranged from 0.25% to 1.75% on certain assets, with the average overall change to cap rates of approximately 0.70%.

The Morningstar DBRS North American Single-Asset/Single-Borrower Ratings Methodology outlines the consideration of qualitative adjustments related to an asset and the asset’s location. As previously noted, these adjustments allow Morningstar DBRS to adjust for the property’s net cash flow volatility, property quality, and market fundamentals. These adjustments are considered in addition to the stabilized cap rate that Morningstar DBRS assigns as part of the determination of the Morningstar DBRS Value for the collateral property and serve to further differentiate assets. In evaluating the market fundamentals for each of the prevalent markets represented in the subject transactions, data from market providers such as Reis, CBRE, and Cushman & Wakefield were reviewed. In addition, Morningstar DBRS held calls with leasing brokers, visited many of the markets and properties, including a walking tour of New York City that included nearly every property in the city that backs an underlying loan in outstanding NA CMBS SASB transactions. Morningstar DBRS also reviewed data and information from the CREFC Investor Reporting Package and from the servicers in response to questions posed throughout this process.

The updates to cap rates and qualitative adjustments can be found in the accompanying appendix, “Cap Rates and Qualitative Adjustments.” In addition, a summary of the rating actions, along with the rating action for each class, can be found in the appendix, “Summary of Credit Rating Actions.”

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024), at https://dbrs.morningstar.com/research/427030.

Various classes are interest-only (IO) certificates that reference a single rated tranche or multiple rated tranches. The IO rating mirrors the lowest-rated applicable reference obligation tranche adjusted upward by one notch if senior in the waterfall.

All credit ratings are subject to surveillance, which could result in credit ratings being upgraded, downgraded, placed under review, confirmed, or discontinued by Morningstar DBRS.

Notes:
The principal methodology is North American CMBS Surveillance Methodology (March 1, 2024), https://dbrs.morningstar.com/research/428798.

Other methodologies referenced in this transaction are listed at the end of this press release.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

Please see the related appendix for additional information regarding the sensitivity of assumptions used in the credit rating process. Please note a sensitivity analysis is not performed for CMBS bonds rated CCC or lower. The Morningstar DBRS Long-Term Obligation Rating Scale definition indicates that credit ratings of CCC or lower are assigned when the bond is highly likely to default or default is imminent, thereby prevailing over a sensitivity analysis.

Please note a sensitivity analysis was not conducted for transactions that remain Under Review with Negative Implications action.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS’ outlooks and credit ratings are monitored.

A number of transactions remain Under Review with Negative Implications. Generally, the conditions that lead to the assignment of this status are resolved within a 90-day period. However, there are factors that could contribute to an extended review period for some transactions included in this action.

DBRS, Inc.
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The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

North American Single-Asset/Single-Borrower Ratings Methodology (March 1, 2024), https://dbrs.morningstar.com/research/428799

Rating North American CMBS Interest-Only Certificates (December 13, 2023), https://dbrs.morningstar.com/research/425261

Interest Rate Stresses for U.S. Structured Finance Transactions (February 26, 2024), https://dbrs.morningstar.com/research/428623

DBRS Morningstar North American Commercial Real Estate Property Analysis Criteria (September 22, 2023), https://dbrs.morningstar.com/research/420982

North American Commercial Mortgage Servicer Rankings (August 23, 2023), https://dbrs.morningstar.com/research/419592

Legal Criteria for U.S. Structured Finance (December 7, 2023), https://dbrs.morningstar.com/research/425081

For more information on this credit or on this industry, visit dbrs.morningstar.com or contact us at info-DBRS@morningstar.com.