Dechert 4 Real

How Climate Change, AI and Office Challenges Are Impacting CMBS With Erin Stafford From Morningstar DBRS

• Dechert LLP • Episode 18

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What is the current state of commercial mortgage-backed security, or CMBS? Dechert 4 Real hosts Jon Gaynor, Ella Smith and Sam Gilbert invite the managing director and head of North American CMBS ratings activity at Morningstar DBRS, Erin Stafford, to the podcast to break down the current headwinds and opportunities in the CMBS space, from climate change’s impact on CMBS ratings to the industry’s emerging interest in data centers. Plus, Sam gives the 411 on New York City’s Safe Hotels Act, Dechert’s John Ludwig-Egan highlights an upcoming re-proposal of the Basel III Endgame rules and the hosts get 4 Real about football season. 

Show Notes: 

Dechert 4 Real Episode 15: Rolling into Summer with CREFC Roulette and the Biggest Takeaways from the June Conference (June 2024) 

THE CRED: Legal & Business Insights from the Private Credit Industry 

Jon Gaynor:

Hello and welcome back to the Dechert 4 Real podcast, where we discuss current issues and trends in commercial real estate finance. We aim to bring market commentary about developments, updates you can use, and hopefully a little bit of banter along the way. I'm Jon Gaynor, a counsel based in Dechert's Philadelphia office.

Ella Smith:

Hi, I'm Ella Smith, a partner based in Dechert's Charlotte office.

Sam Gilbert:

And I'm Sam Gilbert, a partner based up in Dechert's Boston office.

Jon Gaynor:

Today, we're recording in our New York office the day before the CREFC Capital Markets Conference. You'll hear about the Safe Hotels Act from Sam and rumblings from the regulators about an upcoming re proposal of the Basel III Endgame rules from Dechert's own John Ludwig-Eagan. After that, joining us will be a surprise guest who is also in town for the conference, as well as for the guest bartending fundraiser that's happening tonight, the day we're recording, that benefits the American Heart Association.

Ella Smith:

Oh, Jon, I feel like we're doing a Smartless-style intro here. Do you want to give us any more clues about this surprise guest?

Jon Gaynor:

Don't mind if I do! This guest has over 20 years of experience in the commercial real estate finance industry, and currently serves as a managing director and head of North American CMBS ratings activity at Morningstar DBRS.

Ella Smith:

Oh, I know who it is. I know who it is.

Jon Gaynor:

And she is the 2024 CREFC Woman of Distinction.

Sam Gilbert:

Oh, wow. We got Erin Stafford to come in? That's amazing!

Ella Smith:

Well, that was a great intro, guys. I wonder what rating Erin would give it on the DBRS scale.

Jon Gaynor:

I feel like we're gonna find out. But before we bring Erin on, let's get 4 Real with the host to break the ice. We are in the start of autumn, and among other things, welcoming the return of football. So let's kick things off with a question to my fellow hosts: Which NFL team holds your allegiance and why? You want to start, Ella?

Ella Smith:

Absolutely. So, for me, it is definitely the Bears. And I'm not just saying that because Erin's based in Chicago But my husband's actually from Chicago as well, and when I found out he was a long-suffering Bears fan, I felt like I needed to join him in that and support him, be there for him, every Sunday. So this year, the Bears were on Hard Knocks, which is like a reality show about training camp. And I may not be that into football, but I'm definitely into reality TV. So, this season has been really enjoyable so far for me, because I feel like I know who the players are, and I've really gotten into it thanks to the reality show about football.

Jon Gaynor:

You know, good marriages, you find ways to grow together. I like that. What about you, Sam?

Sam Gilbert:

Well, for the listeners who were paying attention at the beginning, the fact that I'm from the Boston office, I guess, sort of tips them off that I'm a Patriots fan. I am old enough to remember the 1-15 Patriots before the dynasty started. I grew up in New Hampshire. I remember watching the games on the Portland, Maine, affiliate because the games on the Boston affiliate were blacked out because they had it sold out in Foxborough. So I've sort of suffered through that. Went through the good years, and now I'm, I think I'm prepared to go through the bad years again with the Patriots. But ...

Jon Gaynor:

Well, so this is the part where I remind people I'm from the Philadelphia office, and if I don't say the Eagles, I might not have a place to go back to at the end of this. But big fan of the Eagles. You know, don't talk to me about last night. We're recording right after their Monday Night Football debacle. It's a funny thing, because when Ella put the script together this time, and she has talks about the gosh dang Eagles there. And so now this is where you guys get to make fun of them. Oh, no

Ella Smith:

Oh, no one makes fun of the Eagles. We make fun of Eagles fans.

Jon Gaynor:

Ah, fair, good point.

Sam Gilbert:

Eagles and Patriots, both 1-1 right now. So

Jon Gaynor:

There we are. We're in good company. So that counts, First up, Sam, I think you are talking to us about the Safe... I think, as getting 4 Real. We're gonna hop over to our 411s now, which we pre-recorded this month. Hotels Act.

Sam Gilbert:

Yeah, thanks, Jon. I just want to take a minute to talk about what's a relatively recent piece of potential legislation that has had a pretty significant impact on the hotel sector here in New York City. It's a proposed bill called the Safe Hotels Act which, as the name suggests, has the stated purpose of making New York City hotels safer. As you may remember, during and since the pandemic, there was a lot of focus and press on hotels in the city as unhoused people and migrants were moved into the hotels, and this bill appears to be somewhat in response to that concern.

Ella Smith:

I was hoping they'd make them safer for my wallet.

Sam Gilbert:

That has not happened and is not in this bill. The act is a lot broader than things like requiring around-the-clock staffing at the front desk or security guards for larger hotels for safety reasons. Most of the proposed bill in its current form deals with control over the operation of the hotels. Now, I should say this is a very fluid situation, and also relatively new to the industry. It was originally proposed just back in mid-July, and has been modified at least once from its initial form, and it's very much unclear at this point whether this will even pass, or if it does pass, which does seem likely, from what I've been hearing, in what form does it pass? But, regardless, it's already had a big impact on the hotel sector here in the city. We've had a handful of deals go pencils down here because the underwriting is just very much unclear at this point. And I'm hearing that others have seen the same thing across the city. There's just too much of an unknown at this point to be able to think about how, or even if, a hotel sale or financing would work. You know, briefly and with, again, the caveat, this is all subject to change, the two biggest items in the act seem to be a new licensing requirement for the hotels and some requirements around staffing. So, the license would be a two-year license, without any objective standards for granting, withholding or extending or not extending the license, and that all apparently would be left to the discretion of the commissioner. There doesn't appear to be an ability to assign the license once you get it, including in connection with the foreclosure. Now, one could take the view that this licensing requirement is really a cover to force hotels to hire more union employees as a condition to approval. You know, the city has more than 300 non-union hotels, many of them owned by small businesses or families. And there is a concern that many of these hotels will be forced to close. You know, and from a financing perspective, from what I would look at, you know, how does the lender give a five- or 10-year mortgage on a hotel with a license that's only valid for a few years at a time? So, obviously, some unanswered questions there.

Ella Smith:

And if their license wasn't renewed, like, do they have to shut down? Or is there a fine? Or do we not know?

Sam Gilbert:

We don't know. It appears they would have to shut down. You just can't operate without the license. Again, a lot of stuff has to be worked out here. This is, you know, a work in progress, hopefully. The second big item is that the bill requires hotels to hire staff for tasks that a lot of them currently outsource, like laundering and security. The bill says a hotel owner must directly employ all of its core employees, and that contracting to any third parties for those core employees would not be permitted, you know, unless you hire a third-party property manager who comes in and does that. This, again, could have a huge impact on operating expenses, especially at some of these smaller hotels. It'll also be interesting to see how the hotel managers and the big brand managers who are usually responsible for employment will react to this. There was a hearing scheduled on this back in August. It was canceled, and to my knowledge, there haven't been any additional hearings. But we'll certainly be keeping a close eye on this bill as it moves forward. Thank you to my partner, Nitya Kumar Goyal, who's been on top of this, and hopefully we'll get some clarity in the coming weeks and months about what this might look like.

Jon Gaynor:

Thanks very much, Sam. And now for our second 411 we've got our very own Notorious JLE, John Ludwig-Eagan, here to talk to us a little bit about Basel III. John, welcome back to the podcast.

John Ludwig-Eagan:

Thanks for having me back.

Jon Gaynor:

So, tell us what's going on about Basel. We know that it was a big focus last year. I think you even talked about it on the podcast before, right?

John Ludwig-Eagan:

Yeah. So, to take a step back for a moment, Basel is an international accord concerning the supervision of banks and, specifically, minimum capital requirements for banks. Given all of the risks that banks face - market risk, operational risk, credit risk - what's the minimum amount of capital that we're going to require them to hold in order to absorb the losses that might result from those risks?

Jon Gaynor:

And the problem with holding lots of capital is that it's equity and equity is way more expensive in terms of how things actually play.

Unknown:

Exactly. And in the United States, the Basel Accord is implemented by the three banking regulators, right? The Fed, the OCC and the FDIC, in a regulation that's commonly known as Regulation Q, Reg Q. A few years ago, there were some changes to the Basel regime that was colloquially known as the Basel Endgame. These were finalized a few years ago, and

John Ludwig-Eagan:

There was also weirdness that might have then in 2023 the U.S. banking regulators proposed revisions to implement those Endgame changes in the United States. There was a lot of dissent, a lot of controversy about it. I believe there were four dissents among all of the banking regulators in publishing this rule criticizing its breadth and, in the dissenters' views, over-prescriptiveness of the regulation. So, in our corner of the universe, the proposed revisions to the credit risk framework were the most significant and most widely discussed. The credit risk framework under the proposal would increase the risk weights for most securitization exposures according to a new formula. It would increase the granularity of the risk weighting for commercial real estate exposures. So, instead of just sorting commercial real estate exposures into a couple different categories, we're going to be a lot more sensitive to their risk weighting depending on what the LTV is of affected how warehouses are looked at because they were kind the loan and whether or not the cash flow depends on the rents from the real estate itself. There was also no clarity on CLNs, credit-linked notes, right? Right now we're under this regime where in order to issue a credit-linked note and get it to count as a securitization, you have to go get specific approval from the banking regulators. A lot of people were looking for some regulatory clarity, permitting people to do CLNs and get securitization treatment as of right. But there was no such clarity in the regulation. And the other big thing for commercial real estate is a punitive cross-default provision on CRE loans. So, you know, if a borrower defaults on one of their loans, you have to treat all of those borrower's loans as defaulted even though they're non-recourse and your exposure is really to the property and not necessarily the borrower. of being looped in to different kinds of financial products. And, you know, I remember some real consternation around all of that too. All of the trade groups put out extensive comment letters and had previously made remarks on a number of these changes, right?

Unknown:

Yeah, the pushback was significant from all corners of industry. I know in our worlds CREFC and SFA put together excellent comment letters to the banking regulators about the proposed rule.

Jon Gaynor:

That takes us to today, right? So, why are we bringing up Basel III Endgame again?

Unknown:

So, it all comes down to a speech that Michael Barr gave a couple weeks ago. Michael Barr is the vice chair for supervision at the Fed, and in his speech he touched on the Basel proposal, and he noted that the view among the banking regulators was that broad and material changes were warranted to the proposal. Now, his remarks didn't necessarily touch on anything specific to commercial real estate or securitization, right? His remarks were focused on things like residential real estate and retail exposures, corporate debt, securities financing. However, it remains to be seen whether or not any of these broad material changes will touch on any of the things that our corner of the world cares about - securitization framework, commercial real estate exposures, things like that.

Jon Gaynor:

What do you think happened that led to them to make the commentary that there are going to be broad and material changes warranted?

Unknown:

I guess a couple things. The first is that there really was tremendous industry pushback on these regulations, to the point where people were threatening litigation. There were really a lot of people who were very exercised about the proposal, and even among the banking regulators themselves, right? There were four dissents, I believe, when this was proposed, so this was not necessarily a slam dunk for them when it came out. The other thing is that if we look back at some of the Supreme Court decisions over the last year or so, and especially the Loper Bright case, which overturned Chevron Deference, regulators are much more trepidatious about broad, sweeping rulemakings, I think, because it's going to be a lot easier to challenge them in court. So, given the Supreme Court's decision in Loper Bright and other recent decisions kind of cabining the power of the administrative state, I think regulators generally are much more trepidatious about stepping over the line and doing something too broad or too sweeping.

Jon Gaynor:

But on the other hand, they are not scrapping the project. They are editing it. They are going to re-propose it. Do you think that they're going to focus on trying to push something out before the election? Or when do you think these these things could come live?

Unknown:

I've been wrong before and I'll be wrong again. I doubt this is coming out before the election. I think, recently, Chairman Powell noted that his timeline was sometime in the next year. I would bet on the later end of that timeline, and not before the election, especially given the fact that if these changes are really broad in material, then that's going to take time. So, I would bet that this doesn't come out before the election. But Chairman Powell's timeline looks like it's in the next year or so.

Jon Gaynor:

Makes sense to me. I know that many industry players have been thinking a lot about how Basel III Endgame, as it was originally proposed, might impact their books. And we're looking more at things like direct lending being less desirable because the risk weights are just out of whack. So hopefully there is some relief and some common sense that gets written in, and we will see how it develops. John, thanks again for joining us on the podcast.

John Ludwig-Eagan:

Yeah, thanks for having me

Jon Gaynor:

Today, we are so excited to welcome Erin Stafford to the podcast. As we noted earlier, Erin is a Managing Director and Head of North American CMBS at Morningstar DBRS. Erin brings with her a wealth of experience and unparalleled depth of knowledge in the commercial mortgage-backed securities market. With over 20 years in the industry, she has been instrumental in driving Morningstar DBRS's analytical and ratings processes, and her insights are highly sought after by professionals and investors alike. Today, we'll be discussing everything from the current state of the CMBS market, emerging trends and what the future holds for commercial real estate in the ever-evolving economic landscape. So, Erin, welcome to the podcast.

Erin Stafford:

Thank you for having me. I love the Smartless introduction, by the way. It is one of my favorite podcasts besides, obviously, this one.

Jon Gaynor:

Oh, we will take that. You know it's us and Smartless. We're just waiting for that Spotify deal to come in, right? Yeah, but that's really nice. So before we get into the actual substance, we have two questions. First, per Ella, what rating would you give our introduction?

Unknown:

Well, you know, in ratings, we have quantitative and qualitative factors that play into what rating we're going to assign it. And I think, in this case, the qualitative factor of playing into my Smartless love, I would give it a Triple A. I'm not gonna monitor that rating, though.

Jon Gaynor:

Well, we can get the ratings letter and close, right guys? Let's get outta here. Interview success. That's very nice of you. We appreciate that. I was worried you were going to put us below investment grade. So, before we get into the substance, is Ella right? Are you also a Bears fan?

Unknown:

So, I am a Bears fan, but you'll be surprised as how

Erin Stafford:

Maybe this is our year. Did you watch Hard Knocks? it's come about, because I'm based in Chicago it's not just because of my location. So, I actually grew up an hour south of Green Bay. So, naturally, one would think that I grew up a Packer fan. But, I don't know, let's jump back 40-plus years when the Bears were actually good and, you know, you're kind of getting into what team you're gonna form your alliance with. I did, and I'm really rooting for the Canadian Eagle. And, OK, well, that was the '85 Bears. And for me, that was those years where, you know, I'm gonna pick my team, and I'm picking the Bears. And I love the Super Bowl Shuffle. I Oh, I love that guy. followed them throughout. And now, you know, love it or hate it, I'm a die-hard Bears fan and, you know, maybe we'll get

Sam Gilbert:

I was checking your math when you said 40 years ago thinking the '85 Super Bowl wasn't 40 years ago. And then I one one of these days. realized it was, oh yeah, makes me very sad. Well, thank you again for coming in. Maybe just to start, if you could just sort of first talk a little bit about your career background, how you got started in the industry, and what brought you to where you are today.

Erin Stafford:

Sure, I would say it was a lot of luck that brought me to the industry. You know, we just jumped back 40 years. Now we'll jump back 30 or so. But, in terms of when I was looking to make my next move, I had three offers on the table. I could go to a healthcare company, I could go to a company that was programming for Y2K - so, remember back when everything, you know, the sky was falling and we needed to program everything for Y2K - or I could have gone to Duff & Phelps at the time, rating agency, rating commercial mortgage backed securities. And I knew nothing about commercial real estate and really just a tad bit of finance training. So I'm like, OK, well, I picked that one. It was kind of the middle of the two in terms of comp offers and the people were really nice. And I think that's one thing just about this industry is the people are great, great to work with, keep you engaged. There's always something to learn. So, it was something that I thought, OK, if I can jump in, they're willing to teach me, maybe not pay me the most, but I'll take that chance. So, after that, the rest is kind of history. So that was working for a rating agency, and I've continued my path forward. Duff & Phelps was acquired by Fitch, went to work for Fitch for a couple of years, and then I had the opportunity to come work for DBRS when they got the approval to rate transactions in the United States. And we were, Mary Jane, and I were their second and third employee in the United States, and now the company's over 800 people. So, it was just a really good opportunity at that time, pretty early on in my career, to lead something and take that risk. And it's really paid off. We've been able to grow the team and ebb and flow through the great financial crisis and now going into this next downturn, as you'll see. So, we've been able to really make headway here and always doing with the utmost of integrity. And, again, I stay in this industry because the people are so great, and there's always something to learn.

Sam Gilbert:

And it's probably, you know, better job security than the Y2K industry, right? At this point?

Erin Stafford:

I would think, yeah.

Ella Smith:

All right, Erin. We are all looking forward to your panel tomorrow on the state of the market from the servicer's perspective, but we wanted to sort of get a sneak peek here, even though this will obviously be released after your panel. But we wanted to ask you, from a rating agency perspective, what issues do you see in the market right now with respect to servicing? Have you seen any trends or shifts in the market over the past year or so?

Erin Stafford:

Yeah, so generally there's a couple trends that I would see that are probably concerning us the most, and one of which is the servicing transfers. And that's largely happening in the single asset, single borrower space. And if you think about it, if you go back to great financial crisis, right? We had single asset, single borrowers deals that never had anything below investment grade. Those deals were always cut off at a Triple B or Triple B low. And so, the default rate on single asset, single borrowers was very, very low coming out of the great financial crisis. Now, heading into this challenge that we're facing with the rise in interest rates and challenges in office, what we've seen is leading up to that there are many of these transactions that have proceeds all the way through the non-rated. So that's just a riskier loan. Those are going to default a little bit more, and as they're defaulting more, you're seeing some of the controlling class holders shift back and forth, and so then you're seeing the servicing transfer. And from our perspective, it's pretty disruptful to the process, I would say, every time if you have to just restart the process, because you transferred it to special servicer. Now you're getting a new asset manager up to speed. What has been agreed with the borrower thus far? Are they starting over and starting from scratch, and does that put them at a disadvantage? And so I think that's one of the challenges that we have, and just that we're looking at is, is this really delaying the process? Is this the best way forward? Now, you'll probably want to talk to a B-piece buyer or a controlling class holder of okay, well, they obviously have the most skin in the game, so they're going to want to have some influence in the process. But if you're servicing for the benefit of all bondholders, we should be comfortable with a single servicer staying in there. So I think that's been a challenge. I certainly understand why it moves, but it's been a challenge from us. The other thing I'll say is the advancing, specifically on the single asset, single borrower transactions, because we haven't had a lot of distress in this asset class. I think that's a little bit more difficult for some of these servicers to figure out when they're going to claw back these advances or stop advancing, and are they waiting for that next appraisal to come? And that's one of the things where when they're waiting for the appraisal, and then we have precipitous decline in values then, all of a sudden, they're in a position where they're nervous that they've over advanced, and start clawing back at those advancing. And what we need for the industry, the industry needs advancing in order to maintain some level of liquidity for these senior bond holders, not at the sake of putting the servicers at a point where they're going to take a loss on that advancing. We don't want that. Maybe there's a little bit more clarity that we can get on a go-forward basis in these transactions, where we don't get into a position where we're clawing back huge advances and doing things for the trust that are less disruptful.

Jon Gaynor:

So you mentioned single asset, single borrower deals a lot, if folks weren't familiar with the SASB acronym, but let's talk a little bit about CMBS and CRE CLO deals. What are you seeing there? And do you have any concerns on those asset classes?

Erin Stafford:

For the large part, where we've seen most of the trend negatives and the downgrades, specifically, has been in the conduit CMBS. So there's definitely some negative pressure there. A lot of that relates to office. We have seen, just in terms of modifications, a lot of modifications in the CRE CLO space, specifically. A lot of those modifications, because these are shorter-term loans, tend to be that maturity extension, bringing the borrower to the table to either put in a little bit more equity, fund the business plan a little bit more strongly. In some cases, obviously, there are agreements to address the rate cap purchase in a different manner than maybe having to go out and buy another rate cap. And in large part, certainly in some cases, we can understand that, too is, you know, for the most part, we've seen rates go up, and that's what interest rate caps are meant to protect us against. This rise in rate. Well, that's now largely happened, so are there other ways that you can mitigate that risk? And there are, and that's what you're seeing, I think, some of the CRE CLO issuers get a little bit more creative with. Their borrowers, instead of coming out of pocket for a large rate cap purchase, perhaps, maybe, they're looking at, you know, funding the asset a little bit more, paying down the debt. So there usually is an offset there. And I would say, as it relates to traditional multi-borrower CMBS, and the modifications, you know, we're not just seeing the kind of the kick the can down the road. We are seeing meaningful equity contributions or changes that the borrower are putting into the asset in order to make that modification justified.

Ella Smith:

So when you're looking at mods that might require, like, a no-downgrade confirmation, you're not just looking at the specific requirement that would trigger the no-downgrade, but at the mod holistically. Like, you're seeing the mitigants, as well as, sort of, the creativity of, how do we make this asset as good as it can be?

Erin Stafford:

So, that's actually interesting. Generally, we're not getting asked to provide a no-downgrade confirmation on the mods. So, those are usually happening either in the context of special servicing or, in the context of the CRE CLOs, they're happening under the modifications that are prescribed within the documents already. So the collateral manager and the servicers have a little more flexibility in the CRE CLOs to make those modifications, so we actually don't get asked.

Jon Gaynor:

And these are the admin-based and criteria-based modifications? Awesome.

Ella Smith:

The can be or even special servicing. There are

Unknown:

Well, maybe shift gears a little bit. You mentioned some only very specific modifications that would require a no-downgrade confirmation, and they depend on the size of the big issues in 2024 right? You hit on office, you hit on loan in the pool, as well as if they're hitting these certain due-on-sale or due-on-encumbrance triggers. Otherwise, they can pretty much be done if the special servicer decides it's within the servicing standard. Or, again, like you said, the admin, are criteria-based. interest rates and rate caps. Another big issue that people have been talking about in 2024 and recently, from a rating agency perspective, is how climate-change risk and also ESG initiatives are impacting CMBS ratings. Are there specific criteria or, maybe, adjustments that are being made to account for these factors?

Erin Stafford:

So, right now, I would say it's something that we're watching really closely with ESG and specifically on the climate side, right? I mean, it wasn't that long ago that you didn't have to worry about a wildfire in Boulder, Colorado, or things like that. So it's really what's happening with the insurance industry. And so, we're engaging our insurance ratings analysts to understand, really, what's going on there. We're working with some of the third-party providers that are reviewing insurance requirements. Because I think what you're seeing is you used to be able to get 1000-year look-back coverage. Now, it's maybe 500-year look-back. What does that mean to us as a rating agency to bondholders, in terms of if something happens with a named storm event, what is going to be our recovery? This is a risk where we just don't want to have that factored into our analysis. Like, I can look back in history and look back at thousands of loans that have defaulted, but not losses that are happening because they haven't had the adequate insurance in place. And that's really the issue, is what's happening with that market, and what happens if it becomes commercially unavailable in the market, right? We all dealt with that with TREA at some point in time. There was a backstop. I don't know what it means for if we have a really bad hurricane season, and insurance companies maybe stop offering coverage or go out of business. And with the reinsurance industry, there's so much that's intertwined to try to understand how these properties are going to perform, and so that becomes a really big factor to just stay on top of. I don't think we have the answers yet, but it is something that we're really watching.

Sam Gilbert:

Yeah, in our deals it used to be sort of an afterthought, right? Insurance was something you checked the box, and now it's certainly becoming much more important.

Erin Stafford:

The other thing, I would say, from a servicing perspective, and maybe that's a question I can ask my panel, so maybe it'll already be answered.

Sam Gilbert:

Closed to the media, though.

Erin Stafford:

True. But what happens year two, year three, year four, when they're monitoring these insurance provisions that the borrowers are supposed to get? Are the borrowers still getting that same level of insurance, or has it just naturally waned and we just don't know? So I think that's another risk that we could really look into as an industry.

Sam Gilbert:

Interesting.

Ella Smith:

So, Erin, considering the current economic climate, what scenarios are you preparing for in CMBS ratings? What geopolitical tensions or macroeconomic variables play into your forecasts?

Erin Stafford:

Really hard to say. That's a great question, and if I had the answer for that, then I really feel like I'd be able to nail this. But I think from the standpoint of what's in front of us, right, there's obviously a lot of political noise that can cause a lot of volatility to our market, whether that be, you know, something that impacts liquidity or something that puts us into a recession. So there's a lot of things like that. So what we're focused on, since I don't know exactly what it is, what we're focused on is staffing open surveillance and really working on and using the technology to our favor to run the data in a way forward looking, stressing interest rates, also bringing interest rates down. Like, what would that do if we have a quarter basis point cut? If we get to 100 basis points at the end of the year like people are saying, like, what does that do? Does that change things? Or what if it just stays the same, which is also a possibility, right? So, like, really looking at that and what that could impact us from, you know, maturities and going forward.

Jon Gaynor:

So one other asset class that we see a lot in commercial real estate right now is single family rental or SFR, and I know Morningstar DBRS is very active in that space. Can you tell us your thoughts about how that asset class is performing and what you see going on there?

Erin Stafford:

So, generally speaking, that asset class, we look at both the single borrower-type style SFR, and then also the multi-borrower, and I would say they're both performing very, very well in terms of collections and

Jon Gaynor:

Well, build-to-rent homes have been sneaking into expenses and things like that. Things that maybe we had put in the unknown bucket for, how is this going to perform as we move forward? Are people going to stay in these houses long term? I think we're seeing good occupancy rates. We're seeing the expenses turn out what we thought. Maybe they're a little higher for capital items and things like that, but otherwise, it's performed pretty well from our perspective. And unless there's something that changes that, right, if there's municipality or zoning or other laws, I think we'll continue to see that. I think we're seeing a lot of interest from the build-to-rent community as well, which will eventually turn itself into the SFR. these deals over time already, but I do think you're right that eventually we're going to see securitizations that may even have entirely a build-to-rent constituency. And it'll be interesting when it lands. To what extent have advancements in technology and in data analytics influenced CMBS rating methodologies? Are you using AI? Are there other innovations that you think are really impactful?

Erin Stafford:

Well Morningstar, in general, being a financial I think creating kind of uniform, comparable data sets is services firm, is a huge proponent of AI. But then when really the first step before you can even go into deeper and, you get down to the rating agency as being highly regulated entity, a little bit more tepid of dipping its toe into the AI. I think where we can use it, right, is to analyze big data sets, see what that turns out. Does that give us any more predictability in our models, things like that. But at this stage, we're a little bit hesitant to use it. I think where we're looking at CMBS data, that's a data-rich environment, right? And where we can leverage that is using technology to make our processes faster so that we can get to market faster. One of the things that we did earlier this year was we put our entire book of SASB office transactions under review while we sorted out what's going on in the office space in terms of, you know, where our values headed in different markets, and looking at that and really use technology to be able to look at that across the board as a like, have AI do the same kind of thing it's doing in things whole, instead of, you know, singularly looking one transaction at a time, and I think that's where we're going to be able to really leverage technology on a go-forward. like cancer, where it can, like, detect something the human eye can't as well. I think, you know, we're a little bit away from that, at least in legal documents. I can't speak for the rest of the world.

Sam Gilbert:

my rule. I mentioned it earlier in this podcast as well. But other than office, are there any property types that you see is maybe becoming more challenging, or, on the flip side, more promising in terms of ratings?

Erin Stafford:

So, I'm gonna be the optimistic, since we're not So is Morningstar DBRS looking at data centers as CMBS rating methodologies and not ABS? talking about office. I think most of the fundamentals of the other asset classes are pretty good. I mean, you're gonna have pockets, always. That's not unusual, but nothing is on our radar in terms of the next retail or the next, you know, nothing's on our radar from that perspective. I think the interesting thing, if we go back to the AI question, is the interest in data centers. We've looked at a lot of data centers. We rolled out our methodology in January of this year, and that seems to be the property type du jour. If everyone's interested in that, there's demand for it, there's a lot of construction happening, but it's a unique asset class in terms of we need to look at different things than we'd normally looked at for commercial real estate - considering power, considering the redundancy these properties offer. And I think that's an interesting asset class, for sure, and how that makes its way into mainstream. We have a standalone methodology for this, and it's primarily, I

Jon Gaynor:

That's so interesting. I was talking to a would say, CMBS-centric in terms of you have the real estate at lender client the other day, and, like, he was talking about how to look at data center and how to evaluate them. So, how did you guys build up that kind of view? Is it just, like, historical performance? Because it's so new, it's not like there's a lot of comps out there right now.

Erin Stafford:

Right. So we specifically formed a working group with our CMBS analysts and our ABS analysts and then we also brought in our infrastructure analysts. So it was a multi-team effort to really look at this asset class the end of the day, that's what you have. But then it does look and use the data that we have from the other asset classes, at some of that churn and things that are typical ABS concepts because the structures are a little bit more ABS-style. So what does that do in terms of how we're thinking about credit? The physical plant, as I mentioned, as much, you know, it's commercial real estate, and then the infrastructure, right? Like, does the city have the infrastructure to bring the that maybe we wouldn't give as much credit to in a traditional power to the plant and commit to that on an ongoing basis? So, we CMBS and renewal probabilities are much higher in this regard. use all of the resources available to us, besides the Specifically, if you're looking at data centers that are secured fact that we don't have historical data. And then, you by single tenants and what they're going to do with the know, we're just kind of watching these things play out property going forward. and seeing how they perform. And, you know, we're a learning organization, so as things come in, new data comes in that we need to adapt to, we will.

Ella Smith:

Thanks, Erin. That's really interesting about data centers, because it's a new, developing property type, new to the market. I wanted to also ask you about your ratings on something else that's sort of a new emerging product, which are CPACE loans. And I know that Morningstar DBRS does offer CPACE ratings. Can you talk to us a little bit about how you rate those and what factors you look at?

Erin Stafford:

Sure. So the CPACE - the commercial property-assessed clean energy for the acronym police out there- those we've been looking at for quite some time, and that product, actually, is directly ESG, right? Because that is an ESG product that is designed to improve your buildings for sustainability going forward. And the interesting thing about CPACE is that there's no national program for it. It's very much statewide or municipality based. So you really need to dig in at what qualifies for the CPACE loans within those particular properties and given their location. I think the other thing that's really interesting about CPACE is its position in the capital structure. If you think about it, it's collected at the time you collect your taxes, so it primes your mortgage. From a ratings and credit perspective, that's a pretty secure position to be in. The challenge is a lot of people want to use it for construction, and construction then brings in a whole other risk to the transaction. So, while we've looked at a lot of construction deals, sometimes they're too early in the process, it's better when it's closer to C of O for that funding, but they do want to use that funding, often, to use things that are for the infrastructure of the building as they're doing construction. But we'll look at it on a single loan-basis, we'll also look at it as a multi-borrower pool basis. And that we're doing in conjunction with our asset-backed team as well.

Jon Gaynor:

Certificate of occupancy. I got your back, Mom, don't worry.

Ella Smith:

Well, we have one final question, and we will hold you to your answer here. Want you to predict the future, but looking beyond 2024 what are some of the primary challenges and opportunities that you foresee for the CMBS market?

Erin Stafford:

I think the CMBS market has a tremendous opportunity in front of it in terms of when banks pull back from lending in commercial real estate, which they have over the last couple of years, CMBS is still open for business, and they can be there to fulfill that need. So there is definitely a demand that can be met with CMBS. So that's an opportunity. The challenge will be making sure that we still have a good, solid investor base that wants to buy this product. And I think that can happen, but we're going to need to make some more investments in technology in terms of the transparency that we give people, the timeliness of information that we give people - what they have at their fingertips - so that can give them some comfort. Because any time you're talking to an investor, right, they're calling us because people two or three levels above them have read the headline and are responding to the headline, and they want to know, what do we have in our book that's related to this? And we need to try to make sure that we're getting in front of that as an industry, so that we can make sure that people feel comfortable with where they're buying bonds.

Jon Gaynor:

It's simple. We rebrand CMBS private credit. Problem solved.

Ella Smith:

There we go. We call it private credit. It must be good.

Erin Stafford:

Everything's private credit,

Ella Smith:

Absolutely. And speaking of, let's have a word about THE CRED.

Jon Gaynor:

So, before we close out, the private credit industry is always on the move, and it can be difficult keeping pace as you navigate its most complex challenges and opportunities. And that's why Dechert created THE CRED our new platform dedicated solely to providing legal and business insights on the private credit landscape. To learn more and to sign up for the cred newsletter visit Dechert.com.

Ella Smith:

Wow, that was a smooth transition to that advertisement.

Jon Gaynor:

You set that one up really well. Thanks.

Ella Smith:

Really, the thanks here goes to Erin.

Jon Gaynor:

Yeah, Erin, thank you so much. This has been really eye opening, and we're just thankful for you to come out to here in New York today and record with us and even suffer through that ad. And it was great hearing about all of the stuff that you've got going on. We're just glad you were here.

Erin Stafford:

Thank you so much for having me.

Jon Gaynor:

That's great. And so this brings us to our 4 Real High Fives. So I'm going to take this one and I'm going to give a High Five to the 4 Real podcast. We are recording the day before the rate cuts are expected to be announced. If they aren't announced or were wrong, I guess this gets deleted. So if you heard this, then we saved our editor some work on the podcast. But back when we recorded after the CREFC New York Conference, we made a prediction about what would happen in September. Cue the reel! I think they might do it in September. They don't want to risk seeming too political. And there's a risk of really acting too late. You know, as long as the numbers keep supporting it, they said it was modest improvement on inflation during the meeting on Wednesday. But I am hopeful, and maybe I've kind of had that irrational exuberance infect me over time, so we'll see. And if I'm wrong, you guys can all razz me on it the next time we do this roulette.

Stewart McQueen:

Got it. Yeah, well, the good thing about predictions is you don't have to be right.

Ella Smith:

Wow, John, that's really impressive. Do you want to head to Vegas this weekend and place any bets?

Jon Gaynor:

No, thanks. I try to be very demure. I'm very mindful when I'm making my predictions. I try to, you know, keep it contained. Is that getting ... I'm getting cut motions from production team. But internet memes aside, we're really grateful that all of you joined us for another episode of the Dechert 4 Real podcast. If you have any thoughts, or if you want to give us a CMBS-style rating, please share them with us at our email inbox, realpodcast@dechert.com Also, if you like what you heard, give us a five-star rating on whatever platform that you found this on. This episode was hosted by Sam Gilbert, Ella Smith and me, Jon Gaynor, Stewart, McQueen, Matt Armstrong and Kate Mylod produced it. Production Support is by Kara Ray, Mallory Gorham, Alyssa Norton, Peggy Heffner, James Wortman and Jacob Kimmel. Our editor is Andy Robbins of AudioFile Solutions. Thanks for listening, and we'll see you next time on the Dechert 4 Real podcast.

Ella Smith:

So, Erin, I think you might have brought a dad joke for us. Oh, I

Erin Stafford:

did. I have two actually.

Ella Smith:

Oh, let's have them both.

Erin Stafford:

So, we took the kids to the aquarium this last weekend.

Ella Smith:

How was it?

Erin Stafford:

Well, we didn't stay long. That place is really

Ella Smith:

Perfect. fishy.

Erin Stafford:

And I finally bought the limited-edition thesaurus that I've always wanted, but when I opened it up, all the pages were blank. Words cannot describe how angry I am.

Ella Smith:

Oh, wow, I love it.

Jon Gaynor:

That's some delivery. That's good.