What to Look for: Loan Size/Concentration
The loan size varies from $1 million to, more recently, greater than $1.5 billion. Smaller loans allow for greater diversification and less credit risk, yet they are more difficult to analyze. Large-loan deals are typically purchased by buy-and-hold accounts, such as insurance companies and pension funds with real estate expertise, and often are preferred by these “real estate-savvy investors” as it is economical to spend the time analyzing the property.
Smaller loan deals (conduit) are more liquid and are typically purchased by total-return, mark-to-market investors that, lacking real estate experience, are more apt to rely on diversification and the rating agencies’ analysis and judgment.
Fusion deals, presently the most common type of CMBS deal, are “lumpy” conduit deals. Generally, a fusion deal has a few large loans that are typically shadow-rated investment-grade loans that are combined with a diverse pool of conduit loans. They grew in popularity after 9/11, which shut down the single-asset and large-loan type CMBS deals due to concerns that the risk of a terrorist act against one large property was too great. As a result, these large loans were split up and portions placed into various CMBS, thereby creating fusion deals. Much focus is placed on the top 10 and top 20 loans in any given deal as these can have a substantial influence on performance.
Concentration is important because it is sometimes difficult for the rating agencies to predict commercial loan defaults. The rating agencies use measures to score loan concentration and, accordingly, require more or less credit enhancement. For example, Moody’s uses the Herfindahl index to determine the effective number of loans within a pool. A pool of 100 loans that had a Herfindahl index of 65 indicates that the pool has an effective diversity of 65 loans.