Impact of Rising Interest Rates on European CMBS Transactions

Further increases in the overall financing costs for European commercial mortgage-backed securities (CMBS) are likely as the Bank of England and the European Central Bank eye additional interest rate hikes in their fight against soaring inflation. While interest rate cap agreements are usually used to hedge the risk of rising interest rates, the loans are exposed to higher interest rates at refinancing or in circumstances where the borrower is unable to arrange a new hedging agreement due to skyrocketing costs. To estimate the impact of rising interest rates on the loans' ability to meet debt service obligations in a high interest rate environment, DBRS Morningstar stress tested the floating-rate loans in its CMBS surveillance portfolio.

Key highlights include:
--The majority of loans will be able to cover interest payments even if reference rates double from current levels;
-- Loans referenced to the Sterling Overnight Index Average (Sonia) appear to be more exposed to interest rate risk than those benchmarked to the Euro Interbank Offered Rate (Euribor). Additionally, cap strike rates are below current Sonia rates for almost all DBRS Morningstar-rated UK loans, which amplifies extension and refinancing risks for these transactions; and
-- DBRS Morningstar anticipates that sponsors may be called upon to provide remedial actions for some transactions.

“Based on the stress analysis at current NOI levels, the majority of the Euribor-referenced loans in the DBRS Morningstar surveillance portfolio (24 out of 27 loans) will meet their debt service obligations at a healthy DSCR of 1.3x or higher, even if the reference rate doubles and the loans are left unhedged. However, the situation is reversed for loans benchmarked to Sonia. Due to higher interest and subsequently higher reference rates, only three out of 15 DBRS Morningstar-rated loans showed a DSCR of 1.3 times or higher in the stress exercise”, said Violetta Volovich, Senior Analyst of European CMBS at DBRS Morningstar.