March 12, 2019

Morningstar Credit Ratings to Begin Rating CRE CLOs

New methodology brings a transparent and flexible approach to rapidly growing sector

NEW YORK, March 12, 2019 /PRNewswire/ -- Morningstar Credit Ratings, LLC today published an appendix to its U.S. CMBS Conduit/Fusion Ratings Methodology that outlines the process the company will apply when rating pools of transitional commercial real estate collateral, commonly known as commercial real estate collateralized loan obligations (CRE CLOs).

Morningstar's new methodology provides an overview of key qualitative and quantitative factors the company considers when rating CRE CLO transactions. Morningstar's approach is designed to be clear, concise, and easy for market participants to replicate.

"We are very excited to begin rating CRE CLOs," said Kurt Pollem, managing director and head of CMBS at Morningstar Credit Ratings. "We're confident in our transparent methodology that market participants can easily understand and apply—one that doesn't hide behind black boxes or proprietary tools. Our criteria incorporates the flexibility to adapt to a rapidly-changing market, and we have a strong CMBS senior team with real-world experience evaluating transitional collateral."

Morningstar announced its proposed methodology on Jan. 7, 2019, along with a Request for Comment. No comments were received during the comment period, which ended February 25.

Morningstar will utilize its CRE Credit Model as the basis for calculating expected losses for a pool of transitional commercial real estate loans. The CRE CLO version of the company's CRE Credit Model incorporates certain changes to account for the structural features not present or allowable under a real estate mortgage investment conduit, or Remic. Specifically, Morningstar modified its CRE Credit Model to account for the presence of future funding components and of ramp up and reinvestment periods. The company also adjusted its approach to assessing diversity within the CRE CLO transaction.

The key components that drive Morningstar's proposed credit rating methodology for CRE CLO transactions are:

  1. Morningstar's underwritten sustainable net cash flow, or NCF, and value of the underlying commercial real estate. For transitional properties, the decision to stabilize is asset specific and based on the property's operating history, the borrower's business plan and experience, market fundamentals, and certain loan structural features.
  2. Expected loss of the mortgage loans as indicated by the loan-level and pool-level loan to-value ratios (loss severity) and debt service coverage ratios based on Morningstar's underwritten sustainable value and NCF (probability of default) derived from the CRE CLO version of its CRE Credit Model.
  3. Transaction diversity as indicated by a blended Herfindahl score, known as the Morningstar CLO diversity score.
  4. Programmic adjustments to a pool's required base credit enhancement levels for manager quality and ramp-up and reinvestment periods.
  5. Cash flow modelling utilizing an engine such as INTEX DealMaker to determine the benefit of the structural features of a CLO, including overcollateralization and interest-coverage tests, from an advance rate/credit enhancement perspective.
  6. Comprehensive legal review of the key documents at both the transaction and the borrower/property level.

About Morningstar Credit Ratings, LLC and Morningstar, Inc. 

Morningstar Credit Ratings, LLC is a nationally recognized statistical rating organization (NRSRO) offering a wide array of services including new-issue ratings and analysis, operational risk assessments, surveillance services, data, and technology solutions. Morningstar Credit Ratings, LLC is a subsidiary of Morningstar, Inc. (Nasdaq: MORN). For more information visit www.morningstarcreditratings.com. Follow us on Twitter @MstarCrdRatings.

Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individual investors, financial advisors, asset managers, retirement plan providers and sponsors, and institutional investors in the private capital markets. Morningstar provides data and research insights on a wide range of investment offerings, including managed investment products, publicly listed companies, private capital markets, and real-time global market data. Morningstar also offers investment management services through its investment advisory subsidiaries, with more than $193 billion in assets under advisement and management as of Dec. 31, 2018. The company has operations in 27 countries. For more information, visit www.morningstar.com/company. Follow Morningstar on Twitter @MorningstarInc.

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