DBRS Morningstar Confirms All Classes of BAMLL Commercial Mortgage Securities Trust 2016-ISQR, Changes All Trends to Negative

DBRS, Inc. (DBRS Morningstar) confirmed its ratings on the Commercial Mortgage Pass-Through Certificates, Series 2016-ISQR issued by BAMLL Commercial Mortgage Securities Trust 2016-ISQR as follows:

-- Class A at AAA (sf)
-- Class XA at AAA (sf)
-- Class B at AA (low) (sf)
-- Class XB at A (sf)
-- Class C at A (low) (sf)
-- Class D at BBB (low) (sf)
-- Class E at BB (low) (sf)

DBRS Morningstar changed the trends on all classes to Negative from Stable.

The Negative trends reflect persistent declines in performance metrics as a result of tenants vacating upon lease expiration and a lack of leasing activity to backfill vacant spaces. Office submarket fundamentals have softened, and there is general uncertainty surrounding future demand for office space. Despite the downward pressure to ratings as a result of the reduction in net cash flow (NCF), DBRS Morningstar considered mitigating factors as support for the rating confirmations, including the strong sponsorship, prime location, collateral quality, and a recent lease renewal for the largest tenant. In addition, DBRS Morningstar considered the recent multi-million-dollar property renovation, which included upgrades to ground-floor amenities, as well as the remaining loan term, which has some time for stabilization ahead of the 2026 maturity.

The transaction consists of a $370.0 million trust loan secured by the fee interest in the Class A, 1.16 million-square-foot (sf) International Square office property in downtown Washington, D.C. The trust loan consists of a $166.7 million senior A-1 note and a $203.3 million junior note with an additional $80.0 million pari passu senior A-2 note split across three commercial mortgage-backed security (CMBS) multiborrower transactions. The loan is sponsored by a joint venture between Tishman Speyer Properties and the Abu Dhabi Investment Authority, which purchased the subject in 2006. The fixed-rate loan is interest only (IO) throughout the 10-year loan term.

The property includes three separate office buildings connected by a 12-story atrium developed between 1978 and 1982 along I Street NW between 18th Street NW and 19th Street NW. The subject has direct access to Farragut West Metro Station and is four blocks northwest of the White House in the Golden Triangle area of the central business district in Washington, D.C. In addition to the 1.1 million sf of office space, the collateral includes 67,000 sf of ground-floor retail space, 12,000 sf of storage space, and a 637-space subterranean parking garage.

As of September 2022, the property was 68.7% occupied, and the loan has remained on the servicer’s watchlist since October 2020 for low occupancy, which has steadily declined from 94.2% at securitization. The occupancy decline has been attributable to notable tenants, including the World Bank, Morgan Stanley, and HQ Global Workplaces LLC, downsizing or completely vacating the property in the last few years. According to the September 2022 rent roll, presale leases total approximately 5.8% of the net rentable area (NRA) and tenant rollover risk over the next three years is minimal with tenants representing 8.3% of the NRA scheduled to roll through year-end (YE) 2025. According to LoopNet as of February 2023, there is 280,230 sf (23.1% of the NRA) available for lease, which suggests that additional square feet may have been absorbed since the September 2022 rent roll provided by the servicer.

The current largest tenants are the Federal Reserve System (the Fed; 33.7% of the NRA) and Blank Rome LLP (14.5% of the NRA), which account for more than half of the property’s rental revenue combined. The Fed recently executed leases to renew 319,888 sf out of the 390,233 sf it currently occupies at the subject. The terms of the renewals include rent concessions ranging from eight to 14 months and a tenant improvement allowance ranging from $70 per sf (psf) to $110 psf. The leases will extend through 2029 and 2033, with the Fed vacating the remaining 55,675 sf (4.8% of the NRA) at lease expiration dates in January 2026 and April 2028.

Based on financial reporting for the trailing nine-month (T-9) period ended September 30, 2022, the loan reported annualized NCF of $11.7 million, compared with the YE2021 NCF of $25.0 million and the DBRS Morningstar NCF of $34.25 million, derived when ratings were assigned in April 2020 and based on an annualized T-9 ended September 30, 2019, figure. It is noteworthy that the DBRS Morningstar NCF figure was more than $4.0 million below the issuer’s figure, reflecting the in-place cash flows at the time, which have consistently reported below the issuer’s expectations.

Despite declining occupancy, the debt service coverage ratio (DSCR) remained well above breakeven until the September 2022 reporting when it fell to 0.71 times (x), which reflects concessions for the renewal leases executed by the Fed. NCF is expected to increase in 2023, and the DSCR is expected to return to above breakeven as the concessions will have burned off. However, the property is not expected to realize NCF in line with pre-Coronavirus Disease (COVID-19) pandemic levels until the property occupancy reaches stabilized levels. DBRS Morningstar expects an extended lease-up period given the current office market landscape; however, DBRS Morningstar notes that the recent $40 million renovation project enhancing the ground-floor amenities, including a new food hall and an upgraded fitness center and conference space, should aid in attracting new tenants.

According to Reis, as of November 2022, the Downtown Washington, D.C., submarket for Class A office had an average vacancy rate of 14.1% compared with 12.3% at YE2020, and an average asking rental rate of $55 psf. Market rents were relatively unchanged from the YE2020 levels but remained below the in-place rents at the property, which averaged approximately $62 psf, and recently renewed leases by the Fed, which averaged a rental rate of $60 psf. Although the submarket vacancy rate remained relatively low compared with the subject’s in-place vacancy rate, DBRS Morningstar notes sublease availability was likely much higher, with the probability of renewal down across the sector given the current shift allowing for flexible work schedules for office workers.

To determine the ratings exposed to the impacts of the challenges of occupancy declines in recent years, DBRS Morningstar considered a stressed analysis based on an estimate of the as-is value of the property. A stressed DBRS Morningstar NCF of $31.0 million, assuming a property vacancy rate of 20%, was derived by analyzing the submarket as well as the leases in place as of September 2022 and an estimate of expenses based on historical figures. Based on that figure and a capitalization rate of 6.75%, the resulting DBRS Morningstar value was $458.6 million, implying a loan-to-value ratio (LTV) of 80.7% on the trust debt and 98.1% on the whole loan compared with the LTV of 59.4% on the whole loan based on the appraised value at securitization. This stressed value and the resulting levels implied by the LTV sizing benchmarks support the Negative trends assigned for all classes. DBRS Morningstar will continue to assess the market dynamics, as well as leasing activity at the property over the next year as these trends and ratings are monitored.

The DBRS Morningstar ratings assigned to all classes are lower than the results implied by the LTV sizing benchmarks. These variances are warranted given the below-market occupancy rate, recent investment in the property, strong sponsorship, and leases in place that suggest the loan should return to a DSCR above breakeven in the near to moderate term. In addition, DBRS Morningstar notes sales for five properties since Q2 2020 in the Downtown submarket indicate values ranging from $354 psf to $536 psf compared with the outstanding debt of $388 psf for the whole loan, suggesting the trust remains generally well insulated against loss through the remainder of the loan term.

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 DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

Classes XA and XB are 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 ratings are subject to surveillance, which could result in ratings being upgraded, downgraded, placed under review, confirmed, or discontinued by DBRS Morningstar.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal methodology is North American CMBS Surveillance Methodology (October 3, 2022), which can be found on dbrsmorningstar.com under Methodologies & Criteria. For a list of the structured-finance-related methodologies that may be used during the rating process, please see the DBRS Morningstar Global Structured Finance Related Methodologies document, which can be found on dbrsmorningstar.com in the Commentary tab under Regulatory Affairs. Please note that not every related methodology listed under a principal structured finance asset class methodology may be used to rate or monitor an individual structured finance or debt obligation.

The DBRS Morningstar Sovereign group releases baseline macroeconomic scenarios for rated sovereigns. DBRS Morningstar analysis considered impacts consistent with the baseline scenarios as set forth in the following report: https://www.dbrsmorningstar.com/research/384482.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Please see the related appendix for additional information regarding the sensitivity of assumptions used in the rating process.

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

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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