DBRS Morningstar Finalizes Provisional Ratings on Velocity Commercial Capital Loan Trust 2023-2

DBRS, Inc. (DBRS Morningstar) finalized its provisional ratings on the Mortgage-Backed Certificates, Series 2023-2 (the Certificates) issued by Velocity Commercial Capital Loan Trust 2023-2 (VCC 2023-2 or the Issuer) as follows:

-- $133.8 million Class A at AAA (sf)
-- $7.7 million Class M-1 at AA (sf)
-- $15.6 million Class M-2 at A (low) (sf)
-- $15.9 million Class M-3 at BBB (sf)
-- $29.2 million Class M-4 at BB (sf)
-- $17.4 million Class M-5 at B (sf)
-- $3.4 million Class M-6 at B (low) (sf)
-- $133.8 million Class A-S at AAA (sf)
-- $133.8 million Class A-IO at AAA (sf)
-- $7.7 million Class M1-A at AA (sf)
-- $7.7 million Class M1-IO at AA (sf)
-- $15.6 million Class M2-A at A (low) (sf)
-- $15.6 million Class M2-IO at A (low) (sf)
-- $15.9 million Class M3-A at BBB (sf)
-- $15.9 million Class M3-IO at BBB (sf)
-- $29.2 million Class M4-A at BB (sf)
-- $29.2 million Class M4-IO at BB (sf)
-- $17.4 million Class M5-A at B (sf)
-- $17.4 million Class M5-IO at B (sf)
-- $3.4 million Class M6-A at B (low) (sf)
-- $3.4 million Class M6-IO at B (low) (sf)

Classes A-IO, M1-IO, M2-IO, M3-IO, M4-IO, M5-IO, and M6-IO are interest-only (IO) certificates. The class balances represent notional amounts.

Classes A, M-1, M-2, M-3, M-4, M-5, and M-6 are exchangeable certificates. These classes can be exchanged for combinations of initial exchangeable certificates as specified in the offering documents.

The AAA (sf) ratings on the Certificates reflect 40.90% of credit enhancement (CE) provided by subordinated certificates. The AA (sf), A (low) (sf), BBB (sf), BB (sf), B (sf), and B (low) (sf) ratings reflect 37.50%, 30.60%, 23.60%, 10.70%, 3.00%, and 1.50% of CE, respectively.

Other than the classes specified above, DBRS Morningstar does not rate any other classes in this transaction.

Velocity Commercial Capital Loan Trust 2023-2 (VCC 2023-2 or the Issuer) is a securitization of a portfolio of newly originated fixed, first-lien residential mortgages collateralized by investor properties with one to four units (residential investor loans) and small-balance commercial mortgages (SBC) collateralized by various types of commercial, multifamily rental, and mixed-use properties. The securitization is funded by the issuance of the Certificates, which are backed by 675 mortgage loans with a total principal balance of $226,439,361 as of the Cut-Off Date (April 1, 2023).

Approximately 64.2% of the pool comprises residential investor loans and about 35.8% is SBC loans. All loans in this securitization were originated by Velocity Commercial Capital, LLC (Velocity or VCC). The loans were underwritten to program guidelines for business-purpose loans where the lender generally expects the property (or its value) to be the primary source of repayment (No Ratio). The lender reviews the mortgagor's credit profile, but it does not rely on the borrower's income to make its credit decision. However, the lender considers the property-level cash flow or minimum debt service coverage ratio (DSCR) in underwriting SBC loans with balances of more than $750,000 for purchase transactions and more than $500,000 for refinance transactions. Because the loans were made to investors for business purposes, they are exempt from the Consumer Financial Protection Bureau’s Ability-to-Repay (ATR) rules and TILA-RESPA Integrated Disclosure rule.

PHH Mortgage Corporation (PMC) will service all loans within the pool for a servicing fee of 0.30% per annum. In addition, Velocity will act as a Special Servicer servicing the loans that defaulted or became 60 or more days delinquent under Mortgage Bankers Association (MBA) method and other loans, as defined in the transaction documents (Specially Serviced Loans). The Special Servicer will be entitled to receive compensation based on an annual fee of 0.75% and the balance of Specially Serviced Loans. Also, the Special Servicer is entitled to a liquidation fee equal to 2.00% of the net proceeds from the liquidation of a Specially Serviced Loan, as described in the transaction documents.

The Servicer will fund advances of delinquent principal and interest (P&I) until the advances are deemed unrecoverable. Also, the Servicer is obligated to make advances with respect to taxes, insurance premiums, and reasonable costs incurred in the course of servicing and disposing properties.

U.S. Bank National Association (rated AA (high) with a Stable trend by DBRS Morningstar) will act as the Custodian. U.S. Bank Trust Company, National Association will act as the Trustee.

The Seller, directly or indirectly through a majority-owned affiliate, is expected to retain an eligible horizontal residual interest consisting of the Class P and Class XS Certificates, collectively representing at least 5% of the fair value of all Certificates, to satisfy the credit risk-retention requirements under Section 15G of the Securities Exchange Act of 1934 and the regulations promulgated thereunder. Such retention aligns Sponsor and investor interest in the capital structure.

On or after the later of (1) the three-year anniversary of the Closing Date or (2) the date when the aggregate stated principal balance of the mortgage loans is reduced to 30% of the Closing Date balance, the Depositor may purchase all outstanding Certificates (Optional Purchase) at a price equal to the sum of the remaining aggregate balance of the Certificates plus accrued and unpaid interest, and any fees, expenses, and indemnity payments due and unpaid to the transaction parties, including any unreimbursed P&I and servicing advances, and other amounts due as applicable. The Optional Purchase will be conducted concurrently with a qualified liquidation of the Issuer.

Additionally, if on any date on which the unpaid mortgage loan balance and the value of real estate owned (REO) properties has declined to less than 10% of the initial mortgage loan balance as of the Cut-off Date, the Directing Holder, the Special Servicer, or the Servicer, in that order of priority, may purchase all of the mortgages, REO properties, and any other properties from the Issuer (Optional Termination) at a price specified in the transaction documents. The Optional Termination will be conducted as a qualified liquidation of the Issuer. The Directing Holder (initially, the Seller) is the representative selected by the holders of more than 50% of the Class XS certificates (the Controlling Class).

The transaction uses a structure sometimes referred to as a modified pro rata structure. Prior to the Class A credit enhancement (CE) falling below 10.0% of the loan balance as of the Cut-off Date (Class A Minimum CE Event), the principal distributions allow for amortization of all senior and subordinate bonds based on CE targets set at different levels for performing (same CE as at issuance) and nonperforming (higher CE than at issuance) loans. The target principal balance of each class is determined based on the CE targets and the performing and nonperforming (those that are 90 or more days MBA delinquent, in foreclosure, are REO, or subject to a servicing modification within the prior 12 months) loan amounts. As such, the principal payments are paid on a pro rata basis, up to the target principal balance of each class so long as no loans in the pool are nonperforming. If the share of nonperforming loans grows, the corresponding CE target increases. Thus, the principal payment amount increases for the senior and senior subordinate classes and falls for the more subordinate bonds. The goal is to distribute the appropriate amount of principal to the senior and subordinate bonds each month, always maintaining the desired level of CE, based on the performing and nonperforming pool percentages. After the Class A Minimum CE Event, the principal distributions are made sequentially.

Relative to the sequential pay structure, the modified pro rata structure is more sensitive to the timing of the projected defaults and losses as the losses may be applied at a time when the amount of credit support is reduced as the bonds' principal balances amortize over a life of the transaction. That said, the excess spread can be used to cover realized losses after being allocated to the unpaid net weighted average coupon shortfalls (Net WAC Rate Carryover Amounts). Please see the Cash Flow Structure and Features section of the report for more details.

COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS) METHODOLOGY
The collateral for the small balance commercial (SBC) portion of the pool consists of 200 individual loans secured by 200 commercial and multifamily properties with an average cutoff date loan balance of $405,890. None of the mortgage loans are cross-collateralized or cross-defaulted with each other. Given the complexity of the structure and granularity of the pool, DBRS Morningstar applied its “North American CMBS Multi-Borrower Rating Methodology” (the CMBS Methodology).

The commercial mortgage-backed securities (CMBS) loans have a weighted-average (WA) fixed interest rate of 11.40%. This is approximately 87 basis points (bps) higher than the VCC 2023-1 transaction, 215 bps higher than the VCC 2022-5 transaction, 309 bps higher than the VCC 2022-4 transaction, and more than 450 bps higher than the VCC 2022-3, VCC 2022-2, and VCC 2022-1 transactions, highlighting the recent increase in interest rates. Most of the loans have original loan term lengths of 30 years and fully amortize over 30-year schedules. However, 12 loans, which represent 7.7% of the SBC pool, have an initial interest-only (IO) period ranging from 60 months to 120 months.

Most SBC loans were originated between April 2022 and March 2023 (99.4% of the cutoff pool balance), with one loan originated in April 2015 (0.6% of the cutoff pool balance), resulting in a WA seasoning of 2.4 months. The SBC pool has a WA original term length of 359.5 months, or nearly 30 years. Based on the current loan amount, which reflects approximately 59 bps of amortization, and the current appraised values, the SBC pool has a WA loan-to-value (LTV) ratio of 60.4%. However, DBRS Morningstar made LTV adjustments to 27 loans that had an implied capitalization rate more than 200 bps lower than a set of minimal capitalization rates established by the DBRS Morningstar Market Rank. The DBRS Morningstar minimum capitalization rates range from 5.0% for properties in DBRS Morningstar Market Rank 8 to 8.0% for properties in DBRS Morningstar Market Rank 1. This resulted in a higher DBRS Morningstar LTV of 64.4%. Lastly, all loans fully amortize over their respective remaining terms, resulting in 100% expected amortization; this amount of amortization is greater than what is typical for CMBS conduit pools. DBRS Morningstar’s research indicates that, for CMBS conduit transactions securitized between 2000 and 2021, average amortization by year has ranged between 6.5% and 22.0%, with a median rate of 16.5%.

As contemplated and explained in DBRS Morningstar’s “Rating North American CMBS Interest-Only Certificates” methodology, the most significant risk to an IO cash flow stream is term default risk. As DBRS Morningstar noted in the methodology, for a pool of approximately 63,000 CMBS loans that had fully cycled through to their maturity defaults, the average total default rate across all property types was approximately 17%, the refinance default rate was 6% (approximately one-third of the total default rate), and the term default rate was approximately 11%. DBRS Morningstar recognizes the muted impact of refinance risk on IO certificates by notching the IO rating up by one notch from the Reference Obligation rating. When using the 10-year Idealized Default Table default probability to derive a probability of default (POD) for a CMBS bond from its rating, DBRS Morningstar estimates that, in general, a one-third reduction in the CMBS Reference Obligation POD maps to a tranche rating that is approximately one notch higher than the Reference Obligation or the Applicable Reference Obligation, whichever is appropriate. Therefore, similar logic regarding term default risk supported the rationale for DBRS Morningstar to reduce the POD in the CMBS Insight Model by one notch because refinance risk is largely absent for this SBC pool of loans.

The DBRS Morningstar CMBS Insight Model does not contemplate the ability to prepay loans, which is generally seen as credit positive because a prepaid loan cannot default. The CMBS predictive model was calibrated using loans that have prepayment lockout features. Those loans’ historical prepayment performance is close to a 0% conditional prepayment rate. If the CMBS predictive model had an expectation of prepayments, DBRS Morningstar would expect the default levels to be reduced. Any loan that prepays is removed from the pool and can no longer default. This collateral pool does not have any prepayment lockout features, and DBRS Morningstar expects this pool will have prepayments over the remainder of the transaction. DBRS Morningstar applied a 5.0% reduction to the cumulative default assumptions to provide credit for expected prepayments. This assumption reflects DBRS Morningstar’s opinion that in a rising interest rate environment fewer borrowers may elect to prepay their loan.

As a result of higher interest rates and lending spreads, the SBC pool has a significant increase in interest rates compared with prior VCC transactions. Consequently, more than 70% of the deal has less than a 1.0 times (x) Issuer net operating income (NOI) debt service coverage ratio (DSCR), which is a larger composition than previous VCC transactions in 2022. Additionally, although the DBRS Morningstar CMBS Insight Model does not contemplate FICO scores, it is important to point out that the WA FICO score of 717 for the SBC loans is lower than prior transactions. With regard to the aforementioned concerns, DBRS Morningstar applied a 5.0% penalty to the fully adjusted cumulative default assumption to account for risks given these factors. A comparison of the subject deal to previous VCC securitizations is shown on page 9 of the related presale report.

The SBC pool is quite diverse based on loan count and size, with an average cutoff date loan balance of $405,890, a concentration profile equivalent to that of a transaction with 107 equal-size loans, and a top 10 loan concentration of 20.8%. Increased pool diversity helps to insulate the higher-rated classes from event risk.

The loans are mostly secured by traditional property types (i.e., multifamily, retail, office, and industrial), with no exposure to higher-volatility property types, such as hotels or other lodging facilities.

All loans in the SBC pool fully amortize over their respective remaining loan terms, reducing refinance risk.

As classified by DBRS Morningstar for modeling purposes, the SBC pool contains a significant exposure to office (24.5% of the SBC pool) and retail (22.5% of the SBC pool), which are two of the higher-volatility asset types in the pool. Loans counted as retail include those identified as automotive and potentially commercial condominium. Combined, retail and office properties represent 47.3% of the SBC pool balance. Retail, which has struggled because of the Coronavirus Disease (COVID-19) pandemic, is the third-largest asset type in the transaction. DBRS Morningstar applied a 20.5% reduction to the net cash flow (NCF) for retail properties and a 31.3% reduction to the NCF for office assets in the SBC pool, which is above the average NCF reduction applied for comparable property types in CMBS analyzed deals.

DBRS Morningstar did not perform site inspections on loans within its sample for this transaction. Instead, DBRS Morningstar relied upon analysis of third-party reports and online searches to determine property quality assessments. Of the 85 loans DBRS Morningstar sampled, 13 were Average quality (23.7%), 64 were Average – (71.1%), and eight were Below Average (5.2%). DBRS Morningstar assumed unsampled loans were Average – quality, which has a slightly increased POD level. This is consistent with the assessments from sampled loans and other SBC transactions rated by DBRS Morningstar.

Limited property-level information was available for DBRS Morningstar to review. Asset summary reports, property condition reports, Phase I/II environmental site assessment (ESA) reports, and historical cash flows were generally not available for review in conjunction with this securitization. DBRS Morningstar received and reviewed appraisals for the top 30 loans, which represent 39.8% of the SBC pool balance. These appraisals were issued between February 2022 and March 2023 when the respective loans were originated. DBRS Morningstar was able to perform a loan-level cash flow analysis on the top 30 loans. The NCF haircuts for the top 30 loans ranged from -2.5% to -100.0%, with an average of -28.5%. No ESA reports were provided nor required by the Issuer; however, all of the loans have an environmental insurance policy that provides coverage to the Issuer and the securitization trust in the event of a claim. No probable maximum loss information or earthquake insurance requirements are provided. Therefore, a loss severity given default penalty was applied to all properties in California to mitigate this potential risk.

DBRS Morningstar received limited borrower information, net worth or liquidity information, and credit history. Additionally, the WA interest rate of the deal is 11.40%, which is indicative of the broader increased interest rate environment and represents a large increase over previous VCC deals. DBRS Morningstar initially assumed loans had Weak sponsorship scores, which increases the stress on the default rate. The initial assumption of Weak reflects the generally less sophisticated nature of small balance borrowers and assessments from past small balance transactions rated by DBRS Morningstar.

RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS) METHODOLOGY
The collateral pool consists of 475 mortgage loans with a total balance of approximately $145.3 million collateralized by one- to four-unit investment properties. Velocity underwrote the mortgage loans to No Ratio program guidelines for business-purpose loans.

The transaction assumptions consider DBRS Morningstar's baseline macroeconomic scenarios for rated sovereign economics, available in its commentary “Baseline Macroeconomic Scenarios for Rated Sovereigns: April 2023 Update,” dated April 28, 2023. These baseline macroeconomic scenarios replace DBRS Morningstar's moderate and adverse coronavirus pandemic scenarios, which were first published in April 2020.

The ratings reflect transactional strengths that, for residential investor loans, include the following:
-- Improved underwriting standards,
-- Robust loan attributes and pool composition, and
-- Satisfactory third-party due-diligence review.

The transaction also includes the following challenges:
-- Residential investor loans underwritten to No Ratio lending programs, and
-- Representations and warranties framework.

The full description of the strengths, challenges, and mitigating factors is detailed in the related Presale Report.

DBRS Morningstar incorporates a dynamic cash flow analysis in its rating process. A baseline of four prepayment scenarios, two default timing curves, and two interest rate stresses were applied to test the resilience of the rated classes. DBRS Morningstar ran a total of 16 cash flow scenarios at each rating level for this transaction. Additionally, WA coupon deterioration stresses were incorporated in the runs.

ENVIRONMENTAL, SOCIAL, 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 (May 17, 2022).-

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 methodologies are North American CMBS Multi-Borrower Rating Methodology (March 16, 2023; https://www.dbrsmorningstar.com/research/410913) and RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology (March 3. 2023; https://www.dbrsmorningstar.com/research/410473).

Other methodologies referenced in this transaction are listed at the end of this press release.

With regard to due diligence services, DBRS Morningstar was provided with the Form ABS Due Diligence-15E (Form-15E), which contains a description of the information that a third party reviewed in conducting the due diligence services and a summary of the findings and conclusions. While due diligence services outlined in Form-15E do not constitute part of DBRS Morningstar’s methodology, DBRS Morningstar used the data file outlined in the independent accountant’s report in its analysis to determine the ratings referenced herein.

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 rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the rating process for this rating action.

DBRS Morningstar had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is a solicited credit rating

Please see the related appendix for additional information regarding the sensitivity of assumptions used in the rating process. Please note a sensitivity analysis is not performed for CMBS bonds rated CCC or lower. The DBRS Morningstar long-term rating scale definition indicates that ratings of CCC or lower are assigned when the bond is highly likely to default or default is imminent, thereby prevailing over a sensitivity analysis.

The full report providing additional analytical detail is available by clicking on the link under Related Documents below or by contacting us at [email protected].

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

DBRS, Inc.
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The rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies

-- Assessing U.S. RMBS Pools Under the Ability-to-Repay Rules (April 28, 2023),
https://www.dbrsmorningstar.com/research/413297/assessing-us-rmbs-pools-under-the-ability-to-repay-rules

-- Interest Rate Stresses for U.S. Structured Finance Transactions (August 30, 2022),
https://www.dbrsmorningstar.com/research/402153/interest-rate-stresses-for-us-structured-finance-transactions

-- Third-Party Due-Diligence Criteria for U.S. RMBS Transactions (September 11, 2020),
https://www.dbrsmorningstar.com/research/366613/third-party-due-diligence-criteria-for-us-rmbs-transactions

-- Representations and Warranties Criteria for U.S. RMBS Transactions (April 22, 2020),
https://www.dbrsmorningstar.com/research/359902/representations-and-warranties-criteria-for-us-rmbs-transactions

-- Legal Criteria for U.S. Structured Finance (December 7, 2022),
https://www.dbrsmorningstar.com/research/407008/legal-criteria-for-us-structured-finance

-- Operational Risk Assessment for U.S. RMBS Originators (November 23, 2022),
https://www.dbrsmorningstar.com/research/405664/operational-risk-assessment-for-us-rmbs-originators

-- Operational Risk Assessment for U.S. RMBS Servicers (November 23, 2022),
https://www.dbrsmorningstar.com/research/405665/operational-risk-assessment-for-us-rmbs-servicers