DBRS Morningstar Finalizes Provisional Ratings on Velocity Commercial Capital Loan Trust 2023-4

DBRS, Inc. (DBRS Morningstar) finalized its provisional ratings on the Mortgage-Backed Certificates, Series 2023-4 (the Certificates) issued by Velocity Commercial Capital Loan Trust 2023-4 (VCC 2023-4 or the Issuer) as follows:

-- $136.6 million Class A at AAA (sf)
-- $11.4 million Class M-1 at AA (low) (sf)
-- $10.8 million Class M-2 at A (low) (sf)
-- $16.2 million Class M-3 at BBB (sf)
-- $28.0 million Class M-4 at BB (sf)
-- $18.9 million Class M-5 at B (sf)
-- $136.6 million Class A-S at AAA (sf)
-- $136.6 million Class A-IO at AAA (sf)
-- $11.4 million Class M1-A at AA (low) (sf)
-- $11.4 million Class M1-IO at AA (low) (sf)
-- $10.8 million Class M2-A at A (low) (sf)
-- $10.8 million Class M2-IO at A (low) (sf)
-- $16.2 million Class M3-A at BBB (sf)
-- $16.2 million Class M3-IO at BBB (sf)
-- $28.0 million Class M4-A at BB (sf)
-- $28.0 million Class M4-IO at BB (sf)
-- $18.9 million Class M5-A at B (sf)
-- $18.9 million Class M5-IO at B (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 40.50% of credit enhancement (CE) provided by subordinated certificates. The AA (low) (sf), A (low) (sf), BBB (sf), BB (sf), and B (sf) ratings reflect 35.55%, 30.85%, 23.80%, 11.60% and 3.35% of CE, respectively.

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

VCC 2023-4 is a securitization of a portfolio of newly originated and seasoned fixed and adjustable-rate, 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 Mortgage-Backed Certificates, Series 2023-4 (the Certificates). The Certificates are backed by 652 mortgage loans with a total principal balance of $229,513,200 as of the Cut-Off Date (October 1, 2023).

Approximately 65.7% of the pool comprises residential investor loans and about 34.3% of 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 mortgagor's credit profile, though it does not rely on the borrower's income to make its credit decision. However, the lender considers the property-level cash flows or minimum debt-service coverage ratio (DSCR) in underwriting SBC loans with balances over $750,000 for purchase transactions and over $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 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 Mortgage 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 Mortgage 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 (U.S. Bank; rated AA (high) with a Negative 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 M-7, 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. Each Class's target principal balance is determined based on the CE targets and the performing and nonperforming (those that are 90 or more days MBA delinquent, in foreclosure and REO, and 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 each Class's target principal balance, 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, to always maintain 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 the 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).

COMMERCIAL MORTGAGE-BACKED SECURITIES (CMBS) METHODOLOGY

The collateral for the SBC portion of the pool consists of 186 individual loans secured by 186 commercial and multifamily properties with an average cut-off date loan balance of $422,976. 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 CMBS loans have a weighted average (WA) fixed interest rate of 11.9%. This is approximately 10 basis points (bps) lower than the VCC 2023-3 transaction, 50 bps higher than the VCC 2023-2 transaction, 140 bps higher than the VCC 2023-1 transaction, 260 bps higher than the VCC 2022-5 transaction, and more than 360 bps higher than the interest rates of the VCC 2022-4, VCC 2022-3, and VCC 2022-2 transactions, highlighting the recent increase in interest rates. Most of the loans have original term lengths of 30 years and fully amortize over 30-year schedules. However, three loans, which represent 1.3% of the SBC pool, have an initial interest-only (IO) period ranging from 60 months to 120 months.

Most SBC loans were originated between July 2023 and September 2023 (99.4% of the cut-off pool balance), with two loans originated between July 2015 and January 2016, resulting in a WA seasoning of 1.3 months. The SBC pool has a WA original term length of 360 months, or 30 years. Based on the current loan amount, which reflects 30 bps of amortization, and the current appraised values, the SBC pool has a WA loan-to-value ratio (LTV) of 59.5%. However, DBRS Morningstar made LTV adjustments to 28 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 64.1%. 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 (CPR). 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 payments. The 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 rate and lending spreads, the SBC pool has a significant increase in interest rates compared with prior VCC transactions. Consequently, approximately more than 70.0% of the deal has less than a 1.0 times (x) Issuer net operating income (NOI) 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 the WA FICO score of 720 for the SBC loans, which is relatively similar to prior transactions. With regard to the aforementioned concerns, DBRS Morningstar applied a 5.0% penalty to the fully adjusted cumulative default assumptions to account for risks given these factors.

The SBC pool is quite diverse based on loan count and size, with an average cut-off date balance of $422,976, a concentration profile equivalent to that of a transaction with 109 equal-size loans, and a top 10 loan concentration of 19.0%. Increased pool diversity helps 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 retail (24.1% of the SBC pool) and office (14.4% of the SBC pool), which are two of the higher-volatility asset types. Loans counted as retail include those identified as automotive and potentially commercial condominium. Combined, retail and office properties represent 38.5% of the SBC pool balance. DBRS Morningstar applied a 20.0% reduction to the net cash flow (NCF) for retail properties and a 30.0% 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 80 loans DBRS Morningstar sampled, 20 were Average quality (33.4%), 47 were Average– (47.3%), and 13 were Below Average (19.3%). 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 (PCRs), 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 39.9% of the SBC pool balance. These appraisals were issued between July 2023 and September 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 -3.1% to -53.2%, with an average of -15.4%. 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 (PML) information or earthquake insurance requirements are provided. Therefore, a loss-given default (LGD) 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 11.9%, which is indicative of the broader increased interest rate environment and represents a large increase over previous VCC deals. DBRS Morningstar generally 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. Furthermore, DBRS Morningstar received a 12-month pay history on each loan as of September 30, 2023. If any loan had more than two late pays within this period or was currently 30 days past due, DBRS Morningstar applied an additional stress to the default rate. This occurred for two loans, representing 0.5% of the SBC pool.

RESIDENTIAL MORTGAGE-BACKED SECURITIES (RMBS) METHODOLOGY

The collateral pool consists of 466 mortgage loans with a total balance of approximately $150.8 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: September 2023 Update,” published September 28, 2023. These baseline macroeconomic scenarios replace DBRS Morningstar’s moderate and adverse Coronavirus Disease (COVID-19) 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 report.

DBRS Morningstar incorporates a dynamic cash flow analysis in its rating process. A baseline of four prepayment scenarios under the Standard (The standard payment rate consists of voluntary prepayments only. Prepayment amount and default amount are applied to the loans independently) Intex convention and 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, WAC deterioration stresses were incorporated in the runs.

DBRS Morningstar’s credit ratings on the Certificates address the credit risk associated with the identified financial obligations in accordance with the relevant transaction documents.

DBRS Morningstar’s credit ratings do not address non-payment risk associated with contractual payment obligations contemplated in the applicable transaction document(s) that are not financial obligations. For example, in this transaction, DBRS Morningstar's ratings do not address the payment of any Net WAC Rate Carryover Amounts or Prepayment Interest Shortfalls based on its position in the cash flow waterfall.

DBRS Morningstar’s long-term credit ratings provide opinions on risk of default. DBRS Morningstar considers risk of default to be the risk that an issuer will fail to satisfy the financial obligations in accordance with the terms under which a long-term obligation has been issued.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

There were no Environmental factors that had a relevant or significant effect on the credit analysis.

Social (S) Factors
There were no Social factors that had a relevant or significant effect on the credit analysis.

Governance (G) Factors
There were no Governance factors that had a relevant or significant 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 (July4, 2023) https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings.

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

The principal methodologies applicable to the credit ratings are RMBS Insight 1.3: U.S. Residential Mortgage-Backed Securities Model and Rating Methodology (August 31, 2023) https://www.dbrsmorningstar.com/research/420108/rmbs-insight-1.3:-u.s.-residential-mortgage-backed-securities-model-and-rating-methodology and North American CMBS Multi-Borrower Rating Methodology (November 3, 2023) https://www.dbrsmorningstar.com/research/422859/north-american-cmbs-multi-borrower-rating-methodology.

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

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/421227.

The credit rating was initiated at the request of the rated entity.

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

This is a solicited credit rating.

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

DBRS, Inc.
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New York, NY 10005 USA
Tel. +1 212 806-3277

The credit 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)

-- Interest Rate Stresses for U.S. Structured Finance Transactions (June 9, 2023; https://www.dbrsmorningstar.com/research/415687)

-- Third-Party Due-Diligence Criteria for U.S. RMBS Transactions (September 8, 2023; https://www.dbrsmorningstar.com/research/420333)

-- Representations and Warranties Criteria for U.S. RMBS Transactions (May 16, 2023; https://www.dbrsmorningstar.com/research/414076)

-- Legal Criteria for U.S. Structured Finance (December 7, 2022; https://www.dbrsmorningstar.com/research/407008)

-- Operational Risk Assessment for U.S. RMBS Originators (August 31, 2023; https://www.dbrsmorningstar.com/research/420106)

-- Operational Risk Assessment for U.S. RMBS Servicers (August 31, 2023; https://www.dbrsmorningstar.com/research/420107)

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