Morningstar DBRS Downgrades Credit Ratings on All Classes of HMH Trust 2017-NSS

DBRS Limited (Morningstar DBRS) downgraded its credit ratings on all classes of Commercial Mortgage Pass-Through Certificates, Series 2017-NSS issued by HMH Trust 2017-NSS as follows:

-- Class A to CCC (sf) from AAA (sf)
-- Class B to C (sf) from AA (low) (sf)
-- Class C to C (sf) from BBB (low) (sf)
-- Class D to C (sf) from BB (low) (sf)
-- Class E to C (sf) from CCC (sf)

There are no trends as the CCC (sf) and C (sf) credit rating categories typically do not carry trends in commercial mortgage-backed securities (CMBS) credit ratings. The credit rating downgrades are reflective of the increased loss expectations for the loan, which remains in special servicing as of the date of these credit rating actions, driven by the trust's increasing exposure and most recent decline in appraised value, as well as the potential for further credit deterioration based on the uncertain timeline for disposition and potential for further value decline. Since Morningstar DBRS' last review in June 2023, the outstanding advances and shortfalls have increased, some of the underlying collateral properties have seen further performance deterioration, and some properties have seen stabilization trends stall out. The 2023 reporting shows revenue growth has slowed from lows during the coronavirus pandemic, and overall cash flow remains well below the issuance level because of a combination of slightly lower revenues and significantly increased expenses from the Issuer's underwritten figures.

In addition, negotiations with the borrower regarding a resolution strategy have fully deteriorated, and the special servicer has begun the process of preparing for an asset disposition through a receiver sale process. Given the further value and performance impairments, Morningstar DBRS believes the special servicer's incentive to make ground lease payments has significantly diminished in the last year. These circumstances could also impair efforts to sell the properties off via the planned receiver sales. Given these factors, Morningstar DBRS did not rely on its loan-to-value (LTV) sizing benchmarks for this review, but rather analyzed this transaction using a liquidation scenario, as outlined below. The results of the liquidation scenario suggest losses could be realized into Class A, supporting the credit rating actions with this review.

The potential for principal loss is the primary driver for the downgrades; however, Morningstar DBRS' credit ratings factor in Morningstar DBRS' expectation of a continued increase in outstanding interest shortfalls prior to disposition, which has also contributed to the credit rating actions with this review. Interest shortfalls currently total $8.6 million (with Classes E and F being shorted as of the May 2024 remittance), up from a total interest shortfall amount of $3.9 million at the time of the last credit rating actions. Unpaid interest continues to accrue month over month, driven primarily by the appraisal subordinate entitlement reduction (ASER) amounts calculated by the special servicer as new appraisals have been obtained. Morningstar DBRS has minimal tolerance for unpaid interest to high investment-grade rated bonds, limited to one to two remittance cycles for the AA (sf) and A (sf) credit rating categories and six remittance cycles for non-investment-grade rated credit rating categories.

The $204.0 million trust mortgage loan is secured by the fee-simple interest in one hotel and the leasehold interests in 21 hotels across nine different states, with the largest concentrations in California, Florida, and North Carolina. In the event that the leasehold owner defaults on its ground rent obligations and the leased fee ground owner assumes the hotels, the subject trust may be left with no collateral. Although it is generally expected that a leasehold owner would make every effort to make a ground rent payment in order to prevent the loss of the leasehold collateral, as previously noted, Morningstar DBRS believes that the risk of a default on the various ground leases has become significantly elevated in the last year given the continued underperformance of the hotels and increased costs associated with the prolonged workout, further supporting the credit rating downgrades.

The properties have solid brand affiliation, with either Hilton Worldwide Holdings Inc.; Hyatt Hotels Corporation; Marriott International, Inc.; or Choice Hotels International, Inc. flags on each hotel. Nearly half the pool operates as extended-stay hotels, with the remaining operating as either limited-service or select-service hotels. The sponsor for the loan is Jay H. Shidler, founder of The Shidler Group, which was founded in 1972 and is headquartered in Honolulu. The capital stack includes a $25.0 million mezzanine loan held outside of the trust, and the trust permits an additional $26.0 million mezzanine loan; however, additional mezzanine debt has not been obtained to date. The mezzanine loans are co-terminous with the trust mortgage loan, which matured in July 2022. The status of the existing $25.0 million mezzanine loan is unknown, but given that the appraised value suggests the trust loan is underwater, Morningstar DBRS believes it is highly likely that the mezzanine debt is in default and the mezzanine lender is not interested in taking control of the borrower.

The loan has been in special servicing since May 2020 as a result of imminent monetary default after the borrower stopped making debt service payments and subsequently requested pandemic-related relief. The borrower has since consented to a court-appointed receiver and, according to the special servicer, in February 2024 the receiver was granted full authority to proceed with deeds in lieu or resolve the assets via foreclosure sales, with property liquidations expected to occur over the next 12 to 18 months. As such, Morningstar DBRS' approach for purposes of these credit rating actions included a recoverability analysis based on a stress to the most recent appraised value.

Since issuance, the servicer has obtained four rounds of updated appraisals, the most recent of which valued the collateral portfolio on an as-is (leasehold) basis at $180.0 million ($62,435 per key) in August 2023, representing a 55.0% decline from the issuance value of $400.4 million ($138,883 per key) and an LTV of 113.3% on the trust loan. Furthermore, outstanding advances continue to accrue, with principal and interest advances totaling $17.4 million as of the May 2024 remittance, an increase from $12.4 million at the time of Morningstar DBRS' last review. Factoring in all outstanding advances and cumulative unpaid advance interest, the loan's total exposure is currently $234.7 million, resulting in an implied LTV of approximately 130.4%.

Given the presence of additional leased fee debt on the ground underneath 21 of the 22 properties, Morningstar DBRS derived a look-through value for the portfolio to evaluate the recoverability prospects to the subject trust in the event of a liquidation. In the analysis for this review, Morningstar DBRS derived a look-through value for the leased fee interests by analyzing the appraiser's year two net cash flow (NCF) figure for each property and removing the ground rent expense. This analysis suggested a portfolio NCF of $33.3 million. Morningstar DBRS applied a capitalization rate (cap rate) of 9.25%, in line with cap rates that Morningstar DBRS derived for comparable limited-service hotel portfolios and in line with the fee-simple cap rate contemplated when credit ratings were assigned in 2020. A haircut of 10% was applied to allow for cushion against future value volatility over the remaining workout period and the potential for increasing servicer advances. This resulted in a value of $324.1 million for the fee-simple interest of the portfolio.

Because the collateral is primarily composed of leasehold interests, with each property subject to substantial ground lease payments (exceeding 35% of the updated look-through portfolio NCF), Morningstar DBRS assumed that the value attributed to the leased fee would be commensurate with the $224.0 million of debt that is estimated to be outstanding on the land underneath the hotels, which would imply a value for the collateral totalling approximately $99.9 million, representing a -44.4% variance from the August 2023 appraised value. Based on a total trust exposure of $248.2 million, which factors in the subject leasehold debt of $204.0 million, all outstanding advances and advance interest, ASER amounts, one year of additional principal and interest advances, and a 1.0% liquidation fee, a liquidation scenario based on the $99.9 million value attributed to the collateral results in losses to the subject trust in excess of $140.0 million, fully eroding the bulk of the capital stack, with losses projected to creep into Class A.

According to the financials for the trailing nine months ended September 30, 2023, the portfolio reported an annualized NCF figure of $7.4 million (reflecting a debt service coverage ratio (DSCR) of 0.76 times (x)), in comparison with the YE2022 figure of $12.4 million (reflecting a DSCR of 1.27x). Per the most recent STR, Inc. report, the portfolio reported occupancy, average daily rate, and revenue per available room figures of 66.6% (-0.8% year-over-year (YOY)), $142 (+3.8% YOY), and $96 (+3.1% YOY), respectively, for the trailing 12 months ended January 31, 2024, reflecting penetration rates of 107.4%, 107.1%, and 115.9%, respectively. The collateral properties have exhibited improvements across all performance metrics since bottoming out in 2021; however, cash flows have not re-stabilized in line with Morningstar DBRS' expectations. The collateral's ground rent obligations are expected to continue to limit cash flow growth. Using the appraiser's year two NCF, which assumes a nominal amount of stabilization, the ground rent expense as a percentage of NCF exceeds 35.0%, ranging from 14.2% to 85.0% across the portfolio.

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 Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) at https://dbrs.morningstar.com/research/427030.

All credit ratings are subject to surveillance, which could result in credit ratings being upgraded, downgraded, placed under review, confirmed, or discontinued by Morningstar DBRS.

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

The principal methodology is the North American CMBS Surveillance Methodology (March 1, 2024), https://dbrs.morningstar.com/research/428798.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at [email protected].

The credit ratings were initiated at the request of the rated entity.

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

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

This are solicited credit ratings.

Please note a sensitivity analysis is not performed for CMBS bonds rated CCC or lower. The Morningstar DBRS Long-Term Obligation Rating Scale definition indicates that credit 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.

DBRS Limited
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Toronto, ON M5H 3M7 Canada
Tel. +1 416 593-5577

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

-- North American Single-Asset/Single-Borrower Ratings Methodology (March 1, 2024), https://dbrs.morningstar.com/research/428799

-- DBRS Morningstar North American Commercial Real Estate Property Analysis Criteria (September 22, 2023), https://dbrs.morningstar.com/research/420982

-- North American Commercial Mortgage Servicer Rankings (August 23, 2023), https://dbrs.morningstar.com/research/419592

-- Legal Criteria for U.S. Structured Finance (April 15, 2024), https://dbrs.morningstar.com/research/431205

A description of how Morningstar DBRS analyzes structured finance transactions and how the methodologies are collectively applied can be found at: https://dbrs.morningstar.com/research/417279.

For more information on this credit or on this industry, visit https://dbrs.morningstar.com or contact us at [email protected].