Morningstar DBRS Downgrades Seven Classes of BAMLL Commercial Mortgage Securities Trust 2016-ISQR

DBRS, Inc. (Morningstar DBRS) downgraded its credit ratings on seven classes of Commercial Mortgage Pass-Through Certificates, Series 2016-ISQR issued by BAMLL Commercial Mortgage Securities Trust 2016-ISQR as follows:

-- Class XA to BBB (sf) from AA (low) (sf)
-- Class A to BBB (low) (sf) from A (high) (sf)
-- Class B at BB (low) (sf) from BBB (high) (sf)
-- Class XB to B (sf) from BBB (sf)
-- Class C to B (low) (sf) from BB (high) (sf)
-- Class D to CCC (sf) from B (high) (sf)

Morningstar DBRS also confirmed its credit rating on Class E at CCC (sf). The trends on Classes XA through C have been changed to Stable from Negative. There are no trends on Class D and Class E as those classes have a credit rating that does not typically carry a trend in commercial mortgage-backed securities (CMBS) credit ratings.

All credit ratings have been removed from Under Review with Negative Implications where they had been placed on April 15, 2024, as part of Morningstar DBRS' review of transactions secured by office properties within its North American Commercial Mortgage Backed Securities Single-Asset/Single-Borrower (NA CMBS SASB) portfolio. The review was prompted by Morningstar DBRS' view that a shift in the use and demand for office space has been observed in the last few years. Amid the increase in remote work and hybrid schedules, tenant demand in urban markets, such as those most frequently represented in the NA CMBS SASB space, has been the most resilient for those higher-quality buildings that offer extensive amenity packages and are located close to transportation hubs with other nearby draws for commuters and city dwellers alike. These trends are expected to be sustained in the long term and their ripple effects of increased tenant improvement costs, capital improvement expectations, and decreased demand for some markets and neighborhoods will continue to influence investment activity for the office sector as a whole. For more information regarding the approach and analysis conducted, please refer to the press release titled "Morningstar DBRS Takes Rating Actions on North American Single-Asset/Single-Borrower Transactions Backed by Office Properties," published on April 15, 2024.

At the conclusion of the April 2024 review, several transactions, including the subject transaction, remained Under Review with Negative Implications. This generally reflected the existence of evolving factors for those credits for which Morningstar DBRS identified a need for more information to be gathered to inform the analysis. With this review of the subject transaction, Morningstar DBRS has resolved the Under Review with Negative Implications status. The full details of the credit rating action and ratings rationale are outlined below.

The credit rating downgrades reflect the increased credit risk exhibited by the downward pressure in the loan-to-value (LTV) sizing benchmarks following the updates to the analysis made with this review. The updates to the Morningstar DBRS net cash flow (NCF) and LTV sizing benchmarks were made to capture the secular shift noted above in addition to the property's prolonged declines in occupancy and cash flow, contributing to a significant decline in property value, well below the $757.0 million valuation at loan closing. While the YE2023 NCF of $18.5 million represented an improvement over the YE2022 NCF of $12.4 million, performance remains significantly below the YE2021 NCF of $25.0 million and the issuer's NCF of $39.0 million derived at loan closing in 2016.

The collateral, International Square, is an office property consisting of three buildings connected by a central atrium and totaling1.2 million square foot (sf) in downtown Washington. The subject includes 67,000 sf of ground-floor retail space, 12,000 sf of storage space, and a 637-space subterranean parking garage. The property, developed between 1978 and 1982, is on I Street NW between 18th Street NW and 19th Street NW with direct access to Farragut West Metro Station. Sponsorship is provided by a joint venture between Tishman Speyer Properties and the Abu Dhabi Investment Authority, which has owned the property since 2006.

Morningstar DBRS also notes the increased refinance risk for the 10-year, interest-only (IO), fixed-rate loan as the current 3.62% coupon is considerably below observable interest rates for single-asset, single-borrower, CMBS transactions currently being financed. While the loan does not mature until August 2026, Morningstar DBRS believes the current performance of the property will not be able to sustain the current debt load at maturity. Total debt held against the property is $450.0 million with the trust debt of $370.0 million, consisting of a $166.7 million senior A-1 note and a $203.3 million junior note. There is an additional $80.0 million pari passu senior A-2 note split across three CMBS multiborrower transactions. To test the durability of the assigned credit ratings, Morningstar DBRS conducted a refinance analysis in which an elevated, market-rate coupon was assumed. Based on the analysis and the updated Morningstar DBRS NCF of $25.1 million detailed further below, the property could support debt service on Classes A, B, and C before fallling below a debt service coverage ratio (DSCR) of 1.0 times (x).

According to the rent roll, the property was 76.4% occupied with an average base rental rate of $62.56 per square foot (psf). The occupancy rate represents an improvement over the YE2023 figure of 73.3% and YE2022 figure of 68.7%, but remains well below the occupancy rate of 94.2% at closing. The largest tenant remains the Federal Reserve System (the Fed), which occupies 33.1% of the total property net rentable area (NRA) with leases across all three buildings. In April 2022, the Fed renewed its lease for approximately 270,000 sf (22.6% of the total property NRA) for periods of seven or 11 years. The tenant pays base rental rates of $60.67 psf or $63.56 psf on the individual suites and receives tenant improvement allowances in the form of rental abatements, which are expected to end by YE2024. In its analysis, Morningstar DBRS gave long-term credit tenant treatment to this block of space leased by the Fed, accepting the tenant's full, unabated rent payments and removing any future leasing costs related to the space in the analysis. The remaining spaces leased by the Fed have lease expiration dates of January 2026 and April 2028. The second-largest tenant, Blank Rome LLP (Blank Rome), occupies 14.0% of the total property NRA on a lease expiring in July 2029. Combined, the Fed and Blank Rome, have historically contributed more than half of the property's rental revenue.

According to the servicer, only one lease, with Legal Services Corporation (3.2% of the total property NRA), has been executed over the past year. The tenant executed a 15-year lease, which is slated to commence in January 2025. The tenant will pay a starting base rental rate of $59.20 psf and received a significant tenant improvement allowance of $200 psf ($7.4 million), meaning the lease will not become profitable for several years. While Morningstar DBRS notes the positives regarding the sponsor's commitment to the property in funding the allowance, the large allowance is also an indication of how expensive it is to execute leases in this submarket and the specific challenges the sponsor continues to face in signing new leases. The loan currently has no outstanding leasing reserve and Morningstar DBRS took the Legal Services Corporation lease into account when deriving below-the-line leasing costs in its analysis. The sponsor also invested $13.3 million in the property in 2023 to upgrade the central atrium food court and bar as well as the ground floor retail space; however, subsequent improvements in the office space occupancy rate have not followed. According to Q1 2024 Reis data, office properties in the Downtown District of Columbia reported an average asking rental rate of $55.69 psf with the vacancy rate at 16.5%. Class A properties reported figures of $60.11 psf and 16.9%. The subject continues to trail the submarket in terms of vacancy; however, tenant rollover risk throughout 2024 is limited to one tenant occupying 2.1% of the total property NRA.

The updated Morningstar DBRS property valuation of $323.3 million was derived by applying a 7.75% cap rate on the updated Morningstar DBRS NCF of $25.1 million. In its LTV sizing analysis, Morningstar DBRS also applied cumulative positive qualitative adjustments of 1.5% for cash flow volatility and property quality. At closing in 2016, the issuer's implied cap rate based on its $39.0 million NCF and the original $757.0 million property valuation was 5.1%. Based on currently available information, that assumption is aggressive, as according to the "CBRE United States Cap Rate Survey H2 2023," value-add Class A office properties in the Downtown Washington market were valued at cap rates ranging from 9.00% to 11.00%, while stabilized Class A office properties in the market were valued at cap rates ranging from 7.25% to 9.00%. Morningstar DBRS expects the loan to remain current and for the YE2023 DSCR of 1.12x to improve as the full unabated rental revenue from the Fed is realized; however, the sponsor is expected to encounter stress at loan maturity unless it is able to significantly increase property occupancy and cash flow, which is not expected to occur given the recent performance, the softness in the market, and the change in demand for the office sector from tenants, lenders, and investors alike.

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 DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024); https://dbrs.morningstar.com/research/427030.

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

On July 17, 2024, Morningstar DBRS amended the above press release to correct the trust debt figure to $370.0 million from $350.0 million. The total debt figure was correct in the original press release.

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 Morningstar DBRS rating assigned to Class B is higher than the result implied by the LTV sizing benchmarks by three or more notches. The variance is warranted as the loan is expected to remain current throughout the remaining term with improvement in cash flow as rental abatement periods to the Fed end. Morningstar DBRS also notes the sponsor continues to fund leasing costs, though new leasing activity is minimal. Additionally, Morningstar DBRS conducted a refinance analysis in which an elevated, market-rate coupon was assumed. Based on the analysis and the updated Morningstar DBRS NCF, the property could support debt service on Classes A, B, and C before falling below a DSCR of 1.0x.

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.

Morningstar DBRS 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.

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

Morningstar DBRS North American Commercial Real Estate Property Analysis Criteria (June 28, 2024), https://dbrs.morningstar.com/research/435293

North American Commercial Mortgage Servicer Rankings (August 23, 2023), https://www.dbrsmorningstar.com/research/419592

Interest Rate Stresses for U.S. Structured Finance Transactions (February 26, 2024), https://dbrs.morningstar.com/research/428623

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

Rating North American CMBS Interest-Only Certificates (December 13, 2023), https://www.dbrsmorningstar.com/research/425261

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

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/410863.

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