OREANDA-NEWS. Rising commercial real estate (CRE) prices in Germany have increased the buffer between market values and mortgage lending values in Pfandbrief cover pools, Fitch Ratings says. This shows how the rules governing CRE valuations when mortgage lenders originate loans refinanced through Pfandbriefe further insulate bondholders from CRE price volatility.

Our updated analysis of nearly 7,500 German commercial properties shows that the market value (MV), which must be updated regularly, was on average 13.8% higher than the original mortgage lending value (MLV) at end-1Q15, up from 12.4% two years earlier.

German Pfandbrief law requires collateral valuations to reflect long-term property values, sustainable through property market and economic cycles. Regulation sets parameters for income and cost calculations used to determine the MLV when loans are originated.

The increase in the cushion is not an exact reflection of the total price increase for CRE in Germany in the same period, as reported, for example, by research and consulting firm BulwienGesa. If MVs had tracked BulwienGesa's price data exactly, the average difference between MVs and MLVs would be 22%.

Several factors may have contributed to this difference. The revaluation of some properties in German Pfandbrief cover pools may not have kept pace with transaction prices, and cover pools may include a greater proportion of properties in locations that have had slower growth. In addition, the rules for calculating MLVs leave some room for interpretation, and we think valuers might apply them less conservatively in benign economic circumstances.

The overall effect is that MLVs are less cyclical than market prices. The resulting MV cushion provides additional protection for Fitch-rated commercial mortgage Pfandbriefe against potential falls in property prices, on top of the 60% eligibility threshold for cover pool inclusion, which is based on the loan-to-mortgage-lending value. A 13.8% cushion leads to an equivalent limit of 53% if based on the loan-to-market value. This protection is reflected in the relatively high weighted average recovery rates of 70%-90% in our 'AAA' scenario asset analysis for Pfandbriefe secured by CRE loans.

The size of the cushion differs considerably depending on property type, size, and location. It remains biggest for offices (20% at end-1Q15), followed by retail properties (16%) and multi-family housing (12%). The MV cushion increases with property size (the average cushion ranges from 13% for small properties worth less than EUR5m to 22% for large properties worth EUR50m or more).

This suggests that riskier properties, such as offices with limited tenant diversification, will usually have higher MV cushions than those where a more diverse mix of tenants results in more stable cash flows.

Germany is one of few countries where banks use the MLV principle in their CRE mortgage book. The European Banking Authority said this week that "the concept of MLV... is key for the prudent assessment of risks stemming from exposures secured by immovable property," but that it should not be a prerequisite for covered bonds' preferential risk weights.