OREANDA-NEWS. Increasing hold times on real estate-owned (REO) assets likely indicate higher losses for U.S. CMBS, according to Fitch Ratings.

The average time REO assets spent in special servicing increased 10% in 2015, while REO aging increased 16%. Given workout duration is correlated to loss severity, 2016 special servicer reviews will focus on the decision of special servicers to retain REO assets through several years of stabilizing commercial real estate markets.

Fitch's preliminary review of CMBS special servicers' REO asset inventory indicates the average time REO assets spent in special servicing increased to 42 months as of year-end 2015 from 38 months the prior year. Additionally, the average time special servicers hold REO post-foreclosure increased to 22 months from 19, with some servicers clearly exceeding the average. On the positive side REO inventory declined by 33% (by count) since year-end 2013 as REO sales reflected improving commercial real estate fundamentals and market liquidity.

While partially explained by adverse selection, the increase in REO aging remains a concern given waning improvement in property values, the complexity and uncertainty of certain business plans, higher loss severity generally associated with extended workouts, and the reduction in net recoveries given expenses and advances.

Special servicers are charged with maximizing value prior to disposition. For REO assets this often includes a stabilization period after foreclosure during which repairs are made and leasing is stabilized prior to the REO sale. In some cases, special servicers address deficiencies or perform capital improvements intended to increase property performance and achieve higher sale prices. While maximizing recovery is subject to servicer discretion, investors expect incremental cost, extended resolution time and execution risk to be considered relative to potential incremental value. In its preliminary analysis, Fitch observed multiple recent examples of material property value declines or valuations at or near the outstanding debt, prompting questions on REO hold and capital improvement strategies.

To address these concerns, Fitch will review special servicers' REO inventory during its 2016 operational risk reviews with particular attention to REO assets held greater than 36 months. Fitch expects to review REO business plans and discuss with asset managers the complexity of the workout plans, alternate resolution strategies, net present value determinations, and underlying assumptions used to substantiate the resolution selected. Fitch will also consider the practicality and certainty of stabilization plans, the potential impact of losses on CMBS transactions and the motivation of the special servicer in the transaction. Fitch will publish a follow-up report on REO dispositions and its discussions with special servicers in the second quarter of 2016.