CMBS - 2011


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December 2011
Real Estate Finance: BUS 348 01 (0045)

Natalie Cohen
Neville O'Callaghan
& Mark Ungewitter

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CMBS - 2011

  1. 1. CMBSCommercial Mortgage Backed Securities
  2. 2. CMBS Part ITypical Characteristics Brief HistoryIndustry Participants
  3. 3. (CMBS) What are Commercial Mortgage-Backed Securities?CMBS consist of many single mortgages pooled together andtransferred to a trust. The trust issues a series of bondsthat vary in yield, duration and payment priority.As several commercial bonds and mortgages are broughttogether, investors get dividends funded by the pooledmortgages. Borrowers Guide to CMBS
  4. 4. CMBS are an increasingly popular investment option thatinvestors can consider during their asset allocation processCMBS are similar to Mortgage-Backed Securities (MBS):  Asset-backed securities secured by a mortgage or collection of mortgages  Bonds backed by mortgage paymentsCMBS and MBS differ:  MBS - loans related to residential property  CMBS - loans related to commercial property
  5. 5. Typical Characteristics of CMBS Term Period –terms are typically three, five or ten years long Repayment of Investment – principal and interest of the mortgages is used to pay the principal and interest of the CMBS Rates of Return – influenced by fluctuations in the overall position of the real estate market RRSP Eligible – CMBS are eligible through The Registered Retired Savings Plan
  6. 6. Typical Characteristics of CMBS continued…  Ratings – credit ratings are assigned by nationally recognized rating agencies: (AAA/AAA through BBB-/Baa3) (BB+/Ba1 through B-/B3) Unrated Class  Risk Structured Payment directly correlated with rating class  REMIC – (real estate mortgage investment conduit) structured as a pass-through securitized certificates, while individual investors pay taxes on income they receive from REMICs, the securities themselves are exempt from business income tax
  7. 7. Brief History of CMBS 1968 - Ginnie Mae (GNMA), first mortgage backed pass through security - to provide a liquid secondary market for existing loans; provided lender’s the ability to originate more primary loans 1971 - Freddie Mac (FHLMC) issued first mortgage pass through mostly of private mortgages 1981 - Fannie Mae (FNMA) issued its first mortgage backed security 1983 - first CMBS transaction was priced - Fidelity Mutual Life Insurance, issued $60 million of commercial mortgage–backed securities to three life insurance companies 1985 - total annual issuance of CMBS reached $3.7 billion and the market established itself as an effective financing mechanism for commercial real estate 1980’s and 1990’s - tax and regulatory reforms made these investments more appealing and suitable for a wider range of investors
  8. 8. CMBS Industry Participants Primary or Sub-Servicer Master Servicer Special ServicerDirecting Certificate Holder / Controlling Class / B-Piece Buyer Trustee Rating Agencies
  9. 9. CMBS Industry Participants
  10. 10. CMBS Part IIAdvantages & Disadvantages Borrower Issuer Investor
  11. 11. Borrower Advantages Creates additional sources of funding for the development of projects by introducing diversified levels of risk Level of Protection Through Defeasance As a substitution for collateral (real estate property) for the remainder of the term on a mortgage note, a borrower can elect to pay the note before its maturity date (defeasance) through the substitutive purchase, exactly matching the cash flow of all scheduled mortgage payments, of US Treasury bonds
  12. 12. Issuer Advantages "CMBS helps in converting immovable real estate into liquid and tradable capital market instruments. CMBS acts as an additional source of funding for the bank/developer. The rating on CMBS defined can be separated from the rating of the bank/developer for a desired rating on the CMBS instrument. CMBS is more beneficial than bank loans as it reduces the overall cost of funds and optimizes the funds raised, due to offering different categories of options to suit different investor classes. CMBS helps lenders manage risk, by securitizing selected commercial mortgages and buying or selling suitable CMBS papers." -
  13. 13. Investor Advantages "Investors are able to participate in real estate lending in amounts that are small. Investors can meet their objectives by choosing options that suit their credit and maturity preferences. Investors can gain access to segments of the sector at low transaction and information costs. Internationally, defaults experienced on CMBS are much lower than on other types of securities." -
  14. 14. Disadvantages Borrowers Borrowers may be locked out of prepayments, leading to financial losses in an environment of lower interest rates. Borrowers are expected to make a balloon payment at the end of the loan term and becomes dependent on a source of funding to either retire the debt, or refinance. Higher rates may lead to financial losses. Inability to obtain funding may result in default loss, referred to as extension risk.
  15. 15. Disadvantages Lenders There is a much higher rate of default in CMBS issuances due to the reliance on cash flows and income from commercial tenants and financial risk due to macro and local economic conditions and demographic trends. The loans are generally made without recourse, leaving the lender dependent on the sale of the property to recoup costs and losses. Lenders ability to recoup their investment is determined by the tranche position of their investment. Senior tranches are paid first, followed by subordinated and residual class investors. Liquidity crunches and financial loss can cause an investor to lose their entire investment if sale proceeds do not exceed the debt.
  16. 16. CMBS Part III Valuation of CMBS &Difficulties in Valuation
  17. 17. VALUATION OF CMBS CMBS collateral property valuations requirethe analysis of details and inherent complexities attributed to the uniqueness of each commercial property
  18. 18. Commercial properties are each distinct owing to theircompetitive positioning within their markets and themakeup of their physical structure, tenancy/occupancy,and management.  Parking Lots  Office Properties  Hotels  Industrial Properties  Malls  Multi-Family Properties  Restaurants  Retail Shops  Hospitals  Self-Storage Facilities
  19. 19. A Few Examples of Risk Considerations Location/Visibility  In place vs. Market Rate Leases Demographic Trends  Environmental Risks  Rent Roll Employment Growth  Availability of Nearby  Government Subsidies Undeveloped Land Supply and Demand Dynamics  Management/Franchise  Security Agreements Occupancy/Tenancy/Co-  Consolidations Tenancy/Shadow  Competition/Competitiv Anchors e Strength  Expenses Subleasing/Subleasing  Structure/Design/Physic  Shareholder Profiles Rates al Attraction/Layout/Parki ng
  20. 20. Property Cash Flow AnalysisA collateral property’s net cash flow is the principal indicator asto whether a proposed loan’s periodic debt service will be paid.Cash flow analysis requires the underwriter to obtain informationon Net Operating Income (total recurring revenue less totalexpenses) generated by the income producing property from itsusual operations.
  21. 21. Property Cash Flow Analysis continued… Revenues - income from tenancy or occupancy, and reimbursement of operating expensesHowever, recurring revenue related to a property’s operationscould come from a variety of sources.Example, in addition to rent, income from a retail tenant basedon the percentage of sales by the retail store can be an additionalsource of revenue for the property.
  22. 22. Property Cash Flow Analysis continued…  Expenses - costs of operating and maintaining property: • management fees • facility supplies • franchise fees • costs of goods sold • utilities • insurance • leased equipment • service agreements like • maintenance landscaping or marketing • employee salaries
  23. 23. An underwriter’s document requirements from the borrower are specificto the uniqueness of each property and at minimum include thefollowing: Operating statements – current plus three prior calendar years Operating budget – current and following year’s operating budget Current Rent Roll – includes tenant names, co‐tenancy provisions, leased square foot area, lease commencement dates, lease expiration dates, current rents (contractual rent increases during lease terms), renewal options, termination options, and current or future concessions
  24. 24. Market AnalysisBy tracking and projecting market trends, an underwriter canreasonably predict the commercial viability of a particularproperty over the term of the loan and beyond the anticipatedrefinance period to provide the basis for the probableperformance of the collateral.
  25. 25. Market Analysis continued… Macro and Local Economic and Demographic Tr e n d s I n f l u e n c e t h e D e m a n d f o r S p a c e Supply and Demand Conditions Nominal GDP (as indicative of  Local Population Growth increasing prices)  Major Local Employers Employment Growth Rate  Local Job Patterns Disposable Income  Household Formation Changing Demographics in Markets  Median and Disposable Income Market‐Specific Economic
  26. 26. Risk AnalysisTo properly value CMBS, an underwriter must consider allthe risk factors specific to the uniqueness of each property.Additionally, underwriters must also consider a borrower’sability to make timely payments and eventual repayment onthe loan at the maturity date.This calls for lenders to customize their underwriting toreflect the risk within each proposed loan in relation to thecriteria and conditions of each property.
  27. 27. Monetary Risks Term Default -“Term Risk” is the probability of default from loan origination through loan maturity: Underwriter’s Considerations: probabilities in fluctuations in cash flows due to lease turnover and changes in expenses Require higher debt service coverage ratio and credit enhancements such as; reserve funds based on the uniqueness of each property
  28. 28. Monetary Risks Maturity Default – “Maturity Risk” is the probability of default at the date a loan is due: Reflects ability of a borrower to: attain refinance proceeds to fully repay the matured loan or sell the property and utilize sales proceeds to repay the loan Debt constants, debt-yields and loan‐to‐value ratios are used to assess Maturity Risk
  29. 29. Non-Monetary Risks Technical Default – determining the probability of a technical default, an underwriter evaluates: borrower’s motivation and capacity to abide with constraints of loan agreements beyond payment terms Technical defaults can have severe repercussions if not cured by borrower within a reasonable period of time Example: borrower neglects to sufficiently insure a property, the property and loan may suffer adverse consequences and risk of loss
  30. 30. Rating Issues
  31. 31. Conclusion
  32. 32. CMBS - PowerPoint Presentation 2011 By Natalie Cohen Neville O’Callaghan Mark UngewitterPublic Domain Photo Credits Photo By Denise Gould Photo By Jim Peaco Photo By David Hafley Photo By Natalie Cohen
  33. 33. Sources CMBS.Com,, accessed December 2011 Invetopedia,, accessed December 2011 Ilikeinvesting,, accessed December 2011 CMBS Borrower’s Guide,accessed December 2011 , accessed December 2011 Urbanland, , accessed December 2011 , accessed December 2011 Defeasnce, Wikipedia – accessed December 2011 The Ratings Debate, YouTube –, accessed December 2011 Buffet on Derivatives, YouTube -, accessed December 2011