FINANCING REAL ESTATE DEVELOPMENT
THROUGH RATED COMMERCIAL PAPER:
AN ANALYSIS OF 75 STATE STREET
by
LIETZ
CORDELL A.
Bachelor of Science; Architectural Studies
Arizona State University
(1981)
Submitted to the Department of Architecture
in Partial Fulfillment of the Requirements for the Degree
of
Master of Science in
Real Estate Development
at the
Massachusetts Institute of Technology
July 1989
Cordell A.
Lietz
1989
The author hereby grants to MIT permission to reproduce and to
distribute copies of this thesis document in whole or in part.
Signature of Author
Cordell
Department of
Lietz
chitecture
ulv 21. 1989
Certified by
James McIellar
Visiting Professor
Department of Architecture
Director of the Center For Real Estate Development
Thesis Supervisor
Accepted by
Michael Wheeler
Chairman
Interdepartmental Degree Program in Real Estate Development
-1-
(SEP 2519)
FREWRI
FINANCING REAL ESTATE DEVELOPMENT
THROUGH RATED COMMERCIAL PAPER:
AN ANALYSIS OF 75 STATE STREET
by
CORDELL A.
LIETZ
Submitted to the Department of Architecture
on July 31, 1989 in Partial Fulfillment of the Requirements
for the Degree of
Master of Science in Real Estate Development
ABSTRACT
This paper explores the changes that have taken place in the
real estate capital markets over the past decade, and the new
breed of financing instruments that have emerged. The paper
focuses on the securitization of to-be-developed properties,
and more specifically, the issuance of rated, commercial
paper, for construction and permanent financing.
As a model
for the analysis ,
a case study of the 75 State Street
development in Boston, Massachusetts is presented.
This
development represents the first time commercial paper was
issued on a to-be-built office building, with no pre-leasing,
using interest rate swaps to fix the rate.
In analyzing the success of the commercial paper program
used on 75 State Street, the evolution of the real estate
capital markets is set forth, as are the new financing
instruments that
emerged under the new
capital market
structure. The paper attempts to explain why securitization
has not
been used
more frequently
on to-be-developed
properties and discusses the future of commercial paper
programs in real estate development.
Thesis Supervisor:
Title:
James McKellar
Visiting Professor, Department of
Architecture; Director of The Center For
Real Estate Development.
-2-
TABLE OF CONTENTS
CHAPTER I.
INTRODUCTION ...................
CHAPTER II.
CASE STUDY:
........
75 STATE STREET .....
.......
4
7
The Players
Financing Objectives
Commercial Paper Program
Interest Rate Swaps
Additional Hedges
CHAPTER III.
THE REAL ESTATE CAPITAL MARKET
ERISA
......
21
Federal Reserve Policy
Deregulation
Foreign Investment
CHAPTER IV.
THE NEW FINANCIAL STRUCTURES
....
.. . . . . 32
Development Partnerships
Participating-Type Mortgages
Accrual Mortgages
Floating Rate Instruments
CHAPTER V.
......
SECURITIZATION ..................
37
Analysis of 75 State Street
CHAPTER VI.
CONCLUSION ............................
48
APPENDIX A
............................
50
APPENDIX B
............................
56
APPENDIX C
...................
ACKNOWLEDGEMENTS
58
.......................60
BIBLIOGRAPHY ..........
-3-
.....
..............
61
CHAPTER I.
INTRODUCTION
In the past decade, real estate capital markets have undergone
dramatic changes.
As part of
these changes, we have
seen a
significant shift in the distribution
of risks and rewards in
real
that had
estate, between
supplied
equity
those
capital
parties
and
those
traditionally
institutions
that
had
traditionally supplied debt.
The financial volatility that occurred at the beginning of the
1980's caused a new capital
structure has
vehicles
market structure to emerge.
produced a new
that
Participating-Type
breed of real
include;
Institutional
Mortgages,
Accrual
This
estate financing
Partnerships,
Mortgages,
and
the
Securitization of real estate.
Securitization epitomizes
capital
market
integration
the move away from
structure
of Wall
and
Street
the traditional
represents
into the
the
real estate
continuing
industry.
However, once touted as the wave of the future, securitization
has
not lived
especially
up
to many
true with
people's
the
expectations.
securitization of
This
is
to-be-developed
properties.
The purpose of this paper
to-be-developed
issuance of
is to examine the securitization of
properties
commercial paper
-4-
and,
more
specifically,
for construction
the
and permanent
As a model for this analysis, the paper focuses on
financing.
on a to-be-built office building,
commercial paper was issued
with
no pre-leasing,
time
the first
represents
This development
Massachusetts.
in Boston,
Street development
75 State
of the
a case study
to fix
rate swaps
using interest
the
rate.
Chapter
Street and
75 State
study of
the case
II presents
provides a brief history as to the origin of this development.
The
outlines the
case study
to obtaining
established prior
objectives that
the developers
financing and
the commercial
paper program that was ultimately used.
Chapter III examines the evolution
markets
has
that
occurred
established
in
and
1974,
decade.
past
of
banks
and
under
thrifts
financial
the
to
This volatility
the change in monetary policy in
was caused by
It
the ERISA pension
1980's.
has occurred in the
volatility that
deregulation
the
during
for the evolution to
attributes the reason
legislation
in the real estate capital
1979, and the
the
new
Reagan
administration.
Chapter IV
that
looks at
evolved
analyzes
the
the new
under the
new
alternatives
developers of 75 State Street
financing instruments
breed of
capital
that
market structure.
It
to
the
were
available
and offers examples using these
alternate financing vehicles in Appendix A and B.
-5-
Chapter
V
examines
the
to-be-developed properties.
use
of
securitization
It outlines the reasons
of
why the
commercial paper program was successful on 75 State Street and
why
securitization has
conclusion,
the paper
securitization
as
a
not
been used
discusses
more frequently.
what the
financing vehicle
for
future holds
In
for
to-be-developed
properties.
Limitations
This paper
the
real
is not intended
estate capital
to provide a complete
markets
instruments that are available.
a thorough analysis
uses.
or
history of
the various
financing
Nor is it intended to provide
of all securitization programs
and their
Rather, the intent is to provide a specific case study,
of a to-be-developed property, that employed securitization as
a financing
the solution,
time and the
vehicle and
then
given the state
analyze
the effectiveness
of the capital markets
alternatives that were available.
of
at the
In doing so,
past successes and future dilemmas
it attempts to explain the
of using securitization to finance to-be-developed properties.
-6-
CHAPTER II.
CASE STUDY: 75 STATE STREET
The financing for
75 State Street is one of
the most complex
transactions ever
done on a to-be-developed
property and was
named
one of
Pension
the
and
"most innovative
Investment Age.
financing, involved
was
securitized
interest rate
never
(1)
by
third
party
used.
combined to
story office
district,
included
was
owning approximately 40%.
20%.
pre-development
Construction
includes
a
a
A
Beacon
costs
on the
700 car
and
and
limited
and
partnership
Equitable
which
Real
Estate
each
partners,
own the
and the architect,
Equitable
all
of
garage
shared
the
all
risks
of
below grade,
the
equally.
foot development,
mid-1986 and was completed in early 1989.
-7-
Boston's financial
small group of limited partners,
750,000 square
parking
elements had
to-be-built office
general
as the
original landowner
including the
remaining
by
Inc.
Management
Investment
with
(2)
Companies
Beacon
The
issue, which
other interim
of these
building, located in
developed
by
dollar
enhancement,
Various
finance a
building with zero pre-leasing.
The 31
All
in 1987"
$287 million
credit
the rate.
were also
before been
The
a floating commercial paper
swaps to fix
hedging devices
financings
which
began
in
The Players
The origin of 75 State Street dates back to 1983 when the City
of Boston, under the direction of Mayor Kevin White, wanted to
sell several key parking garages
these properties, which they
(RFP)
on, was
portion
of the
Through the
Brown,
the
Kilby
property
adjacent
to the
One of
solicited a Request For Proposal
Street garage,
now occupied
the garage
RFP process,
a prominent
to private entities.
by
properties be joined in order
stood on
75 State
was acquired
Boston landowner.
Kilby Street
which
Street.
by Harold
Brown owned
garage and
a
property
proposed that
the
to develop a first class office
building.
To give
his proposal
Investment Management
Real Estate
Equitable) who
Equitable
$13
largest
only be
Co.
Insurance
pension fund
equities.
Brown the credibility
They
(3) Equitable
the financial entity.
(herein
referred to
estate subsidiary of
Real
of U.S. real
advisor, currently
in assets.
solicited Equitable
Equitable
third largest holder
billion in
$8.3 billion
Inc.
are the independent real
Life
currently the
over
credibility, Brown
are also
Estate
estate with
the
second
advising more
than
initially intended to
They were brought in
he needed to get
is
to give
through the demanding
regulatory process that exists in Boston.
In
1983, Brown,
along
with Equitable
Gund, were tentatively designated
-8-
and architect
Graham
by the Boston Redevelopment
Authority
(BRA) as
However,
shortly
the
thereafter
administration which
Raymond
course.
The
plan for
tentative approval
The first
replaced White
Flynn, the
75
for the
several events
development plan.
altered the
mayor,
development team
BRA
State
occurred
Under
a dramatic
Street that
the new
change
of
received
had
favorably upon by
was not looked
which
the new
event was
in 1984.
took
property.
the new
administration.
Furthermore, Equitable was not
convinced that Brown possessed
the necessary expertise to develop a downtown office building.
As the
financial entity, they
were pressuring him to
find a
Brown finally decided he wanted
partner with more experience.
out of the deal altogether.
to save
In order
Companies to join them
are
a privately
commercial
held
as co-developer.
Boston but have substantial
United States.
Leventhal family
Boston
developed several
real estate.
who established
company.
They are
based in
are closely run
the business
Over the
years,
downtown office buildings and
with the Boston development process.
-9-
both
experience throughout the Eastern
The Beacon Companies
construction
The Beacon Companies
concern, developing
real estate
and residential
The Beacon
Equitable approached
the deal,
by the
in 1946
Beacon
as a
has
are familiar
Equitable
was most
concerned with
getting re-designated by the BRA
on
Beacon's
experience
associations that
Beacon would be
in
the regulatory
with a new developer.
downtown
Boston,
the zoning process.
Equitable was no longer a financial
the
Boston.
believed
the new
that
limited
only as
facing at the time.
to the
They
contribute
also
would
general partner, with 40%
they had
potential,
the
Beacon would
partnership which
the regulatory
weave through
significantly
arrangement
construction experience in the redesign
project.
Brown and Graham
with no control over the project.
development experience
help them
but
new partnership
reduced the risks they were
lend
prior
able to get them through
remained in
Equitable
and
them, they believed
entity but became co-developers with Beacon.
partners,
Based
Equitable has had with
Under the new arrangement,
Gund
risks and
exists in
maze that
their
would
and
design
of the project.
As a
the capital contribution and upside
incentive to
develop a
profitable
Equitable saw their move from being just a financial
entity to co-developer, as
further mitigating their risk.
As
a general partner they potentially had more liability but they
also had more
control over the development.
It also enabled
experience in Boston development for
Equitable to obtain more
future projects they may want to develop themselves.
from
a debt
financial
position
exposure.
to an
The
-10-
position reduced
equity
majority
The move
of
the development
their
cost
would now
be funded by
not want to depend on
a third party source.
Equitable did
their parent company for financing this
venture.
In 1985,
Beacon and Equitable
co-developers
for
approximately $80
from Brown and
was
75
were designated by the
State
million to
Street.
acquire the
the garage from the City of
non-recourse
to
the
two
cross-collateralization.
It
companies
was
secured
They
BRA as
borrowed
existing buildings
Boston.
and
by
The loan
involved
the
no
existing
structures only..
The Financing Objectives
The financing
for 75 State
Street evolved
out of a
list of
objectives that were established by Beacon and Equitable.
objectives were
would
desire
essentially a "wish list"
to have
for
their
The
that any developer
These
project financing.
objectives are outlined below.
1) 100%
$287
Financing.
million,
The
developers wanted
which
was the
total
to finance
project
cost
including reserves for operating deficits during the
lease-up
(tenant
also
period,
and
the
improvements and
included the
million loan
free rent).
repayment
that the
of
leasing
costs
This amount
the existing
developers took out
initial land acquisition.
-11-
actual
$80
for the
2) Fixed Rate Financing.
Interest rates were favorable
at the time and they did not want to risk the chance
of
an adverse
move.
rate financing
They
for both
wanted to
obtain fixed
the construction
loan and
the permanent loan.
3) No
Further
Participation.
co-developers already
the
the
giving 20% of the
limited partners,
anymore away
With
they
to a lender.
did not
two
project to
want to
Essentially
give
they wanted
to obtain the maximum amount of leverage possible.
4) 10 To
12-Year Term.
The rates for
were favorable at the
time, vis-a-vis the project's
proforma, and the developers
for long
term financing.
in early
approximately 9%
term
longer
than
twelve
and
available
ten-year money
wanted to lock them in
(10-year
1986).
years
would
Treasuries were
Financing
was
not
for a
readily
significant
involve
participation on behalf of the lender.
5) Limit Personal
and Corporate
Guarantees.
the project
was highly speculative, they
to stand on
its own.
business, did
to obtain
Beacon, being
not want to give
financing.
Although
wanted it
a family owned
personal guarantees
Equitable Real
Estate wanted
to act as a co-developer and not be dependent on the
credit of their parent company.
the parent company for
If they had to use
credit enhancement, it would
have cost them 1% of the principal amount.
-12-
6) Right To
long
Pre-Pay.
term
Although the
financing,
they
flexibility to
pre-pay the
little
penalty.
or
no
maximum amount
or
partnership wanted
also
wanted
money at any
This would
refinance
it
once
it
was
time with
give
of flexibility to sell
the
them
a
the property
fully
leased
and
seasoned.
7) Lowest
to
Cost.
meet
all
Even
of
though the
developers
their objectives,
obvious limit on
there
what they were willing
wanted
was
an
to pay for
these advantages.
The Financing
The partners considered traditional financing alternatives but
realized that
none of these
all
key objectives.
of their
alternatives were going
Ten-year, fixed-rate,
loans were
not available for an
building.
The partners
lease
with
financing.
an
anchor
require substantial
ended
but to
loan
get
participating and/or
This
would seriously
Furthermore,
on a
they
a
commitment
the participating
pre-payment penalties.
-13-
the
could
obtain
take-out
would require
a
pension fund.
partners equity
mortgage
would
A closed
forward
convertible mortgage to a
dilute
below market
the partners.
requires
such a
so
do a
construction loan
guarantees from
construction
commitment,
want to
just
ended
bullet
unleased, to-be-built office
did not
tenant
Going open
to meet
position.
would carry
severe
After a brainstorming session over the above set of objectives
with the investment
partners decided
techniques
banking firm of Goldman Sachs
to try to apply
to real
estate.
The
& Co.,
the
certain corporate financing
elements of
the successful
financing are outlined below.
Commercial Paper Program
To raise
the $287
paper carrying
to carry
the lowest
the
partnership
investment grade
who
has
In order
to sell commercial
rating
credit in
the amount
issuance and then
of
by
never get the required ratings.
a third
needed
of
party
project.
the U.S.
all
retained for the credit enhancement.
of
S&P and
project, so
the
rating to guarantee the
the highest
the paper
from both
grade rating
pre-leasing on
no
itself, the development would
Therefore,
partnership issued
interest rate possible,
an investment
There was
Moody's.
funds, the
commercial paper.
floating rate
had
million in
with
an
Citicorp,
banks,
was
Citicorp posted a letter
$287 million
acted as the commercial
to guarantee
the
paper dealer.
The
letter of credit guarantees the paper for a ten year term.
Interest Rate Swaps
The commercial paper was issued approximately every 90 days to
approximate
the construction
amount
issued it
was
Citicorp continues to be
will
draw schedule.
float
for
a ten
Once the
year
full
period.
the dealer, constantly revolving and
-14-
re-issueing
the
commercial
paper.
paper
program
desired fixed-rate
interest
rate
is
swaps
to
commercial paper.
Goldman
rate.
series of
The swaps were
swap
forward
issuence of the
provided the
decided
to
solicited
bids
Goldman
that
set up to
conuterparties
let
to
avoid
from
forward swap commitments and, in
awarded three
rate swaps
the
developers
Eight
the partnership
the
find
Citibank was
interest
the
once.
counterparties for the eight
fact,
for
entered into a
Although Citibank could have
pricing.
monopolistic
the
draw schedule and the
commitments,
Sachs
and
rate
established since the commercial paper
match the construction
swap
floating
fix
being issued all at
forward
the interest
financing, they
serial-swaps had to be
was not
Since
eight swaps.
of the
were entered
into
are listed
The
in
Exhibit 2.1, 75 State Street Interest Rate Swaps.
One of the risks inherent in
commitments are
based on
Citicorp's
30-day
rating.
composite
currently
slight,
Although
and
any
the
Citicorp's
downgrading
Citicorp's
rating would
Given
amount of
the
the Federal Funds
obligation for the actual
Index, while the
on
the transaction is that the swap
debt
payments is based
spread
commercial
or
increase this
sovereign
30-day Composite
inherent
between
the
paper
is
rumors
in
spread significantly.
held by
Citibank
currently outstanding, this possibility is not remote.
-15-
and
75 STATE ST.
Interest-Rate Swaps
Fixed
Ultimate
Counterparty
Ha
05~
Amount
(millions)
Rate
Start
Date
End
Date
Annual
Fixed
Rate
Pay
Dates
Floating Rate
(N.Y.F.R.B
H-15 Composite
1-mo. C.P. Rate)
Receipt Date
(in arrears)
Floating Rate
Set Date
P1111
Group, Inc.
$100
1/5/87
1/1/97
8.15%
3/1 & 9/1
1st of each month
1st day of each period.
UBS Securities
(Union Bank ofr
Switzerland
affiliate)
$25
9/15/87
12/15/96
8.451%
6/15 & 12/15
15th of each month
Avg. rate during each
period.
Citibank, N.A.
$25
12/15/87
12/15/96
8.542%
6/15 & 12/15
15th of each month
Citibank, N.A.
$25
3/15/88
12/15/96
8.632%
6/15 & 12/15
15th of each month
Citibank, N.A.
$25
6/15/88
12/15/96
8.722%
6/15 & 12/15
15th of each month
Morgan Guaranty
Trust Co.
$25
12/15/88
1/15/97
8.727%
15th of each
month
15th of' each month
KDCF (Kleinwort
$25
Benson Cross Financi ng)
3/15/89
12/15/96
8.97%
6/15 & 12/15
15th of each month
12/15/96
9.56%
6/15 & 12/15
15th of each month
KBCF
$36.5
6/15/89
1st day of each period.
$286.5
Note:
If any Pay Date, Receipt Date or 1-mo.
the next business day.
C.P. Rate Setting Date falls on a weekend or holiday it will become
The combined
eight swaps
gave the
development a
fixed rate
payment of slightly more than 9.5% for a ten year period.
The
developers obligations under the swap contract are as follows;
1)
Pay
the
Federal
commercial paper,
index
and
from
2) Cover
Citicorp's
0 to
10
the issuers
approximately
Bank's
30-day
points),
paper
3)
Pay
for
100 basis
the letter
the commercial
points but
of
for
the composite
(currently
between 10 and 12 basis
fee
composite
the spread between
commercial
basis
dealer's fee (ranges
Pay
Reserve
points),
ranging
paper
and 4)
credit (which
can range
was
anywhere from
50-200 basis points).
Additional Hedges
One
of
the
problems
inherent
with
financing vehicle is the time involved.
11 months
to close the
interest
financing,
throughout
the year
change in this
instead of
were
falling
To protect
trend, the developers bought
early in the process.
10-year Treasuries
futures, because
themselves from a
to fall and wanted to
trend.
-17-
Beacon and
dramatically
themselves from
a
"put" options on
They chose options
although they wanted
rise in interest rates,
rates would continue
a
While they were working out
rates
(1986).
as
It took approximately
transaction from the time
Equitable started working on it.
the
securitization
to protect
they believed that
benefit from this
The 120 day option was for 10-year Treasuries at 8%, which was
50 basis
amount
points out of
equal
the money.
to their
principal
Interest rates
continued to fall
option expire.
However, several
locked in their rate by
Treasuries, which at
The premium paid
amount
was $5.5
for an
million.
and the developers
let the
months later, the developers
selling short $280 million of 10-year
the time were in the low
7% range.
The
cost of the short sale was 10 basis points.
Summary
The financing
for 75
objectives,
approximately
maximum
State Street met
giving
them
9.5%.
This
financing gives
They
can unwind
flexibility.
10-year
program at any time, simply
the roll
over occurs.
The developers
interest rate
market
and
swaps can
paying the
future value (if
place and applied
The
credit
financing
any).
at
partnership
paper
downgrading in
have a significant adverse impact.
conventional financing
support the commercial
also be unwound
difference
also
expensive guarantee can be found.
-18-
be
The
them to
the current
Conversely, the swaps can
can
paper.
by marking
between
to the new financing
enhancement
the
fixed
the commercial
reason, any
could simply switch to
another party to
the partner's
by not re-issueing the paper when
For this
Citicorp's rating does not
or find
all of
and
be left in
or another financing.
replaced
if
a
less
A LIBOR
(London
interest rate
Interbank
swaps would
Offered
Rate)
have given the
based
loan
with
developers similar
flexibility and would have eliminated the differential between
the
30-day composite
paper.
However,
developers
even
found that
would have been
index and
with
LIBOR
Citicorp's rated
this
spread
eliminated,
based financing,
at the
25 basis points more expensive.
million financing,
the 25 basis
points equated to
$700,000 per year in extra finance costs.
-19-
commercial
the
time,
On the $287
more than
NOTES TO CHAPTER II.
1. Hemmerick, Steve.
"Innovative Financings
Prevail In
1987's Deals,"
Pensions and Investment Age, Fall
1987.
pp. 2.
2.
Ibid.
3. Kateley, Richard.
1989." Real Estate
pp.
"Emerging Trends In Real Estate:
Research Corporation. November 1988.
17.
-20-
CHAPTER III.
THE REAL ESTATE CAPITAL MARKET
To
analyze
effectiveness of
is necessary to
of
financing
the
75
set forth the evolution that
the
has occurred in
Exhibit 3.1 depicts a model
traditional real estate capital
John McMahan Associates.
and
properties, it
securitizing to-be-developed
the real estate capital markets.
of the
Street
State
market established by
This model shows a clear distinction
between the sources of debt and equity.
Exhibit 3.1
Traditional Real Estate Capital Market
Thrift
Passbook
BankMorag
Life Policy
insurance
Developer
Attorney
InvestorsLi
Equities
ted
Partnrsip
tnerh
DAccountant
Broker
Private Syndicator
Capital
Source
Source;
Instrument
Capital
Intermediary
John McMahan Associates
-21-
Inc.
Investment
Intermediary
Investment
In the
traditional capital
market there were
parties who ultimately invested
Commercial
banks invested
three distinct
in a real estate development.
in the
form of
short term
debt, and the
invested through long term
insurance companies
debt,
development partnership retained all of the equity.
Traditional
around
revolved
institution,
a
take-out was essentially
fund a long-term
occupancy.
insurance
from
company.
an
The
life company to
a commitment by the
reached a stabilized
loan once the property
This loan was usually self-amortizing with a fixed
interest rate for
a 25-30 year term.
With
the commitment in
then get
100%
financing from
the developer
hand,
life
the
typically
commitment
take-out
forward
properties,
to-be-developed
for
financing,
could
a
commercial bank for the short-term construction loan.
Prior to the 1980's, the
traditional model of the real estate
efficient and represented little
capital market was extremely
risk to
the parties
The life
involved.
insurance companies
mitigated their risk by not funding until the building reached
a stabilized
occupancy.
investment.
The
At
that
uncertainties
it
point,
of a
new
was
a
development
safer
were
removed and the building could produce a steady stream of cash
flows to service the debt.
For
the construction
investment.
lender it
Real interest
was also
a relatively
rates at the time
-22-
safe
were stable and
markets
were
not
lease-up period
take-out
overbuilt,
could be
commitment
so
the
construction
accurately forecasted.
from
the
life
and
Having the
company
gave
the
construction lender an assurance that the money would be there
to take them out of the
Traditionally, the
development once it was fully leased.
would only be
construction lender
deal for a two to three
in the
year period, depending on the size of
the development.
events
there have
past decade
in the
However,
occurred in
that have
dramatically altered
been several
the United
States which
have
estate and
market for real
the capital
major
the traditional forms of financing.
The first of these events actually occurred more than a decade
ago, but
the effects of it
on the real estate
In 1974, major pension legislation,
not felt until recently.
(Employee
commonly
known
as
ERISA
Security
Act),
was
enacted.
established minimum
for
pensions
of
amounts that
future
For
portfolios, the fund
estate.
Eventually,
retirees.
the
first
time,
The
effect
ERISA
set aside
of
this
supply of new investment
(1) In an effort to diversify their
managers slowly began to
the domestic pension funds
life insurance companies as the
estate.
Investment
Retirement
employers had to
legislation created an unprecedented
dollars in pension funds.
industry were
(2)
-23-
invest in real
replaced the
primary investor in U.S. real
The second major
chairman of
to
event came in October of 1979,
the Federal Reserve Bank
control the
rates.
nation's
This allowed
rates, and for the first
(Paul Volcker),
money supply
the
when the new
free market
started
rather than
interest
to
interest
set the
time in recent history, a relatively
stable interest rate environment disappeared.
The advent of the Reagan administration compounded the problem
when
they
Q,
repealed Regulation
which
had regulated
the
interest rates that banks could pay on various accounts.
deregulation of
invested
banks and thrifts
in real
estate,
freed up more money
while giving
This
to be
to
more uncertainty
interest rates.
rates
and
in recent
began
United States
(3)
highest
the
experienced
government
Exhibit 3.2.
of
real interest
history.
incurring
inflation to
interest
rates
and
Note the dramatic
that
Simultaneously,
major budget
began incurring
This caused
volatility
nominal interest
resulted in extremely volatile
These events
become equally
inflation rates
have
the Federal
deficits
major foreign
we
and
the
trade deficits.
volatile.
are
shown
The
in
increase in the real interest
rate, which is the spread of the nominal interest rate (shown)
over the inflation rate.
-24-
Exhibit 3.2
Financial Volatility: Prime Rate Vs. Inflation Rate
PERCENT
20.0-
17.5 -
15.0 12.5 10.0 7.55.0-
2.5
1970
U.S.
Source;
1975
1980
1985
1988
Bureau of the Census, Real Estate Research
Corporation.
seventies
in the late
volatility that was occurring
With the financial
and early
eighties,
term life insurance rather than
individuals began
purchasing
(4) As a result,
whole life.
the life insurance companies could no longer count on a steady
flow of insurance premiums for the future.
their only source
fact that real
of funds, combined with the
developments
estate
The uncertainty of
becoming
were
more
costly
and
the
construction/lease-up periods taking more time, meant that the
life
insurance
forward
could no
companies
commitments.
(5)
The
-25-
longer
give
primary source
developers
of funds
for
financing in
permanent
the traditional
market was no longer available.
real estate
capital
This forced the developers of
75 State Street and the rest of the industry to look elsewhere
for their long-term money.
The
pension funds
as the
major source
capital for
of long-term
pension act in 1974, the volume
Since the ERISA
real estate.
the domestic
replaced by
companies were
life insurance
of pension fund money needing to be invested has significantly
increased .
In the past four years the pension funds have more
than doubled.
The top 200 pension funds now control well over
trillion
dollars.
control over two
and the top 1000 funds
one trillion dollars
the
Although
of their
percentage
total
assets invested in real estate has remained relatively stable,
the
total dollar
dramatically.
amount invested
in real
estate has
grown
(See Exhibit 3.3; Pension Fund Asset Mix).
Exhibit 3.3
Pension Fund Asset Mix For The Top 200 Funds
Asset type
Stocks
Bonds
Cash
1984
S Billions Percent
264.3
214.2
66.7
41.2
33.4
10.4
564.0
378.4
98.2
47.1
31.6
8.2
2.2
3.3
40.7
3.4
Mortgages
Mortgage-backed securities
14.1
18.6
2.2
2.9
GICs
19.2
3.0
23.1
641.4
3.6
100.0
16.8
40.7
27.5
31.1
1,197.5
1.4
3.4
2.3
2.6
100.0
Real estate equity
Other
Total
Source;
1987
S Billions Percent
Pension and Investment Age, Real Estate Research
Corporation.
-26-
With
the
capital
financial
the
markets,
protecting
volatility
their
pension
combined
with
negative
correlation
investment vehicle
the
returns on
primary
and
hedging
opportunity
which
stocks,
for pension
real estate
in
the
concern
was
inflation.
provided a good hedging vehicle
diversification
to
occurring
funds
principal
Historically, real estate has
a
that was
and
funds.
due
is
the
Exhibit
the S&P
to
it's
primary
3.4 compares
500 to
inflation,
indicated by the Consumer Price Index.
Exhibit 3.4
Real Estate Pooled Fund Returns
and the S&P 500 Vs. Inflation
Year
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
Arithmetic
mean
Source;
Pooled real estate funds
Unrealized
Income Total
appreciation return return
1.3%
2.4
3.2
8.0
11.2
8.6%
8.8
8.8
9.6
9.6
9.9%
11.2
12.0
17.6
20.8
18.2
16.8
9.1
14.2
13.7
10.3
8.6
8.9
9.3
7.9
0.6
5.8
5.3
8.9
2.6
7.7
1.4
0.5
7.2
6.9
7.4
4.5
8.5
13.1
8.5
8.4
8.4
S&P 500 stocks
Unrealized
Income Total
appreciation return return
28.4%
15.1
(8.4)
3.4
8.4
26.4
(8.2)
11.9
21.2
(0.3)
19.2
23.7
2.0
11.0
4.3%
3.8
4.6
5.3
5.5
3.1
32.7%
18.9
(3.8)
8.7
13.9
31.7
(3.0)
17.7
25.6
4.3
23.4
27.2
5.1
4.6
15.6
5.3
5.2
5.8
4.4
4.6
4.2
3.5
CPI
7.0%
4.8
6.8
9.0
13.3
12.4
8.9
3.9
3.8
4.0
3.8
1.1
4.4
6.4
Real Estate Profiles, Evaluation Profiles; Standard
& Poor's; U.S. Department of Labor, Bureau of Labor
Statistics;
Real Estate Research Corporation.
-27-
all the turmoil, has
The result of
cost
the financial
and
of financing
drastically increased the
risk
involved in
new
What has emerged is a new structure to the real
developments.
(See Exhibit
estate capital market.
3.5; The New Real Estate
Capital Market).
Exhibit 3.5
The New Real Estate Capital Market
Short Term
Savers
Passbook
Thrilt
Money Market
Bank
CD's
Capital
Source
L
Instrument
te
Investment
Intermediary
Capital
Intesmedlary
Investment
Source; John McMahan Associaties Inc.
In the
new structure there has
distribution of
had traditionally
been a dramatic shift
risks and rewards between
put up
equity and those
-28-
in the
those parties that
institutions that
had
traditionally
companies who
out of
supplied
had been the
debt.
(6)
life
insurance
primary source of debt
have been
the forward take-out business
years.
(7)
Instead
they
The
have
for approximately seven
focussed
on
investing
in
seasoned properties or providing advisory services for pension
funds.
volatility of
The
interest rates caused
the pension
funds to drastically reduce the term of their fixed-rate loans
years, to not more
from thirty
short as seven.
sought equity
To hedge
often as
than ten years, and
their inflation concerns, they have
positions or
equity disguised
as debt
in the
form of participating and/or convertible mortgages.
While
foreign investors were also
strategies of domestic investors,
affecting
the
financing
investment became
world's
capital markets
of real
estate.
Foreign
result, the
domestic
affected by the
level of
As a
nation.
are now constantly
capital
became the
the United States
essential as
largest debtor
investment
altered the
events dramatically
the above
interest rates, currency exchange rates, and the stock markets
in Europe and Japan.
As
lenders adjusted
(8)
their investment
developers to adjust theirs also.
capital
market structure
is
strategies, it
forced
What evolved under the new
a mixture
of
debt and
equity
instruments such as development partnerships, fee development,
participating-type mortgages and
traditional form of financing,
-29-
securitization.
Gone is the
with the developer owning 100%
of
the project
with a
long term
mortgage for
100% of
the
project's costs.
Developers have become
much more risk adverse
under
capital
They
the traditional
are
more
potential in
parties.
The pension
earlier in
some
of
willing to
the development
The financing
the
allow
ten years
the
the downside risks on
funds are
their returns.
emerged,
surrender
order to spread
these risks
boost
to
willing
structure of
than they were
institution
investment anywhere along the
to
ago.
upside
to other
assume some
process in
order to
alternatives that
enter
a
risk spectrum.
of
real
have
estate
They also allow
a developer to assess their risk preferences, and assign those
risks that they are not willing to take on to other parties.
The
new capital
the
real estate
and
the
is a
process.
an increasing
light
new level
The
become
more
financing tools
comfort
of Wall Street.
in
the
of
with the
-30-
to better
risk
their
in
risk adverse
involved in
being used
the
today
capital markets
on
knowledge of real
These forces
decision process,
financing, for 75 State Street.
in our
of sophistication
developer, and an increasing
estate on behalf
part
in
developers become more
finance, as
behalf of the
integral
rewards
lending institutions
development
reflect
and
risks
The result
profiles.
greater efficiency
rate environment, enabling investors
high interest
balance
structure allows
and
all played an
the
ultimate
NOTES TO CHAPTER III.
1. Perriello, Robert, "New Real Estate Financing Methods
Banker and
Changes In
Capital Markets".
Reflect
Tradesman, December 16, 1987.
2. Downs, Anthony.
The Revolution In Real Estate Finance,
The Brookings Institution, 1985. pp. 215.
3. Perriello, Robert, "New Real Estate Financing Methods
Banker and
Capital Markets".
Changes In
Reflect
Tradesman, December 16, 1987.
4. Ibid.
5. Ibid.
The Revolution In Real Estate Finance,
6. Downs, Anthony.
The Brookings Institution, 1985. pp. 8.
7. West, Richard.
Principal, West Partners.
San Diego, Ca.
8. Perriello, Robert, "New Real Estate Financing Methods
Banker and
Capital Markets".
Changes In
Reflect
Tradesman, December 16, 1987.
-31-
CHAPTER IV.
THE NEW FINANCIAL STRUCTURES
In order to
put
in
analyze the complex financial
place
for
understand the
them.
75
State
for 75
alternatives,
instruments
that
structure.
it
is
necessary
financing alternatives that were
The developers
different
Street,
structure that was
State Street
all
of them
had emerged
These
from
included
available to
explored several
being
the
to
relatively
new capital
development
new
market
partnerships,
participating and/or convertible mortgages, accrual mortgages,
or floating
cap.
rate instruments
The
against
developers
combined with an
weighed
their financing
each
of
objectives and
these
interest rate
alternatives
the risks
they were
willing to assume.
Development partnerships between
are
most popular
currently the
rewards among
Life
it did
program
way to
the different parties.
is considered
ventures.
pension funds and developers
to be
(1)
the pioneer
risks and
shift the
New England Mutual
in development
joint
The concept was first used by them in 1966, however
not take
and
off until they
formed
Copley
Today, Copley is considered
ventures, which
is still
separated their
Real Estate
real estate
Advisors
in
1982.
the leader in institutional joint
a relatively
pension funds.
-32-
new concept
for most
Pension
funds traditionally
shyed away
from to-be-developed
equity investments due to the high degree of risk.
the past
the
few years,
pension funds have
development process
their
returns and
welcomed
by
the
hedge
However in
increasingly entered
earlier on,
in an
effort to
inflation.
Their
desire has
development
community.
With
boost
been
fixed-rate,
forward commitments no longer available, developers have to go
open
ended
markets
on
and
increasing
involved,
their
rising
costs
of
construction
interest
partners that
rates,
development
many developers
loans.
are well capitalized
softening
combined
and
are forced
With
the
length
to find
with
the
of
time
joint venture
and willing to
share the
risks involved.
The
developers
of 75
State
Street
explored a
partnership
arrangement with both domestic and foreign pension funds.
of the problems encountered was
development.
With
no
One
the speculative nature of the
pre-leasing
in
place,
there
was
essentially no pension fund willing to contribute $287 million
in equity.
least
20%
Beacon and
A development partnership would
equity contribution
Equitable, and a
fund in the order of
of
the
original
9-10%.
partner's
($57
have required at
million)
on behalf
preferred return to
the pension
Furthermore, the equity position
interests
would
be
diluted, by a magnitude of approximately one-half.
-33-
of
seriously
Participating and/or convertible mortgages presented a similar
problem
for the
currently
developers.
the
most
widely
to-be-developed projects.
equity disguised
as debt
used
In
of
the
deal
promising half
would also
would have
on
the
note.
Under
to
of the cash
the
lender.
mortgages
and
the
see their equity position
flows to
the lender.
structure, half of the back
go to
participating-type
is essentially
equity and pay a preferred return
coupon rate
Under the convertible
for
participates in
The developers
participating structure, they would
diluted by
instrument
is
this respect it is very similar
development partnerships.
the form
debt
because the lender
contribute a minimum of 20%
in
participating mortgage
(2) The instrument
the project's cash flows.
to
The
A
end of the
further analysis
an example
of
a
of
current
financing using these structures is given in Appendix A.
Another debt instrument
that has evolved out of
estate
is
capital
market
the accrual
essentially a fixed-rate instrument that
in the early years.
the new real
mortgage.
This
is
has a lower pay rate
The difference in the pay rate and coupon
rate accrues
and is paid
was designed
to give developers
at maturity.
The
accrual mortgage
a lower debt service
in the
early years before the property stabilizes but give the lender
a higher
coupon
development.
matches the
In
rate
overall
from
this way, the accrual
project's cash flows than
mortgages did.
Although the
-34-
the
back
end
of
the
mortgage more closely
traditional fixed-rate
accrual mortgage generally gives
a developer a higher loan
it is
amount than conventional financing,
usually lower than what
provides.
Therefore,
a participating-type structure
100% financing
would not
under this alternative.
Due to the lack
accrual
require
mortgage
would
be available
of pre-leasing, the
personal
and/or
corporate
guarantees as well, something that Beacon and Equitable wanted
to
avoid.
Appendix
financing
an
using
B
outlines
accrual
the
terms
mortgage
of
in
a
current
comparison
to
conventional financing.
The developers of
75 State Street also explored
floating rate loan
rate cap.
this
and then fixing the rate
with an interest
Although they would
have had to
post guarantees,
would have
the
scenario
desired.
yielded
100% financing
they
However, interest rate caps had limited availability
for more than a seven year term.
a longer
going with a
period
prevailing
were
interest
400
five years.
to 500
rate.
protection in lieu of the
Caps that were available for
This
basis
did
points
not
above
provide
the
much
volatile interest rates of the past
Even at this level, the cap would cost between 50
and 70 basis points of the principal amount.
-35-
NOTES TO CHAPTER IV.
1. Downs, Anthony.
The Revolution In Real Estate Finance,
The Brookings Institution, 1985. pp. 215.
2. Clagett, Gordon.
Boston, Ma.
Principal,
-36-
Aldrich Eastman
& Waltch,
CHAPTER V.
SECURITIZATION
The securitization program
Street
epitomizes the
estate capital
Street
into
commercial
first
departure
the
real
real estate
Investment
the traditional
a
Securities
relatively recent
(1) They
evolved out
(CMO's).
All
of
risk
as commercial
as Real
Mortgage
and Collateralized
Mortgage
these
vehicles
investment
properties bundled together.
investor less
of the
Estate
Conduit's (REMIC's),
Real
for
phenomena,
several forms such
(REIT's),
real
integration of Wall
industry.
These took
Trusts
involved seasoned
the
are
finance 75 State
market and first appeared
mortgage securities.
Obligations
estate
late 1983.
residential mortgage
Investment
from
market and the continuing
emerging in
Estate
that was used to
through secured
This offered
income streams
and
geographical diversification.
In the past four years,
estate securities ranged
billion
in
1985.
compared to the
now
estimated
the annual volume for commercial real
from $10 billion to a
However,
these
volumes
total amount of commercial debt
to exceed
$1
trillion,
high of $19.7
are
in the U.S.,
and commercial
estate equity now estimated to exceed $2.2 trillion.
The
securitization
of
much slower to develop.
used
to finance
75
miniscule
to-be-developed properties
real
(2)
has
been
The commercial paper program that was
State Street
-37-
was
highly successful
in
meeting all of the developers
time
securitization
office
building.
was
(3)
used on
When the
many people in the industry
future
of
reinforced
the
in
an
to-be-built
transaction first
industry.
securitization
Seattle
unleased,
occurred,
believed securitization to be the
development
by the
development
objectives and marked the first
This
of the
belief
1201 Third
Washington, which
was
Avenue
occurred
shortly
securitization as the
wave of
after 75 State Street.
continues to tout
Wall Street
securitizing
associated
commercial real
it.
with
it
securitization,
successful in
untapped potential of
they recognize the huge
the future, as
estate
However,
is necessary
the past, and the
to
and the
fees that
the future
determine
to
why it
understand
are
of
was
advantages and disadvantages
of using it in the future.
The success of securitization programs depend on the perceived
risk
of the
reason,
investment
investors
compare the risk
in
by the
real
capital
estate
markets.
securities
of the investment (determined
For
will
this
always
by the credit
rating) to the
risk free investment of U.S.
similar term.
When deciding if securitization
is a feasible
must therefore compare
the like-term
alternative, developers
Treasury plus
the securitization costs,
the same duration.
-38-
Treasuries of a
to a bullet
loan of
paper for 75 State
The commercial
year
term.
bullet
the past
Over
over
loans
Street was based on
Treasuries
10-year
volatile, sometimes changing as much
single year.
the spread
six years
has
been
a ten
of 10-year
extremely
as 150 basis points in a
(See Exhibit 5.1; Spread of 10-Year Bullet Loans
Over 10-Year Treasuries).
Exhibit 5.1
Spread of 10-Year Bullet Loans Over 10-Year Treasuries
Basis
Points
300
270
240
210
180150
120
90
60
30
0
'84
'85
'87
'86
'88
'89
Years
Goldman Sach's & Co..
Source;
Barron's,
At the
time of
bullet
loans over
basis points.
the financing
(1986),
10-year Treasuries
This gave the developers
to cover the 120 basis points
the spread
of 10-year
was approximately
230
a significant spread
in fees, plus the spread of the
Federal Funds 30-day Composite Index for dealer paper over the
-39-
Treasury bill, approximately 70
mid-1987,
the spread
of
basis points.
10-year bullet
However, since
loans over
10-year
Treasuries has remained relatively stable, ranging from 120 to
130 basis points.
This is the
primary reason why we have not
seen more commercial paper issues on to-be-developed projects.
Developers continue
to see
securitization as
an alternative
loans and participating-type mortgages
but are finding bullet
to be significantly less expensive in today's market.
The
costs that
involved in
are
detriment to its
is a
needed on most
that is
major
costs is the
The largest of the these
use.
credit enhancement
securitization
(4)
new developments.
The success and pricing of a real estate security depends upon
the credit rating that the property receives.
bonds, such as Standard &
that have typically rated corporate
Poor's
Phelps, have
real
estate.
requirements for such
adapted their
(See
these
Due
ratings).
developers have to
&
ratings to
minimum requirements
for the
Appendix C
credit ratings, and a definition
needed for Standard & Poor's
of
and Duff
Services
Investors
Corporation, Moody's
Credit agencies
to
the
stringent
credit enhancement to
turn to third party
obtain an investment grade rating.
requirements,
The developers of 75 State
Street used Citibank as the third party guarantor for a fee of
approximately
100
securitization of
from
Deutsche Bank
basis
points
or
1201 Third Avenue
AG
to guarantee
issue of $120 million.
-40-
$
2.9
million.
used a letter
The
of credit
their commercial
paper
The
fees for
increases
the
properties
third
party
cost
of
compared
Companies were able
fully leased
credit enhancement
securitization
to
seasoned
of
significantly
to-be-developed
properties.
The
Beacon
to obtain a AA rating on
Center Plaza, a
Boston office building, without
any third party
credit support.
They
were able to obtain
approximately 40 basis points less
10-year Treasuries being 10 basis
financing at 9.1%,
than 75 State Street, with
points higher (7.3%) at the
time of the issue.
If
developers
can
avoid
using
third-party
securitization is much more attractive.
Complex
in Westchester
this.
The
headquarter
1.1
million
the five
The property is
County, New
The IBM Somers Office
York, is
square
foot
operating units
an example
development
of IBM
a joint venture between
guarantees,
of
will
United States.
IBM, The Shorenstein
Company and Bechtel Investments Inc. and will be leased to IBM
for a
term beyond
the term
of the
debt.
The
$206 million
worth of twelve year notes were rated AAA by Standard & Poor's
and Aaa by Moody's Investor Service
tenant.
This financing
ever to receive
of these
was the
due to the quality of the
first mortgage
the highest possible credit
agencies.
(5) Unfortunately, most
rating from both
developments are
not pre-leased to such blue-chip companies as IBM.
-41-
transaction
The cost of credit enhancement
can range anywhere from 50-200
basis points depending on the level of risk in the development
that is
Street
perceived by the
was
sponsor.
speculative,
with
(6) Even though
zero
75 State
pre-leasing,
it
was
perceived by Citibank to be a relatively low risk deal for the
following reasons;
A) The Boston office market
the nation.
The lack
The developers did
lease
with
an
was among the strongest in
of pre-leasing was by design.
not want to sign
anchor
tenant
a below market
just
to
obtain
financing.
B) 75
State
Street was
considered
to
be the
prime
location within Boston's financial district.
C) The quality
75
of the building was
State Street
the
most
considered to give
prestigious address
in
Boston.
D) The quality
and size of the
developers, Beacon and
Equitable, gave further assurances that a successful
project would
be developed
and that a
default was
not likely.
Without the above conditions,
the commercial paper program on
an unleased, to-be-built office building, may not have yielded
such low financing costs without additional credit enhancement
or guarantees from the developers.
-42-
As the cost of development
believe
that
securitization
monopolistic pricing
increases, the
the
worth
of
debt.
decreases
debt.
This
power
monopolistic
of
of financing
only
way
As the
rapidly.
developments such as
in
avoid
a deal
to finance
When dealing
75 State Street,
results
the
with
there are
$300 million
complexity
and
several lenders or suffering the
dealing
the
to
size of
willing to finance
inefficiency of dealing with
capable
the
capital sources willing
sources of capital
very few
is
of their
number of
required amount
large scale
continues to increase, many owners
with
entire
the
few
amount.
This
institutions
fundamental
problem was a primary factor in the decision to securitize the
development of 75 State Street.
(7)
Securitization provides access to a broader range of financing
sources and
costs.
have
By
therefore can give the
developer lower borrowing
accessing the capital markets
able to
been
of
neighborhood
financing.
achieve
50
basis
all-in
points
directly, borrowers
financing costs
lower
than
in
the
conventional
(8) On a $100 million loan, this could equate to a
savings of $500,000 annually and $5 million over the life of a
ten year loan.
However,
many developers
lender to deal with is
and one
believe
having a
single
a major disadvantage to securitization
of the primary reasons
more popular
that not
why the vehicle has
with to-be-developed
-43-
projects.
(9) One
not been
of the
traditional
advantages
supplied by
a large
flexibility
that often
relationship.
usually
potential,
using
develops
evaluating
non-systematic
or
the
risks,
their
course of
the
advisors,
are
returns,
and
are often unique to
financing
purported long-term
through the
institutions,
at
possibilities that
non-securitized
institution, is the
The
experts
to
appreciation
the
development
a particular project.
If the institutions that are supplying the capital have enough
of a time horizon, and they share in the developer's vision of
the project's potential, they often exhibit the flexibility to
change
rates,
terms,
restructure
the
additional capital to a troubled property.
In contrast, the
relatively
securities.
is not
debt as
of the
impersonal,
as
are
When a securitized
the agencies
investment
and understanding to
it signals a
that
and equity are
who
rate
the
does not
negative signal
restructure the
If the developer
to raise additional capital,
community
supply
project gets in trouble there
in traditional financing.
existing issue,
or
(10)
markets for securitized debt
the flexibility
second issue
debt,
tries a
or a restructuring
troubled venture
understand
conditions.
This
will greatly
cost of the
capital infusion, at precisely the
the
to an
market
increase the
time when the
developer needs relief.
The securitization
the nature
of 75 State
of the capital
Street was successful
markets at the
-44-
due to
time, particularly
the high cost of conventional loans in relation to Treasuries.
Until we return
to the large spreads encountered
in 1982 and
1986, the high costs involved will prevent securitization from
being a
financially feasible alternative
projects.
and the
However, developers must
disadvantages discussed
for to-be-developed
weigh the costs involved,
above, against
the relative
advantages securitization provides.
Securitization offers
overall amount,
superior flexibility as to
and prepayment of the
the timing,
financing.
The timing
of an issue can be done all at once for permanent financing or
it
can be
schedule.
staged
The
over
total
time to
amount
million to over $1 billion,
any
institutional
non-recourse
significantly
less
can range
anywhere
Furthermore,
borrower
than
a construction
draw
from
$25
greatly exceeding the capacity of
lender.
to the
match
and can
the
the
be
typical
financing
prepaid at
yield
is
costs
maintenance
penalties that are imposed on conventional loans.
The true test for the
when
While
securitization of real estate will come
existing securitized
there
has been
projects
much
focus
securitization (the lack of annual
service),
Wall
Street faces
(11) Similar
is too
a financing
cycle.
-45-
on
to be
refinanced.
the default
risk
of
cash flows to pay the debt
the more
refinancing risk.
recent of
need
severe problem
of the
to junk bonds, securitization
tool to have
seen it
go full
The future costs of securitization will depend on how well the
rating
agencies have
party sources
securitization
assessed the
have to fund
on to-be-developed
like ten years
how many
their guarantees. -The
what the capital markets look
will look
risk and
future of
properties depends
on not
like today but rather what they
from now.
1980's, the real estate capital
third
As
we have seen
in the
market will continue to adapt
to the changing financial markets and the risk profiles of the
investment community.
-46-
NOTES TO CHAPTER V.
1. Kane, Carol and Weinstein, Robert.
"Alternate Structures
For Commercial Mortgage Securities, The Real Estate
Finance Journal, Summer 1989.
pp. 73.
2. Louargand,
Marc.
Phd.
Center
For
Real
Estate
Development,
Massachusetts Institute
of Technology.
Estimated from Federal Reserve Board Data.
3. Hemmerick, Steve.
"Innovative Financings Prevail
In
1987's Deals,"
Pensions and Investment Age, Fall 1987.
pp.
2.
4. Mahony, Kevin. Vice President, Managing Director, Copley
Real Estate Advisors. Boston, Ma.
5.
Healey, Thomas
"Rated
J.,
Ewald,
Mortgage Notes:
Charles R.,
An Attractive
Estate Finance Journal, Summer 1989.
6. Miller, Adair.
Boston, Ma.
Feder,
Leslie M.
Investment," Real
pp.
70.
Vice President, Citicorp Real Estate Inc.
7. Harwood, C.J.
Senior Vice President, Equitable
Estate Investment Management Inc.
Boston, Ma.
Real
8. Healey, Thomas J., Ewald, Charles R., Feder, Leslie M.
"Rated Mortgage Notes: An Attractive Investment," Real
Estate Finance Journal, Summer 1989.
pp. 69.
9. Mahony, Kevin.
Vice President, Managing Director, Copley
Real Estate Advisors.
Boston, Ma.
10. Macchia, Anthony F. "The Securitization of Real Estate:
Strategies For Investment Banking," Real Estate Finance
Journal, Fall 1987. pp. 25.
11. Shilton, Leon G. "The Snail's Pace of Commercial Debt
Securitization,"
The Real Estate Finance Journal, Fall
1986.
pp.
31.
-47-
CHAPTER VI.
CONCLUSION
The securitization of
successful
to-be-developed properties has produced
financings,
Securitization can
as
evidenced
by
75
State
provide developers with a
flexibility
than
would
financing.
However, the
be
obtained
past
success
Street.
great deal more
through
conventional
of commercial
paper
programs was the result of the state of the capital markets at
rather than the
the time,
financing vehicle.
the
development
The quality of the
team,
as a
innovation of securitization
and
the large
Boston office market,
spread
that
existed
between conventional financing and Treasuries, all contributed
of 75 State Street.
to the success
place,
alternate financing
Without
vehicles would
these factors in
have proved
more
financially feasible.
As office markets around the country continue to be overbuilt,
securitization
feasible.
these
of
to-be-developed
Due the
high
developments,
continue
to
be
recognizing the
degree of
third-party
cost
properties
not
be
speculation inherent
in
credit
prohibitive,
as
potential of default when
will
enhancement
lenders
will
are
now
the refinancing of
securitized properties begins to occur.
Securitization will
can
avoid
the
continue to
costly
be attractive
process
-48-
of
if developers
third-party
credit
enhancement.
necessary
However, credit enhancement
in
the absence
of
will continue to be
pre-leasing
to high
quality,
blue-chip tenants.
If
we
return
to
the
financing and Treasuries
large
spreads
between
that existed in 1982
conventional
and 1986, then
securitization of to-be-developed properties may once again be
financially
continuing
feasible.
use
of
Until
that
occurs, we
institutional
will see
partnerships
the
and
participating-type mortgages as the primary financing vehicles
under today's capital market structure.
-49-
APPENDIX A.
PARTICIPATING AND CONVERTIBLE MORTGAGES
Participating Mortgage
The participating
debt
mortgage is currently the
instrument for
In a
projects.
permanent
most widely used
financing on
typical participating
to-be-developed
mortgage, the
lender
funds the loan at a below market rate and in return receives a
participation
interest
in
the project's
cash
flows.
The
vehicle was first designed prior to the Tax Reform Act of 1986
for financing involving taxable
this
scenario, the
receive the
and non-taxable entities.
non-taxable lender
cash flows from
(pension fund)
the project while
would retain
sole equity ownership
tax benefits
associated with real estate.
this
is
no
longer
as
great
participating
mortgage still
structure
share and/or
to
separate
However,
the primary
the
of the
Since Tax Reform,
issue.
remains
would
the developer
and therefore all
an
In
the
financial
risks and
rewards
between the lender and borrower.
The advisory company
of Aldrich, Eastman & Waltch
was one of
the early pioneers in the participating mortgage market and it
is still their primary investment vehicle.
the
majority of
pension
money is
The reason is that
interested
in an
equity
position (rather than a fixed-rate mortgage) to act as a hedge
against inflation and/or to boost their yields.
-50-
Historically,
participating mortgages have yielded higher returns than fixed
rate mortgages but since the
coupon rate is lower, the higher
yield represents a greater risk than a fixed-rate yield.
The participating
mortgage is essentially an
disguised as debt.
capital and
(1)
equity position
The mortgage provides protection for their
a minimum
return, yet
it helps
the development
The lender gets the
through use of leverage and tax benefits.
upside potential with little downside risk.
The participating
mortgage is also used to separate the cash flows from the back
end of the deal.
Thus lenders use it as an incentive tool for
the developer/partner to deliver a profitable project.
The developer
upside
because
potential
participating
of
the
provides.
mortgage
of the
mind giving away some
usually does not
benefits
The coupon
that
rate
on
mortgage is usually below that of a fixed-rate mortgage.
the
helps
projects
of default.
mitigates the risk
the
an overall
participation.
(2)
in
the
early
The average coupon
years
the
This
and
rate on a
and 9%
with the
yield of approximately
12% with
today is
participating mortgage
lender averaging
flows
cash
the
between 8%
Fixed-rate
mortgages
today
are
currently averaging 10%.
Participating mortgages typically give
amount
of
financing
than fixed-rate
the developer a larger
mortgages.
Primarily
because the lower coupon rate allows a larger principal amount
-51-
coverage ratio.
with the same debt service
be achieved
higher.
all
with participating
The high leverage, low
the tax
sometimes even
mortgages and
coupon rate, and retention of
the development
benefits, enable
to be
better
of cash
service and less risk
a lower debt
capitalized with
90% financing can
calls or default.
Convertible Mortgage
The features of the convertible
mortgage act in much the same
way as the participating mortgage.
debt because
debt into
lender the right to
it gives the
equity at
certain specified time
return while protecting
below
mortgage, gets
coupon
periods.
Again,
base coupon rate
The
developer gets a
rate
but
of the
to keep all
unlike
the developers best
the
participating
cash flows (if
any) until the lender converts the option.
is in
convert their
the downside with a
position on the property.
market
disguised as
upside potential of having a higher
this gives the lender the
and a senior
essentially equity
instrument is
mortgage, the
Similar to a participating
there are
For this reason it
interest to negotiate
the longest
possible time before the lender can convert.
The convertible mortgage is an option on the future cash flows
and residual sale
the lender pays
proceeds of the project.
The premium that
for this option is a lower
coupon rate and a
higher principal amount.
However,
-52-
they reduce their exposure
by having a
first position mortgage with a base
right to convert
if the project appreciates
inflation.
The developer reduces the
short term
through the
amount but pays
rate and the
enough to exceed
risk of deficits in the
lower interest
rate and
for it by granting an option
higher loan
on a portion (a
negotiable percentage) of the developments appreciation.
Convertible
mortgages can
be combined
with a
participating
structure to give the lender both a share in the projects cash
flows as well
as the right to convert.
Exhibit A-1 compares
participating and participating/convertible loan structures to
conventional
financing
million square foot
and clear cash
for
a
recent
regional mall.
financing
The mall
-53-
a
1.5
had annual free
flow of $6.5 million which yielded
$100 million when capped at 6.5%.
on
a value of
Exhibit A-1
Comparative Loan Terms For Conventional,
Participating and Participating/Convertible Structures
Conventional
Participating
Participate/
Convertible
Proceeds Raised
$59 million
$75 million
$85 million
Initial Pay Rate
10.50%
8.25%
6%
8%
9%
Participation
N/A
40% of cash
flow excess
of base debt
60% of cash
flow excess
of base debt
service.60%
of appreciation until
11% yield is
earned & 50%
thereafter.
service.
40% of appre-
ciation at
maturity.
(yrs.1-2)
(yrs.3-5)
(yr.6-15)
Minimum Yield
10.75%
8.25%
8.12%
Estimated Yield
10.75%
11.10%
11.30%
Maturity Period
10 yrs.
15 yrs.
15 yrs.
Initial DCR
1.05
1.05
1.27
Range Of DCR
1.05-1.62
1.05-2.08
1.05-1.68
Range Of LTV
59-36%
75-57%
85-71%
DCR;
LTV;
Debt Service Coverage Ratio
Loan To Value Ratio
Source; Goldman Sachs & Co.
-54-
NOTES TO APPENDIX A.
1. Gorden Clagett, Principal,
Boston, Ma.
2. Ibid.
-55-
Aldrich,
Eastman &
Waltch.
APPENDIX B
ACCRUAL MORTGAGES
The Accrual Mortgage
The accrual
mortgage is another financing
evolved out
of the
Under the accrual
structure that has
current, high interest
rate environment.
mortgage, the schedule of
pay rates slowly
graduate until they meet a specified coupon rate.
The accrued
interest needed to meet the lender's yield requirement is paid
at
maturity.
A variation
this
the loan and
structure
is well
all
this
structure is
the pay rate remains
Discount Mortgage, where
life of
of
of
the
Deep
fixed over the
below the coupon
accrued
the
rate.
interest
is
Under
paid
at
maturity.
Both the accrual
mortgage and the deep
in that they provide
useful to developers
that
more
closely
The
appreciation.
discount mortgage are
the
matches
two
a payment schedule
project's
structures
also
cash
flows
typically
and
provide
higher loan amounts than conventional financing, although they
are usually
provide.
below what
a participating-type
Lender's like accrual mortgages because they provide
a higher coupon rate over the
they are
they
not as desirable as
do not
compares
structure would
offer a
the accrual
life of the mortgage.
participating mortgages because
hedge against
and
However,
inflation.
deep discount
Exhibit
loan structures
B-1
to
conventional financing for the $100 million regional mall used
in Exhibit A-1.
-56-
Exhibit B-1
Comparative Loan Terms For Conventional,
Deep Discount, and Accrual Structures
Conventional
Deep Discount
Accrual
Proceeds Raised
$59 million
$64 million
$73 million
Coupon Rate
10.50%
11.00%
10.75%
Initial Pay Rate
10.50%
9.25%
8.00%
N/A
50 basis
points every
2 years.
Increase In Pay Rate
N/A
Initial DCR
1.05
1.10
1.11
Maturity Period
10 yrs.
7 yrs.
15 yrs.
Range In DCR
1.05-1.62
1.10-1.47
1.09-1.37
Range In LTV
59-36%
64-53%
73-42%
Source; Goldman Sachs & Co.
-57-
APPENDIX C
Minimum Requirements For Standard & Poor's Credit Ratings
Varia bles
'B'
_'88'
Debt service coverage Minimum 1.05 x at
ratioai
origination
Loan-to-value ratioW Maximum 900 3at
origination
Seasoning
Minimum 3 yrs.
Property type
Office building
Property size tonly
50.000 sq. ft.
applicable to office
buildings)
Loan terms
Seasoned mortgage
late payment history
888'
'AA
Minimum 1.1 x at
origination
Minimum 1.15 x at
origination
Minimum 1.2 x at
origination
Maximum 8500 at
Maximum 80% at
origination
Maximum 75%'oat
origination
origination
Minimum 3 yrs.
Minimum 3 yrs.
Office building
Office building
50.000 sq. ft.
50.000 sq. ft.
50,000 sq. ft.
Fully amortizing.
level pay
No late payments in
preceding year no
more than 2 in the 3
years prior to submis-
Fully amortizing.
level pay
No late payments in
preceding year no
more than 2 in the 3
years prior to submis-
Fully amortizing.
level pay
No late payments in
preceding year no
more than 2 in the 3
years prior to submis-
Fully amortizing,
level pay
No late payments in
preceding year no
more than 2 in the 3
years prior to submis-
sion to pool
sion to pool
sion to pool
sion to pool
Needed credit support
Minimum 3 yrs.
- Office builidng
Minimum 1.2 x at
origination
Maximum 75% at
origination
Minimum 3 yrs.
Office building
50.000 sq. ft.
Fully amortizing,
level pay
No late payments in
preceding year no
more than 2 in the 3
years pror to submission to pool
Add 25% to reserve
needed for 'A' pool
(a) Debt service coverage ratio is calculated as effective
gross
revenues minus operating expenses before taxes
divided by total debt service charges.
(b) Loan to value ratio is the amount of the mortgage
outstanding divided by the value of the property.
Source; Standard & Poor's, Real Estate Finance Journal.
Definition of Ratings
Rating
Category
AAA
Highest credit quality. The risk factors are only
slightly more than for risk-free U.S. Treasury
debt.
AA
High credit quality. Protection factors are strong.
Risk is modest but may vary slightly from time to
time due to of economic conditions.
-58-
A
Good quality investment grade securities.
Protection factors are average but adequate.
However, risk factors are more variable and greater
in periods of economic stress.
BBB
Below average protection factors but still
considered sufficient for institutional investment.
Considerable variability in risk during economic
cycles.
BB
Below investment grade but deemed likely to meet
obligations when due. Protection factors fluctuate
according to economic conditions. Overall quality
may move up or down frequently within this category.
B
Below investment grade and possessing risk that
obligations will not be met when due. Protection
factors will fluctuate widely according to economic
cycles. Potential exists for frequent changes in
quality rating within this category or into a higher
or lower quality rating grade.
Source; Real Estate Finance Journal.
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ACKNOWLEDGEMENTS
I wish to thank the following people for contributing
research and providing support for this thesis.
Lawrence S.
Bacow
to my
Associate Professor, Urban Studies and
Planning; Director of Research, Center For
Real Estate Development. Massachusetts
Institute of Technology. Cambridge, Ma.
Robert L. Blakeman
Executive Vice President, Equitable Real
Estate Investment Management Inc.
Boston, Ma.
Gordon J. Clagett
Principal, Aldrich, Eastman & Waltch.
Boston, Ma.
Harve Filuk
Executive Vice President, Mission West
Properties. San Diego, Ca.
Arthur J. Halleran
Chairman, First Winthrop Corporation.
Boston, Ma.
C.J.(Tony) Harwood
Senior Vice President, Equitable Real
Estate Investment Management Inc.
Boston, Ma.
Kevin M. Mahony
Vice President, Managing Director, Copley
Real Estate Advisors. Boston, Ma.
James McKellar
Thesis Supervisor; Visiting Professor,
Department of Architecture; Director,
Center For Real Estate Development.
Massachusetts Institute of Technology.
Cambridge, Ma.
Adair Miller
Vice President, Citicorp Real Estate Inc.
Boston, Ma.
Stephen J. Murphy
Director, Equitable Real Estate Investment
Management Inc. Boston, Ma.
Sjef J.G.
Robert J.
Palmen
Coordinator, International Real Estate
Operations, Algemeen Burgerlijk
Pensionfonds. Heerlen, The Netherlands.
Perriello Vice President, Chief Financial Officer,
The Beacon Companies.
Thomas A.
Steele
Richard West
Boston, Ma.
Chairman, Perini Land and Development.
Framingham, Ma.
President, West Partners Inc.
San Diego, Ca.
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