FINANCING OPPORTUNITIES THROUGH
PROPERTY SPECIFIC COMMERCIAL MORTGAGE SECURITIES
by
STEPHEN J.
MURPHY
Bachelor of Architecture
Temple University
(1981)
Submitted to the Department of Architecture
in Partial. Fulfillment of
the Requirements of
the Degree
of
Masters of Science in
Real Estate Development
at the
Massachusetts Institute of Technology
July 1987
@Stephen J.
Murphy 1987
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_
/,t-ephen / .
Departmefit of Arc
urphy
ecture
July 31,1987
Certified by
iviarp- Louargand
Visiting Associ
e Professor
Department of Urban Studie
and Planning
Thesis Supervisor
Accepted by_____
____________
Michael Wheeler
Chairman
Interdepartmental Degree Program in Real Estate Development
FINANCING OPPORTUNITIES THROUGH
PROPERTY SPECIFIC COMMERCIAL MORTGAGE SECURITIES
by
Stephen J. Murphy
Submitted to the Department of Architecture on
July 31, 1987 in Partial Fulfillment of the Requirements of
the Degree of Masters of Science in Real Estate Development
at the Massachusetts Institute of Technology
ABSTRACT
The purpose of this paper is to identify issues relevant to
real estate professionals considering the financing of
commercial real estate assets
through the public or private
sale
of mortgage
backed securities.
Currently, two
categories
of securitized
debt issues
have emerged;
financings
of
individual,
specified
properties,
and
financings of pools of mortgages, in which the underlying
mortgages may or may not be specified. This paper limits
its examination to property specific financings.
This paper describes the development of the mortgage backed
securities and the security markets. It also examines the
alternative
issuing structures
for property
specific
securities, risk assesment methodologies, and the component
costs of capital raised. Two case studies are evaluated to
illustrate aspects of current security offerings.
Finally,
this paper summarizes the advantages and disadvantages of
these transactions
from the perspective of the borrower of
capital.
Thesis Supervisor: Marc Louargand
Title :
Visiting Associate Professor
Department of Urban Studies and Planning
2
ACKNOWLEDGEMENTS
I wish to
thank my thesis advisor,
Louargand for
while
his able
providing
Harwood
and
Mr.
assistance and
guidance
preparation of this
thesis.
Paul
Investment Management
visiting professor Marc
and
unflagging patience
encouragement
I also wish to
Stevens of
for their
Equitable
the
thank Mr. C.J.
Real
willingness and
providing valuable data and other resources.
3
during
Estate
candor in
TABLE OF CONTENTS
CHAPTER I.
.............................
INTRODUCTION....
5
Purpose
Organization and Methodology
Summary of Conclusions
Limitations and Further Study
CHAPTER II.
DEVELOPMENT OF MORTGAGE SECURITIES. . .....
13
Residential Mortgage Securities
Commercial Mortgage Securities
CHAPTER III.
SECURITY MARKETS................... ......
20
Public Domestic Market
Euromarket
Private Placements
Offering Size
CHAPTER IV. ALTERNATIVE STRUCTURES..................... 29
Pass-throughs
Mortgage Backed Bonds
Collateralized Mortgage Obligations
Real Estate Mortgage Investment Conduits
Senior / Subordinated Structure
Stripped Mortgage Structure
Interest Rate Swaps
CHAPTER V.
RISK EVALUATION...........................51
Property Specific Bonds
Comparison to Corporate Bonds
CHAPTER VI.
THE COSTS OF CAPITAL......................59
Cost of Securitized Offerings
Comparison to Bullet Loans
Opportunity Costs
CHAPTER VII.
CASE STUDIES...................
.........
72
Lincoln Property Associates
Bank of Boston
CHAPTER VIII. CONCLUSION................................
BIBLIOGRAPHY ...........................................
82
e85
4
CHAPTER I.
INTRODUCTION
Purpose
The purpose of this paper
real
estate
is to identify issues relevant to
professionals
considering
commercial real estate assets
sale
of
mortgage
categories
of
financings
of
backed
mortgages may
or may not
its
securities.
debt
individual,
pools of
examination to
financing
of
through the public or private
securitized
financings of
the
Currently,
issues
specified
have
be specified.
property
emerged;
properties,
mortgages, in which
two
and
the underlying
This
paper limits
specific commercial
mortgage
securities (PSCMS's).
In
response
commercial
capital
create
to
real
continuing
estate,
markets, the
the prominent
Wall Street hopes to
of traditional forms of
have incorporated
or residual
and liquid
by
investors
servicers
investment banks,
efficiently priced
By doing so,
interest
have attempted
the
to
trading instruments.
overcome the illiquidity
real estate ownership.
Instruments
debt, equity, participation in
value, fixed
of
in
or floating payments,
cash flow
or accrued
interests.
Wall Street has most recently shown interest
the value
of outstanding commercial real
5
in
tapping into
estate mortgages,
to exceed
estimated
debt,
the
$800
By securitizing
Billion.
investment banks
hope
to
establish a
market as large as the corporate bond market.
opportunities in
success of
security market.
issued,
capital
Assessing the
heralded the
this market, proponents have
its precursor,
this
mortgage backed
the residential
With over $300 billion of these securities
market is
the residential
firmly established
and
growing.
Three principal
date
in
the
structures,
instrument structures have been
commercial
bond
obligations.
mortgage
structures, and
status.
devices
such
Mortgage
collateralized
as
In addition, several
prioritization
stripping, and interest rate
income
pass-through
mortgage
Each is distinguished by its legal, accounting
and tax
the
market;
issued to
stream
and
Investment
internal structuring
of
cash
flows,
coupon
swaps, are available to modify
risk
distribution.
Conduit's
(REMIC's) also
Real
Estate
provide
an
overlay structure which can generate similar permutations of
the security without altering the underlying debt.
Real
estate investors
must address
several issues
choosing PSCMS's as a funding vehicle.
is
important, as
therefore
deals.
many issuing
economies
The
property
of scale
The size of the deal
cost are
can
be
must withstand
before
relatively fixed;
realized on
highly
larger
conservative
scrutiny of all essential operating data in order to achieve
6
an investment grade rating.
on the
Several retrictions are placed
property and its cash
interest of investors.
conventional
protect the
In return for these limitations, the
borrower is able to access
through
flow in order to
much larger sums of capital than
sources,
typically
at
competetive
interest rates.
organization and Methodology
Chapter
II
is a
residential
model
more recent
The
examined for
commercial
the development
market, the
mortgage
of
the
precursor and
commercial mortgage
securities
securities
its similarities to and
residential market.
markets
of
mortgage securities
for the
market.
description
market
is
distinctions from the
Chapter III describes the three capital
accessed through
securitization,
and the
various
regulatory and practical limitations of each.
Chapter
IV describes
which have
the
developed for
alternative security
packaging and
structures
trading mortgages;
pass-throughs, bonds and collateralized mortgage obligations
(CMO's).
The
principal characteristics of the
Investment Mortgage
part
of
Internal
the
Conduit (REMIC) legislation,
Reform
structuring
prioritization,
are also
Tax
Act
of
devices,
coupon stripping,
examined.
Real Estate
1986,
are
identified.
such
as
cash
and interest
Chapter V examines
7
passed as
flow
rate swaps
the risk evaluation
methodology utilized with property specific securities.
Chapter VI
capital
identifies and
imposed
by
examines the component
securitization, including
costs of
direct
and
indirect costs, deferred costs, and opportunity costs, while
Chapter
VII describes
and
evaluates two
case studies
of
securitized financings.
Chapter VIII
concludes the paper
relevant
real
to
estate
with a summary
professionals
of issues
when
considering
the paper
included an
securitization as a financing alternative.
The
methodology used
extensive
Numerous
in developing
literature
search
experts in
real
and
a
fieldwork
estate finance,
component.
securitization,
bond credit rating and credit enhancement were interviewed.
Summary of Conclusions
Securitized transactions are large scale transactions, which
use the
They
global capital
typically raise
capable
of raising
markets as
in
over
excess of
$1 billion
their source
$25
of funds.
million, and
in single
are
offerings.
This capacity far exceeds that of conventional lenders, such
as commercial banks, insurance companies, and pension funds,
which usually loan from $5 million to $200 million.
8
Scale economies play a significant role in the cost of funds
Although the underwriting and
of securitized transactions.
structuring fees paid
to the security issuer
are usually a
percentage of the amount raised, many additional costs, such
and
constant.
As the
size
the cost of funds to the
which
these costs
There is a threshold at
borrower.
the
eliminate
these
load on
an increasing percentage
ability for
securitized
funds available through
with the cost of
issues to compete
relatively
offering diminishes,
of an
translate to
fixed costs
are
expense,
administrative
appraisals
advertising,
printing,
financial
counsel,
legal
as
conventional sources.
In
addition
direct costs,
to
impose indirect
costs on
reserve
asset
reinvestment risk
credit
facilities,
offerings
should
be
the
and
support,
cash flows until
of property
can
of liquid
Posting
the borrower.
bond payments
semi-annual
securitized
payment of
evaluated.
Loan
to
value ratios may be lower than those allowed by conventional
lenders, thereby
forcing the borrower to
invest additional
equity.
Borrowers
seeking to
million must
cost
of
raise
between $25
compare the effective
capital
available through
million and
to the
cost of capital
conventional
$200
lenders.
This comparison must include all costs, including direct and
indirect costs, deferred costs and opportunity costs.
9
Limitations and Further Study
The first property specific commercial mortgage security was
issued by
MSA Shopping
less
date
occured.
than
Most
euromarket
or
requirement
of
30
Malls, Inc. in
transactions
are
securities have
through
private
public
Of
twelve
transactions
paper, only
two were willing
offering.
issues
Furthermore,
have
offering,
limited
thereby
which
source of
directly
were
the
involved
contacted
euromarket and
trading activity
for
to
the
after
this
placement
the
initial
examination
be the investment
in
of their
private
into these transactions will
information to
in the
costs of transactions is
characteristics of these instruments performance.
choose to enter
have
access
to disclose details
limiting
To
without
Therefore
organizations
securitized
to
been sold
placements,
disclosure.
19831.
estimated
of these
specific information regarding the
limited.
June of
of
the
Those who
find the best
banking houses
which underwrite the securities.
With time, the ability to amass comprehensive data regarding
property
improve.
specific
determination of
borrower
issuing
mortgage
One topic for further
involve the
the
commercial
by making
costs of
these
a
securities
may
research in this area would
effective cost of
detailed
comparison of
securities with
10
capital to
respect to
actual
their
rating
classification and
This cost of
increased
when first
capital could then be compared to
capital through
if
their yield
conventional lenders in order
frequency
of issuance
of
issued.
the cost of
to determine
these
securities
fosters pricing efficiency.
Another topic for study is
on
both
the
method
of
the impact of the rating systems
real
estate
appraisal
underwriting guidelines of conventional lenders.
11
and
the
NOTES TO THE INTRODUCTION
1.
Stevenson.
Securitization
The
Eric,
for
Washington, DC: The
Secondary
Income
Property
Market
and
Mortgages,
Mortgage Bankers Association, 1986,
69.
12
CHAPTER II. DEVELOPMENT OF MORTGAGE BACKED SECURITIES
Development of Residential Mortgage Securities
of mortgages has its origins
The impetus for securitization
in federal support of
as a means
the residential sector, and developed
of increasing capital flows to
to ensure access to housing.
made its
first concerted
with the
formation of
This
system
In 1932 the Federal government
effort to support
the Federal
offered
lenders in order
housing policy
Home Loan
financial
Bank System.
support
to
thrift
institutions, the principal mortgage lenders of the era.
exchange, the
thrifts adopted Federal charters
In
and adhered
to standards and regulations established by the Federal Home
Loan Bank Board
1
Further support
of housing access was
provided through the
formation of the Federal Housing Agency (FHA) in 1934.
Agency offered
loan
conforming
insurance against
to
FHA
Veterans Administration
eligible
loans
made
mortgage defaults
standards.
(VA) began
by
In
later
to offer
veterans
2
.
This
on any
years
the
guarantees to
These
programs
constituted the first forms of federal subsidy of mortgages;
it is these federal guarantees
which have made the creation
of a secondary market for residential mortgages viable.
13
As
for mortgage
demand
to
was
Fannie Mae) was formed 3 .
FHA insured
purchase
the relative
and
Its
guaranteed
VA
proved
system
This
origination.
throughout
to
providing further funds for
mortgages from thrifts, thereby
mortgage
arose
Federal National
1938 the
In
task.
to the
Mortgage Association (FNMA or
purpose
the need
The federal government once again put
provide more capital.
its resources
grew,
credit
economic stablity
adequate
following World
War II.
In
the late
serious
1960's and
problem.
credit increased
the
Simultaneously,
cause housing costs
and increased
rate
a
for mortgage
exodus to
demand combined
to
As loan to
to outstrip income growth.
During this period,
interest
imposed
the demand
increased, the creditworthiness
income ratios
declined.
inflation became
dwellers continued the
as city
Inflation
suburbs.
early 1970's,
of borrowers
federal banking Regulation Q
ceilings
on
payable
individual
deposits, the traditional source of the thrift institutions'
Depositors, in
funds.
higher
returns
instruments.
turn,
available
withdrew funds
through
other
in favor
capital
of
market
Insurance companies, which had been purchasers
of whole loans from
thrifts, were also experiencing capital
were increasing
drains.
Policy holders
loans at
below market interest rates,
their demand
which were available
by borrowing against the value of their policies.
14
for
life insurance companies channeled
In response, thrifts and
capital into more interest rate sensitive investments, which
further reduced the funds for mortgage lending.
The loss of
funding, known as disintermediation, in combination with the
increased
demand for
credit, placed
mortgage
upward pressure on mortgage lending rates
significant
4
In 1968, in an attempt to provide additional capital sources
to
the thrifts,
the
Government
(GNMA or Ginnie Mae), was
and credit
provide
backed
originations.
Home Loan
created
borrowing
an
rights
formed.
through
In
the agency
purchases of
1970 the
with
able
the
to
intended to
FHA and
incorporation
Mortgage Corporation
agency
Agency
By using the "full faith
United States",
capital support
Federal
Mac)
of the
National Mortgage
(FHLMC or
purchase,
Federal
of
VA
the
Freddie
through
its
Reserve,
qualifying
mortgages that did not have FHA insurance or VA guarantees 5
The thrifts' access
advent of
them
in
mortgage bankers,
wherever
credit.
to funds was further
regional
enhanced with the
who originated loans
capital exceeded
the
and sold
demand
for
Their activities combined with increased uniformity
the underwriting
facilitate
standards of
interregional
capital
the federal
flows
agencies to
for
mortgage
funding. 6
In 1975,
with the
first GNMA pass-through,
15
these agencies
issuing
These
securities were
sold
by
mortgage funds.
purchases.
with
to facilitate further
thereby
originators,
mortgage
shortages of
mortgages
investors, exchanged
to
other mortgages, or used
lenders for
borrowing
backed by
securities
began
alleviating
three basic forms
Over time,
have developed; pass-throughs, bonds
of mortgage securities
and pass-through derivatives such as collateralized mortgage
Each is distinguished by its legal, accounting
obligations.
and
tax
Chapter
In
status, and
described
in greater
detail
in
IV.
1984
the
Secondary
(SMMEA) was enacted,
of
is
private
Mortgage
Market
Enhancement
which was designed to
agencies
issuing mortgage
Act
expand the role
backed
securities,
through the liberalization of
blue
sky
credit restrictions and state
7
reporting requiements .
Currently, residential
mortgage backed securities of one form or another are issued
by investment banks,
saving and
insurance companies, mortgage bankers,
loans and commercial
banks.
By 1985
over $300
Billion of these securities had been issued
Development of Commercial Mortgage Securities
Wall Street has most recently shown interest in underwriting
the value
of outstanding commercial real
estimated
in 1986
compares
the
to approach
value of
these
$800 Billion.
mortgages
16
estate mortgages,
Exhibit 2.1
to other
capital
markets.
by
Exhibit 2.2 indicates
ownership of
commercial
the growth and distribution
debt, excluding
multi-family,
during the period 1976 to 1986.
OUTSTANDING DEBT
EXHIBIT 2.1: U.S. CAPITAL MARKETS,
(BILLIONS)
Commercial Mortgages $ 500
Multi-Family Mortgages
200
100
Federal Agencies, Mortgage Pools
$
Residential Mortgages
Corporate Debt Issues
Municipal / State Debt
U.S. Treasury Debt
TOTAL DEBT
Source:
$5,700
Roulac and Co.,
EXHIBIT 2.2:
800
1,700
700
700
1,800
Federal Reserve Bulletin
DEBT OUTSTANDING
COMMERCIAL MORTGAGE
1976 -1986
(BY INSTITUTION)
5W
I~~
I
I
I
a
7e
77
78
79
80
82
83
UFE INSJRANCE COS.
OT-ERS
THR1FT INST1TUTIONS
=COMMERCIAL BANKS
Source:
i t
Federal Reserve Bulletin
17
84
5
se
By
banks hope
the
estate,
in
the
For the
studies have
corporate bonds,
of non-convertible
issuance
incentive
through securitization.
fees generated
potential
found
have
underwriters
real
for commercial
not exist
does
for housing
espoused
as the
imperative
social
the
Although
market.
investment
as large
a capital market
to establish
bond
corporate
debt, the
mortgage
securitizing commercial
estimated underwriting fees, often refered to as spreads, to
principal amount of the bonds
be approximately 1% of the
By
this
were
measure,
annual
Since their
$8 Billion.
volume
of
instruments
placement
and
the fees would
backed
$5 billion in 1986.
limited, due mainly to the
trading
market
and
restrictions
euromarkets
outstanding
of
inception in
mortgage
commercial
issuance has grown to over
activity is very
value
debt to be securitized,
commercial mortgage
approach
full
the
10
1983,
the
securities
Yet trading
newness of the
in
where
the
most
private
of
the
securities to date have been issued
Three
markets
principal
exist
securities; the public domestic
the
private placement
issuance
of the
characteristics
market.
security
of
the
for
mortgage
backed
market, the euromarket, and
The choice
is determined
offering,
risk
by
of market
for
the size
and
of
the
profile
offering and differences in return expectations of investors
in each
market.
These
markets and their
discussed in further detail in Chapter III.
18
restrictions are
NOTES TO CHAPTER II.
1.
Editor, The Handbook of Mortgage
Frank J.,
Fabozzi,
Backed Securities, Chicago Illinois: Probus Publishing,
1985,
16.
2.
ibid.
3.
Law
Federal Securities
"The
William C.,
Tyson,
Regulatory Environment Of Mortgage Backed Securities",
The Real Estate Finance Journal, Spring 1986, 6-16.
4.
Fabozzi, 18-20.
5.
ibid.,
16.
6.
ibid.,
19.
7.
Tyson, 9-10.
8.
Fabozzi, 1.
9.
Hartzell, David J. Andrea Lepcio, Julia D. Fernald and
Susan Jordan, Commercial Mortgage Backed Securities: An
Investor's Primer, New York, NY: Salomon Brothers Inc.,
May 1987, 1.
Stock and
of Common
L.A.,"Flotation Cost
10. Green,
A Descriptive and Principal
Corporate Bonds: 1971-1976:
Component Analysis", Unpublished Thesis, Sloan School of
of Technology,
Management,
Massachusetts Institute
February, 1978.
11. Hartzell, 3.
19
CHAPTER III. SECURITIES MARKETS
The Public Domestic Market
Public domestic issues are offered
large,
both institutions
backed
securities,
organized by
issuer
issues
Act of
1933,
offered and sold pursuant
is
typically
a conduit for
are
required to
mortgage
For
the sole purpose
and serving as
domestic
Securities
individuals1 .
and
the borrower for
the securities
Public
the
for sale to investors at
an
of issuing
the proceeds.
conform
which requires
entity
to
securities to
the
be
to a registration statement filed
with, and declared effective by, the Securities and Exchange
.2
Commission
In the case of
.
will identify
a debt offering, the statement
the offering price, coupon
regarding the issuing entity and
the
underlying
historical
collateral.
operating
securities.
legality
of
A
the
owner and a description of
The
description
statements, property
forecasted cash flows extending
the
rate, information
statement
includes
appraisals
and
beyond the maturity date of
of certain
securities and
tax issues,
certifying
testament
the
of
financial auditors will also be included.
The 1933 Act also
requires
to
the
issuer
of
the
diligence and imposes liability
the
registration
statement 3 .
security
exercise
due
for any material defects in
After
registration,
the
offering statement is made available to the investors by the
underwriters in the
form of a prospectus.
20
In keeping with
the public accessibility of
information, the securities are
traded on one of the large national exchanges, typically the
New
York exchange,
and prices
are quoted
daily based
on
trading activity.
Public domestic
well.
issues are subject to
The Securities
Exchange Act
trading in securities and the
dealers.
It
antifraud
reporting
material
provisions
and
requirements,
regulates the
activities of the brokers and
pursuant
to
registration
the
relating
the issuer,
repoting
to the
and
of
any
transaction.
19 39 mandates debt securities be
an
and prohibits
indenture trustees.
1940 defines
additional
including
inside information
requirements,
part of
of 1934
establishes credit restricions of
The Trust Indenture Act of
offered
other requlations as
indenture
conflict of
meeting
interests on
The Investment
and regulates th e activities
certain
the
Company Act of
of an investment
company engaged primarily in the investment, reinvestment or
trading
in securities,
or wh ich
securities valued in excess of
mentioned
in
Chapter
II,
owns or
proposes to
40% of its total assets.
the
Secondry
Mortgage
own
As
Market
Enhancement Act of 1984 was enacted to modify the Securities
Act of 1933, and liberalizes credit restrictions and certain
reporting requirements 4
21
The Euromarket
Euromarket offerings, in the form
of eurobonds, are sold in
The offerings
several international markets simultaneously.
are not subject
exist in some countries.
do
Eurobonds for sale within the U.S.
requirement the issuers
with the SEC, a
must be registered
their issuance
barriers to
few
although a
authority,
any single national
to the jurisdiction of
prefer to dispense with, for reasons of cost, simplicity and
Purchases by
privacy.
through
eurobonds
investors5 .
for
attraction
exempt
from taxation
to remain anonymous.
at
the
is
from
income
issue,
source of
Although payment of tax is required to
country
holder's
only
their
bearer form, allowing the holder
eurobonds are also sold in
the
Not
disclosure
source of
one
is
these offerings
of
requirements
accomplished
limited
The
accounts.
offshore
can be
U.S. citizens
of
opportunity for tax evasion.
anonymity
residence,
creates
Some estimates place over half
of all eurobonds in the portfolios of individuals60
The
growing
euromarkets
U.S.
real
acceptance
estate
and
other
net foreign
to 1986.
securities
mortgage
inflow of
parallels the
illustrates the
from 1976
of
by
foreign capital
securities.
investment in
Rapidly increasing
Exhibit
into
3.1
U.S. securities
in 1985
and 1986,
most of this investment has been in the form of debt.
22
the
EXHIBIT 3.1: NET FOREIGN INVESTMENT IN U.S. SECURITIES
1976 TO 1986
r-
40
z
0
20
z
10
0
-10
I
I
I
I
I
I
I
I
76
77
78
79
80
81
82
83
FET STOCK PURCHSES
Source:
I
84 85
NET WND PURCHAES
Federal Reserve Bulletin
23
I
I
86
Anthony
Downs
several
has noted
reasons
rapid
for this
growth in investment activity:
*
The U.S.
has recently become
a net importer
dollars.
thereby flooding the world with U.S.
*
of capital,
The U.S. is perceived as economically and politically
secure.
*
The value of
relation to some
the dollar has declined in
foreign currencies.
*
some foreign countries is low with
The cost of capital in
respect to the U.S.
*
Some
foreign
eased
have recently
countries
investment
restrictions on major institutions and investors, allowing
increased investment in U.S. real assets.
*
Returns
on
investments
in
foreign
markets
have
historically been lower than those available in the U.S7 .
By
in
investing
securities
backed by
mortgages, foreign investors perceive
U.S.
estate
real
they have gained many
of the same benefits of direct investment, while retaining a
relatively
recent
U.S.
degree
prices paid
real estate
offered by
market
high
liquidity.
have often
been far
for
on mortgage
attractive.
24
the
for premier
greater than
competition, resulting
expectations
the yields
Furthermore,
foreign investors
by some
their domestic
yield
comparison,
of
those
in below
8
.
By
backed eurobonds
seem
the
purchaser
Private Placements
are made to a
Private placement offerings
investors.
of
Act
the Securities
by
defined
As
limited group of
1933,
private placements may not involve public solicitations, and
must be limited to not
more than 35 large and knowledgeable
investors.
which conform to these
exempt
offerings
offering.
sequentially
numbered
for
public
an offering
statement,
identification
purposes,
receives
Each investor
a
of
requirements
registration
the
from
criteria are
containing information substantively similar to a registered
statement.
As
with
euromarket
restrict public access
disclosure requirements
information
about
opportunities
for
the
offerings,
borrowers
to
to specific
This
offerings.
these
objectively
limited
limits
compare
the
advantages and disadvantages of the available structures.
Private placements are
to
the limited
issuer
to
number of
identify the
offering also
somewhat simplified transactions due
investors.
specific
The
investors
provides the opportunity to
ability of
the
prior to
the
carefully tailor
the offering to their specific risk exposure limitations and
return requirements.
25
offering size
Typically
minimum size
the
offerings is $25
have
exceeded
$100
raise
offerings
to date
Fisher
offered
in
Million.
excess
private placement
to
public
offering
Million.
either private
have ranged
Financial
April 1986,
A
Realty
the $970
debt
transactions to date
of $100
have been
offerings, and
Brothers
a
Million 10, but most
typically
eurobond
of
Most
Million
debt
placements or
from the
First
will
$40 Million
Mortgage
Olympia &
Notes
York
Maiden Lane Finance Corporation Floating Rate First Mortgage
Notes offered
February/March 19841.
were offered on the eurobond market
The magnitude of
reason
for
choosing
interviewed for this
and insurance
these issues
12
the Olympia & York
capital potential of these
Both of
markets.
offering indicates the
In fact, the principal
securitization
given
paper was the inability
companies to handle the
by
owners
of U.S. banks
capital requirements
of their transaction.
The capital
than
accessible through these markets
sufficient for
the
issuance of
would be more
pools of
commercial
mortgages through structures similar to the residential pool
offerings.
Yet
one to three
evolution
most offerings
buildings.
of these
to date have
This may indicate
transaction has
26
involved from
that the recent
been accompanied
with
borrowers and investors.
some caution on
the parts of both
A more apparent
reason is the current
level of development
Both
of the underwriting procedures for these transactions.
the public
for
measures
objective
certain
addition,
and the eurobond
domestic markets
of
the
institutional
banking
commissions
permissable
institutions.
Act
(ERISA)
a Legal
publish
for
securities
The Employee
regulates
by
both
Investment
investment
by
Retirement Investment
investment
Insurance companies are subject
activities
have
fiducial
issues they may hold.
restrictions on the quality of
by
In
safety.
securities'
investors
markets look
pension
State
List
of
savings
Savings
funds.
to regulation of investment
state insurance
commissions
National Association of Insurance Commissions.
and
the
The commonly
accepted evaluation of the safety of a particular investment
is the
rating given to the
offering by one or
more of the
rating agencies described in greater detail in Chapter V.
27
NOTES TO CHAPTER III.
1.
Stewart Myers,Principles
Richard and
Brealey,
Corporate Finance, Second Edition", New York, NY:
McGraw-Hill,
of
1984, 299.
2.
Law
Securities
Federal
"The
William C.,
Tyson,
Securities",
Backed
Mortgage
Of
Regulatory Environment
The Real Estate Finance Journal, Spring 1986, 10.
3.
ibid.,
12.
4.
ibid.,
9-16.
5.
Mendelsohn, Stefan, Money
McGraw-Hill,1980, 138.
6.
ibid.,
7.
Downs, Anthony, Foreign Capital in U.S. Real Estate
Markets, New York, NY: Salomon Brothers Inc, April 1987.
8.
Shulman, David and Julia D. Fernald, Japanese Investment
in U.S. Real Estate,New York, NY: Salomon Brothers Inc,
March 1987, 1.
9.
Brealey, 318.
on the
Move, New
York, NY:
148-149.
10. Adler, Tamara L.,
Bonds", The Real
"Pricing Rated Commercial Mortgage
Estate Finance Journal,Summer 1987,
19.
and
Market
Secondary
The
Eric,
11. Stevenson.
Mortgages,
for
Income
Property
Securitization
Washington, DC: The Mortgage Bankers Association, 1986,
70-71.
12. Salomon Brothers Inc, Real Estate Market Review, October
1986, 5.
28
CHAPTER IV. ALTERNATIVE STRUCTURES
Property specific commercial mortgage securities are secured
by a mortgage on a single large property, or by mortgages on
payments of
the
principal are soley
interest and
property's
cash
diversification,
that
systematic risk
is
Systematic risk is
specific risk.
prepayment speed than is
of
determining
significant in
more
is
flows from a
property type,
location or
either by
the
lack
benefit
principal
The
reliant upon
securities
inherent in the cash
mortgages.
of
These
flow.
diversification benefits
pool
to make timely
Their ability
of properties.
a small group
due to economy wide perils, while specific risk is unique to
an
diversified
individual
Property
unseasoned
mortgage
its
or
individual property
pool
specific securities,
prepayment through
A
of
an
the
minimizes
property's effect
are
properties,
immediate environment.
risk
investor.
to the
on returns
particularly those
default risk than mortgage
some form
of credit enhancement
purchased
from third
subject
more
therefore
based on
pools unless
is provided, which
or may
parties
be
to
may be
inherent in
the
internal structure of the offering.
When consideration is
property
given to the unique
mortgage backed security
and
the three
specific financings,
Commercial
Mortgage
risk inherent in
basic residential
structures ; pass-throughs, bonds,
Obligations
29
(CMO's),
are
still
Each of these structures
applicable when suitably adapted.
can
be
tax
and
accounting
its legal,
by
distinguished
status, as discussed below.
Pass-throughs
A pass-through structure does as
portion of
to the investor, a
a monthly basis
through, on
the name suggests; passing
the cash flow yielded by the underlying mortgage or mortgage
pool.
The structure
may be
participation certificates.
certificates
or
certificates
represent an
owning
a
mortgage
represent
pool.
undivided
an
pass through
Pass-through
in a
interest
undivided
or
mortgage
certificates
form of
in the
directly in a mortgage or mortgage pool.
trust
Participation
ownership
interest
A pass-through may
of certificates, each backed by a
have any number of series
distinct mortgage or pool.
The issuer of pass-throughs must
treat the issue as an asset sale for tax purposes.
Pass-throughs
were the
first type
represent the largest segment
market.
due in part to
investment performance.
largely
issued and
of the residential securities
Their
By 1985, over $280 Billion had been issuedA.
popularity is
of
of security
uniform and
interest and
have
their relative predictability
The
governmental
of the
credit support
are
of
The main concern
is the
pass-through, a function
of the
principal payments.
effective maturity
underlying mortgages
30
speed of prepayment of the mortgages.
rates; as
lending
rates drop,
interest
refinance and the probability
early
correlated with
is negatively
Prepayment speed
prepayment
of
changes in
to
the incentive
of prepayment increases.
The
to
the
principal
passes
through
investor, who must then reinvest the funds at the prevailing
lower
This
rates.
from
pass-throughs
prepayment
U.S.
feature
treasuries,
distinguishes
which
no
have
prepayment rights, and corporate bonds, which are limited by
specified call provisions.
with prepayment
The reinvestment risk associated
is compensated with higher
yields as shown
in Exhibit 4.1.
EXHIBIT 4.1:
BOND EQUIVALENT YIELD SPREADS FOR SELECTED
MORTGAGE PASS
AND RESIDENTIAL
COMMERCIAL
CORPORATE BONDS,
ISSUES AND
THROUGH NEW
NONCALLABLE, 31 MAR 86-30 SEP 86
30 SEP 86
31 MAR 86
YIELD SPREAD
YIELD SPREAD
------------------------------------------------------COMERCIAL PASS THROUGHS
9.43% 200bp
9.05% 170bp
AA Rated, Current Coupon
RESIDENTIAL PASS THROUGHS
GNMA 8%
GNMA 9% (New Current Pay)
8.88
9.18
129
159
9.07
9.38
176
202
7.86
8.03
8.10
2
Salomon Brothers Inc
51
68
75
8.04
8.41
8.38
61
98
95
CORPORATE BONDS (NON CALL)
AA Rated Domestic
A Rated Domestic
AA Rated Eurodollar
Source:
The typical commercial mortgage differs from its residential
31
Usually
prepayment.
to
respect
with
counterpart
which time the
a lockout period, during
mortgage will have
the
Yield maintainance
borrower is prohibited from refinancing.
These provide for
requirements are also becoming prevalent.
premiums payable upon refinancing which sustain the yield as
Note the widening of
though the mortgage ran the full term.
shown
increased
the
reflect
may
This
4.1.
Table
in
pass-throughs as
commercial and residential
yields between
perception of overbuilding in office markets nationally, and
the commensurate increase in potential default.
Mortgage Backed Bonds
Mortgage
to appeal
(MBB) were developed
backed bonds
to
traditional fixed income investors, who were not comfortable
with
the
Originally
pass-throughs.
having
treated
as
purposes.
debt
It may
of
of
savings and
cost source of fixed term funds
assets.
sell
to
maturities
issued by banks and
loans, bonds provided a low
without
long
and
risk
reinvestment
the issuer
bond
The
accounting
for
take the form of a
structure
and
is
tax
general obligation of
payment bond secured by a pool of
the issuer, as in a fixed
mortgages, in which the issuer is liable for timely interest
and principal payments.
prepayment
non-recourse
risk.
In this case the issuer assumes all
Property
obligations,
specific
backed
Additional credit enhancement or
32
only
bonds
by
are
the
usually
mortgage.
support may be provided if
the issue is rated.
The
bonds are
entity of
usually
through a
issued
the borrower.
Mortgage payments
trustee which maintains seperate
interest payments.
the bonds.
payments,
bancruptcy-proof
are made
to a
accounts for principal and
The principal
account is used to redeem
The interest account is used to make bond coupon
with any
shortfalls satisfied
account
and
reserve
eliminates mismatched
any credit
support
that
by the
principal
is provided.
timing between
This
mortgage and
bond payments; however it exposes the issuer to reinvestment
risk.
Bonds
can
be
divided
maturity and yields.
options
backed
several
coupons
of
varying
Fractioning the payment stream creates
for investors
mortgage
into
who
prefer
securities
but
the characteristics
desire
shorter
of
term
obligations.
Collateralized Mortgage Obligations
In June,1983, FHLMC issued the first Collateralized Mortgage
Obligations (CMO).
A CMO
consists of mortgages or mortgage
securities repackaged into a
has characteristics of
is treated
as debt
class recieves
multiple class instrument, and
both a bond and
by the issuer
a pass-through.
for tax
a different priority claim
33
purposes.
It
Each
against the cash
flow.
and
recieves a
class
priority
the lowest
Conversely,
risk.
level of
the low
return reflecting
recieves a
safest position
class has the
highest priority
The
higher
return commensurate with its subordinate position.
protection
to
available
for
slow
the
collateral
By tailoring CMO's to various investors yield
expectations and risk profiles,
arbitrage
is
additional cash flow
reducing
thereby
classes,
earlier
class
pay
an accrued interest class, recieving
maturity, can free up
payment only at
requirements.
fast
the
after
only
are
funds
as
class,
pay
of call
a measure
also provides
redemption
The use of
satisfied.
to
It
class.
fast pay
Slow Pay,
certainty and shorter maturities to
provides more cash flow
the
Fast Pay /
referred to as
Prioritization, often
between
the bond
issuers earn profits on the
and
yields
the cost
of
the
a
new
underlying mortgages.
Real Estate Mortgage Investment Conduits
Real
Estate
opportunity
Mortgage
to
create
underlying mortgages.
Investment
multiple
The Tax
the new form of intermediary
simplify
some of
mortgage
backed
legislation was
class
offer
instruments
Reform Act of
from
1986 created
mortgage ownership in order to
the accounting
security
Conduits
and taxation
issuance.
fostered principally
34
problems of
Impetus
by Lewis
for
the
Ranieri and
Andrew Furer of Salomon Brothers and its final form contains
several key provisions:
*
By electing REMIC status,
Elimination of double taxation.
the chosen form of intermediary ownership of the mortgage,
and Connecticut,
York
New
California,
notably
law,
federal
follow
automatically
not
do
(Some states which
entity level.
federal taxation at the
considering
are
However,
taxation of REMICs issued in the corporate form.
no
action
been
had
by
taken
from
exempted
is
trust),
corporation,
(partnership,
this
of
as
state
any
writing.3)
*
Distinction of Ownership Forms.
of
interests
Regular
ownership;
debt
have
which
interests which have equity
characteristics, and Residual
characteristics.
REMICs may have two forms
There may be any number regular interest
classes, but only one
Both type
residual interest class.
of interests are readily transferrable.
*
Payment
allocated
classes
Allocations.
in
of
a
subordinating one
fast
pay and
disproportionate
manner
Reallocation
investors.
or more classes
slow pay
have payments
interests may
REMIC
categories.
among
can
or by the
allows the restructuring of
occur
by
creation of
Reallocation
utilized on both new and existing mortgages.
various
can be
This feature
benefits without altering the
35
transferable, although
readily
limitations
certain
imposed on
be subject
may
they
are
instruments
Subordinated
involvement.
borrower
explicit
without
and
documents
mortgage
underlying
to
regulated investors
for
holders
are
second mortgages.
*
Taxation
treated
as
were
their interests
if
interest
Regular
Interests.
of
holders realize
Residual interest
instruments.
debt
all net income
of the
REMIC not attributed to regular interest holders.
*
Taxation of
Foreign Investors.
the 30%
REMICs eliminate
Foreign investor withholding tax on mortgages issued prior
to July 18,1984 .
*
treated
as
estate
"real
qualification
regular and residual interests are
Both
Effect on REITS.
of
an
for
assets"
organization
as
purposes
Real
a
of
Estate
Investment Trust (REIT).
*
Permitted REMIC Assets.
qualified mortgages and
All of a REMIC's
assets must be
permitted investments.
Qualified
mortgages are principally secured, directly or indirectly,
by an
include
interest in
three
real property.
narrowly
defined
Permitted investments
categories:
cash
flow
investments of a temporary nature producing passive income
in
the form
of interest;
qualified reserve
36
assets; and
foreclosure property which may be held for one year.
greater flexibility
Having
4
industry observers
than CMO's,
predict the REMIC structure will become the dominant form of
issuance of multiple class securities, particularly when the
securities 4 .
which intends to treat
mortgage
the
through
of
achieve most
can
modifications are
the
risk.
stream, as well as the
issued by a sole
benefits of
REMIC
status
internal
Several
the income
can fraction
available which
the
security issuance as
structure.
bond
of
treatment
sale
asset
Property specific financings
purpose entity
debt
receive
to
wishes
issuer
These modifications, senior /
subordinated structuring, stripping, and interest rate swaps
below.
are described
REMIC
structure can
mortgage,
underlying
require
developing
simultaneously
to
It should
be noted that ,
overlayed
be
the
without disturbing
the
modifications
may
internal
these
bond
indentures
mortgage
and
compatability
ensure
while the
and
pricing
efficiency.
Senior /
Subordinated Structure
The senior / subordinated structure
self credit
can be
enhancing instrument.
composed of
which is rated
placement,
and
two classes; a
can be used to create a
senior class
and sold to the public or
a subordinated
37
a security
For example,
class
(class A)
through a private
(class
B) which
is
unrated and is
either held by the issuer or
private placement.
in their
class are subordinated
The B
and interest.
principal
of
receive payment
to
right
sold through a
A
liquid asset reserve fund can be established and replenished
The fund
of class B interests.
with proceeds from the sale
is available to support cash flow disruptions to the class A
Over time, as
holders.
the underlying mortgage seasons and
risk of future losses diminish, the reserve fund balance can
be
receive
class
Eventually,
reduced.
funds from
B holders
reserve as
the
well
can
begin
as interest
to
and
principal.
The
class
senior
intermediate,
fractioning of
by
supported
efficiency
sale of
the
a high
an unseasoned
enhances
The
pricing
the instrument.
class, with its
coupon to offset
property, the
short,
rated classes, each
class,
liquidity of
into
securities.
rateable
subordinated
The
concentration of
the risk.
In the
subordinated interest
an equity option, as it represents
residual value without any
flows.
divided
cash flows into several
the subordinated
is, in effect,
further
term
long
and trading
risk, requires
case of
and
be
can
a bet on
certainty regarding interim cash
Pricing may explicitly acknowledge this relationship
by providing participation in
the residual on a percentage,
rather than a fixed, basis.
38
Stripped Mortgage Structure
The conceptual
greater
income
value
the
stream of
relative to
the securities
for
The
mortgage.
redistributing
by
amount of
made as principal
the
principle
can vary
among the classes
interest allocated
instead of being a constant, pro rata share.
may be
obtain a
stripping is to
premise of coupon
The allocation
may vary
only, interest only, or
proportions of either or both.
By seperating and creating various combinations of principal
be tailored to appeal to a
and interest, the instrument can
broader range of investors.
of the
maintainance provisions
yield
the
Depending on the prepayment and
newly
strips may
created
have
underlying mortgage,
different
prepayment
behavior than an unstripped instrument of equal coupon.
If
a
coupon
created
is
the original
coupon payments,
par
value;
Investors
these
in Discount
are
termed
Strips expect
the
same likelyhood of
the lower
to its
sell at a discount
occur earlier than anticipated, as
difference between
of
rate
To offset
mortgage.
the strip will
hence
coupon
it will retain the
underlying mortgage,
prepayment as
below the
Discount
Strips.
that prepayment
will
their profit lies in the
par value and the
discount amount paid.
Realizing this difference earlier increases the yield to the
investor.
39
the
mortgage and adopts
higher than the underlying
coupon rate
characteristics
prepayment
assures a
prepayment
extended time to
The
coupon payments
flow of
longer term
It
rate.
lower
the
of
a premium to par.
therefore sells at
It has a
opposite characteristics.
A Premium Strip has the
than an unstripped security of the same coupon rate.
A Principal Only
Strip.
extreme form of
Strip is an
no interim coupon payments are
As the name implies,
yield is soley dependent upon
recieved by the investor; the
The investor
of principal.
prepayment
accounts for, thereby increasing
have
limited
and
restricted
therefore
mortgage
maturity,
prepayment
attractivenes
depend on
is
to
applicability
therefore
The
predictble.
the yield.
Principal only
rights are
the prpayment
more
instruments
lockout period;
prior to
prepayable for
several
years
may
be able
to realize
the investor
is
speed
these
of
specific
property
securities since prepayment
commercial mortgage
strips
in premium
the pricing of the strip
expects an earlier prepayment than
strips
the Discount
if the
bond
increased
returns.
An Interest
the
Only Strip separates the
principal.
Without
losses should prepayment
benefit
the
principal, the interest only
interest payment from
of
any
right
to
strip is susceptible to severe
occur rapidly.
40
These instruments'
positively
highly
changes,
rate
interest
with
correlated
be
to
tend
therefore
performance
Because of
typical performance of fixed income instruments.
suitable for
Interest Only Strips are
this characteristic,
the
to
counter
use as hedging instruments.
When used for commercial mortgage securities, the prepayment
risk is significantly reduced to events of default and force
rights are explicitely recorded in
majeur as the prepayment
the mortgage and offering statements.
can
strips
specific
combined
be
Furthermore, property
with
senior
the
/
subordinated structure to create a synthetic amortization of
the
mortgage,
underlying
Consequently the remaining
risk.
default
thereby reducing
risk is principally attributable
to the subordination hierarchy of the classes.
Interest Rate Swaps
specific
Property
interest rate
combined with
yields
better
with
swaps to create
depends on
backed security
the swap.
also
the
As a hedging
provide
floating rate
excess yield
with respect to
a borrower
than
on the
the fixed rate
technique interest rate
with
obligation to
a
method of
a fixed payment
41
other
The attractiveness of the
securities of comparable quality.
combination
floating rate
protection
prepayment
be
can
mortgage securities
commercial
mortgage
payable on
swaps can
converting
stream.
a
This
technique can be useful when
the prefered source of capital
is floating rate debt for its lower cost.
An
interest rate
swap
between
two
payments
rate
of interest
exchange
is the
is
purpose
The
counterparties.
threefold; to reduce interest rate risk by matching floating
to floating
assets
rate
terms between
financing
limit
costs
transaction
the
swap
rate
or fixed
favorable
to exchange
liabilities;
rate
to fixed
assets
liabilities
rate
counterparties; and
to
confidentiality
by
and maintain
avoiding conventional refinancing.
In
a
typical
an
swap
investor
commercial
a
purchases
mortgage bond which has a borrowing rate based on Treasuries
of
comparable maturity.
The investor
the same duration
agreement of
a swap
also enters
The investor
as the bond.
agrees to pay a fixed payment composed of the treasury yield
plus an
additional spread to a
payment is
return
usually
less than the
the
the
retaining the
investor
counterparty
into a
The combined
coupon on the mortgage
recieves
a
floating
Interbank Offer
London
Rate
rate
into
bond.
In
payment,
(LIBOR),
differential between the mortgage
the fixed payment.
synthesized
counterparty.
while
coupon and
The original fixed rate mortgage bond is
a
in turn
fixed payment
floating rate
converts a
instrument.
floating rate
Exhibit 4.2
stream.
flow of funds in a basic swap transaction.
42
The
swap
instrument
illustrates the
EXHIBIT 4.2:
INTEREST RATE SWAP
INVESTOR IN
I interest based I
I----->1 on fixed rates I ----- >ISWAP
I
I
MORTGAGE BONDI<-----I interest based I<-----ICOUNTERPARTY
Ion floating ratel
A
linterest based|
Ion fixed ratesi
A
I<-----I
BOND ISSUER
to
Counterparties
They
liabilities.
payments
principal
Although the
only agree to make
of
not
do
transaction
swap
a
for the interest
obligation.
original
their
liability appears on the
exchange
interest payments to
Each counterparty is liable
one another.
and
interest based I<-----IMORTGAGOR
I on fixed rates I
originator's balance
sheet, the swap does not.
The
technique
swap
ability
spreads.
the
between
rating has to
rating.
These
known
quality
as
the premium a borrower with a
pay over
a borrower with
spreads differ
floating rates and vary over
borrowing
in
differences
counterparties,
A quality spread is
low credit
credit
depends on
time.
for fixed
a high
rates and
It is important to note
that comparisons of these spreads are comparisons of debt of
different maturities.
intermediate term
Floating rates, typically
borrowing, have narrower
short and
quality spreads
than fixed rates, reflecting lenders' perception of reduced
exposure to default risk in shorter term loans.
43
Debt
Interest rate swaps are suitable for longer term debt.
with maturities of up to 2.5 years can utilize interest rate
contracts which
futures
bonds; Bank
and eurodollar
(interest
the asset falls
market value of
seller recieves cash.
cash
The
profits.
the contract,
the
each time
the
rates rise),
the
the reverse happen, the buyer
Should
flow
and Gilts;
date in
a specific
at
life of
During the
future.
CD's; Sterling CD's
specific price
for a
GNMA's)
bills, notes,
financial asset (Treasury
a certain
or sell
agreement to buy
These contracts are an
costs than swaps.
transaction
have lower
typically
handled
is
through
margins
maintained by both parties at the trading exchange.
is the
there
swaps
rate
Interest
underlying
potential for
payments
on
First,
disadvantages.
have certain
the
disintermediation between
either side
of
transaction.
the
While the mortgage is based on Treasuries, the floating rate
payment
recieved is
eurodollar
4.3,
the
As
denominated index.
spread
on LIBOR,
often based
between
eurodollars has been fairly
three
illustrated in
month
other
or some
Exhibit
Treasuries
and
constant between 1983 and 1987.
However, fluctuations such as that which occurred during the
fourth quarter of 1984 create interest rate exposure for the
holder of a swap.
essence,
This
a bet
potential
Transnational interest rate swaps are ,in
on the
future volatility
volatility
can
simultaneous currency swaps.
44
be
of the
mitigated
by
indices.
use
of
EXHIBIT 4.3:
3 MONTH TREASURY VS 3 MONTH EURODOLLAR
February 1983 to May 1987
11
E,
7
I.
ii.
6
5
ix
z
4
3
2
0
- --
--84
-M5 - -MJS8-
-
-
-1
83 AMJ JASON 84 MAMJ JASON 85 MAMJ JASON 86 MAMJ JASON 87 M
0 INIUEST SPREAD
+ EURODO.AR
A 3 M( -REASURY
Source:
Federal Reserve Bulletin
45
can
at additional cost.
guarantees, but
another
security, any
the
but
alternative,
Furthermore
usually
10 to
15
Collateral
the
collateral position
bondholders.
required,
in
of
letters
through
mitigated
be
potential
This
interest payments through default.
exists for loss of
risk
risk, the
is at
principal
although no
Second,
case
the
of
would be
the
posting is
mortgage
subordinate to
of
amount
percent
or
credit
collateral
of principal,
would
debt in a senior / subordinated
reduce the amount of senior
structure. 5
The default risk
acts
as
the
intermediary.
agreements with
counterparty,
is in part assumed by the
provide
consequently, often
the
is.
agent
The
during
guarantees
principal to
intermediaries,
each counterparty to the
other counterparty
settlement
The
does
the
against
for the
not
life of
the
default.
By
life of
make
transaction.
One
know who
intermediary will also
the transaction, the swap
credit exposure
swap dealer who
the
act as
contract,
acting
and
as
a
dealers must accept
the agreement.
Any
decline in the creditworthiness
of either counterparty, and
the dealer's credit exposure is
increased.
protection from
acknowledge
this change; no counterparty
the
possibility
of
a
Yet there is no
is willing to
downgrading
of
their
credit, let alone make provision for it.
In
1986, The
Beacon
Companies and
46
Equitable Real
Estate
downtown
75
at
building
office
of a
the construction
Management financed
Investment
State
new
with
Street
a
commercial paper interest rate swap in lieu of a traditional
draw funds as
In order to
construction loan.
needed, the
borrowers raised money by issuing AAA rated commercial paper
through a
coupon payment
a floating
paper had
This
credit (LOC)
letter of
ten year
with Citibank.
the
indexed to
three month treasury bill rate.
In
interest rate swap with a
a 10
year fixed
floating rate
third party.
rate payment
payment based
at
by the counterparty.
10
points
commercial paper,
debt
payments
arrangement
below
the
the
provided
a
Federal Funds
obligation
the borrower to
commercial
the
exchange for
floating rate payment,
floating
passed through
of
9.5% in
The
into an
They agreed to swap
on the Combined
rate paid
basis
borrower entered
agreement the
a simultaneous
paper
borrower
with
of
meet the
issued.
an
the
This
effective
borrowing rate of 9.6%.
The fundamental concern for the borrower in this transaction
Any downgrading
is the creditworthiness of
the LOC issuer.
of the creditworthiness of
Citibank will raise the required
returns on
funds is
its commercial
paper.
passed directly to
This additional
cost of
the borrower, widening
basis point spread between the floating rate payments.
47
the 10
In
another transaction,
the financing
of construction
Boston Harbor, The
Rowes Wharf, a
mixed use development on
same borrowers
immunized themselves from this
loan with
floating rate
the borrowers negotiated a
the Bank
debt obligation was
credit risk.
made, but instead of issuing
A similar swap arrangement was
commercial paper,
of
of Boston.
The
of this
floating rate
independent from the
based on an index
creditworthiness of the bank.
Interest rate
swaps are a recent
Yet, by 1986, the International
emerged in the late 1970's.
Swap
development, having first
estimated outstanding
Dealer's Association
principal
contracts of it's 33 largest members to exceed $200 Billion.
in
the wake
magnitude
questions
of
relative
their
intermediaries'
questions about their creditworthiness
The
for
secondary market
limited
to
Furthermore
the
their
capacity
is
these
a high interest rate environment,
about
the
Most of
interest rates.
of declining
deals have yet to weather
raising
last two years
the activity has occured in the
The bulk of
no
liquidity becomes an issue.
holdings
6
also
instruments is
these
of
strength.
about
retail
two
market.
dozen
The
raises
currently
dealers.
Consequently
And without liquidity, there is
less chance of laying off risk onto others.
Defaults by intermediaries
seems unlikely.
48
However, should
the
cause
default
the intermediary's
of
downgrading
disintermediation,
counterparty
a
by
the acceptance
would likely diminish.
To
of
credit
worthiness
to
unforseen
due
interest rate
swaps
date, no defaults have occurred,
and over 90% of swaps involve debt rated Baa or better.
49
NOTES TO CHAPTER IV.
1.
Editor, The Handbook of Mortgage
Frank J.,
Fabozzi,
Backed Securities, Chicago Illinois: Probus Publishing,
1985,
2.
1.
Salomon Brothers Inc, Real Estate Market Review, October
1986, 5.
3.
PerlmanJudi,"States
REMIC",Mortgage-Backed
on
Way
Own
Their
Going
Securities Letter, Vol.II, No25
June 22,1987, 1-2.
4.
Furer,"REMIC's - The
Shenkman, Martin M., and Andrew E.
Estate Financing", The Real Estate
New Vehicle for Real
Finance Journal, Spring 1987, 29.
5.
Swaps
"When
Gregory,
Miller,
Investor,November 1986, 173.
6.
ibid.,
165.
50
Unwind",
Institutional
RISK EVALUATION
CHAPTER V.
As identified
of
securities
can be
either
case,
the
sold with
Mortgage
backed
or without
a rating,
but in
be
must
risk
determine a commensurate return.
as Standard &
some
deal.
the
of
risk
the
disclosure
market in
there is
is sold,
backed security
a mortgage
which
regardless of the
in Chapter III,
evaluated
in
to
order
The rating agencies, such
and Duff &
Poor's, Moody's Investor Services
Phelps, have simply institutionalized the risk assesment for
These
the benefit of both buyers and sellers of securities.
agencies
are
disinterested
providing objective measures.
analysis
is
security
with
and
to qualify
respect
parties to
transactions,
purpose of the agencies'
The
categorize
its
to
the
capacity
the risk
to
make
payments of interest and repayment of principal.
is not a
it
recommendation to buy or sell a
a commentary
on
the
price or
the
of
the
timely
The rating
security.
Nor is
suitability for
a
particular investor.
While the designations differ among the rating agencies, the
interpretations are similar.
Standard & Poor's rating
system uses the following designations:
AAA
The highest quality.
strong.
AA
Capacity to
from AAA.
Capacity
pay is very strong;
51
to
pay is
extremely
differs only slightly
A
more
but somewhat
is strong,
to pay
Capacity
susceptible to changes in circumstance and economic
conditions than AA, AAA.
BBB
Capacity is adequate
respect to
speculative with
Predominately
rated
lower
and
(These
pay.
to
capacity
issues are characterized as "high yield" or
"junk" bonds).
BB,B,CCC,CC
C
Reserved for income bonds on which no interest is being
paid.
D
Debt is in default; payment is in arrears.
Studies have indicated that
of
default.
Hickman
the ratings are good predictors
found that,
to
period 1900
for the
1943, approximately 6% of bonds rated AAA or AA and 13.4% of
rated A at the time of the offering subsequently
2
Furthermore, bond ratings have been found to be
defaulted .
3
highly negatively correlated to yields
bonds
In 1984, Standard & Poor's
for
rating
securities.
with their
same
property
specific commercial
own versions4 .
this
paper
examination of these rating
not
As all
examines the
are
they
rated.
a
particular
S&P
have the
By
system.
systems, one can understand the
securities, whether or
More significantly,
identify the limitations placed on
achieve
backed
Phelp's followed
three systems
risk relevant to mortgage
issues of
mortgage
and Duff &
1986, Moody's
In
purpose,
(S&P) developed the first system
rating.
evaluated with respect to their
to the borrower.
52
one
can
also
the borrower in order to
These
limitations
can
be
effect on the cost of funds
Standard & Poor's Rating System
First the
Standard & Poor's uses a two part rating process.
specifics of the property
Then the
are carefully analyzed.
proforma revenue stream is tested against a phased-in, worst
case
The
scenario.
for
developed
use
with staff
been
fully
occupied
operating histories.
However,
indicate the
members
be expanded in
model may
has
model
quality,
prime
on
properties with demonstrated
interviews
analytical
current
the near future to
the
scope of
include other
commercial uses.
In
examining the
property, S&P
engineering reports and historical
followed by a site visit.
reviews an
MAI appraisal,
operating data.
This is
After establishing the quality of
the physical asset, the projected income stream is subjected
to
the
worst
case
scenario.
Houston's economic changes after
will
experience
sharp
declines
vacancy and operating expense
a matrix of eight variables
to
their
effect
on
The
scenario,
based
on
1982, assumes the property
in
rental
increase.
income
while
The model develops
which are weighted with respect
each analytical
illustrates these relationships.
53
factor.
Exhibit 5.1
S&P WORST CASE MODEL FACTORS
EXHIBIT 5.1:
(%)
Worst Case Analytical Factors
------------------------------------Project Size
Lease Terms
Tenant Quality
& Mix
Property
Management
Energy
Efficiency
Construction
Quality
Site Location
Local Economy
RENT
5
25
VACANCY
5
20
EXPENSE
0
5
5
5
5
25
30
30
5
5
30
5
20
10
5
20
10
30
0
0
100
100
100
Total
National Worst Case: Maximum Reduction
---------------------------------
29.0%
11.5%
15.0%
Rent Reduction
Vacancy Increase
Operating Expense Increase
Standard & Poor's Corp.
Source:
The
order
to
be reduced
phased in
reflect
a
region is
the
reflect
property under
be
factor for
to determine the
Variable Sum)
over
characteristics
evaluation,
each of the
to 90%.
the first
three years of
already in
the current
or can
(100
the property.
of
the
In
specific
eight variables can
can be
the projections to
occur immediately
if
complete decline.
worst case cash flow
and worst case
every year the
by
These reductions
from 10%
worsening recession,
After the
multiplied
are
reduction factors
Maximum
5
projections are calculated,
market value is
calculated for
S&P
uses the income
bonds are outstanding.
54
selecting
approach,
will
vary
depending
residual
and
phased in over time.
capitalization rates, which are
rates
rates
discount
severe
on the
desired
bond
These
rating,
starting with a 10% real rate
of return for AA and dropping
50 bp for ratings AA through
BBB, then 100bp for ratings BB
and B. Any growth rate is added to this real rate.
Finally
and property
flows
the cash
against financial ratios
.
values are
measured
These ratios also vary depending
on the rating desired, and are listed in Exhibit 5.2.
EXHIBIT 5.2: WORST CASE FINANCIAL RATIOS
FOR OFFICE BUILDINGS
RATING
AA
A
BBB
BB
B
Source:
LOAN TO VALUE
RATIO (%)
DEBT SERVICE
COVERAGE
75%
75%
80%
85%
90%
1.25
1.15
1.1
1.05
1
Standard & Poor's Corp. 6
In addition to these financial ratio tests, S&P reguires the
project maintain
greater
of two
a liquidity
months
reserve account equal
to the
or three
months
of gross
rental payments from the highest
must the liquidity reserve be
annual debt service on the
revenue
paying tenant.
In no case
greater than one third of the
bonds.
This reserve is required
to insure against late mortgage payments.
55
Any shortfall of cash flow to meet bond interest payments or
shortfall of residual value to cover principal repayment for
any
years
of the
the bond
that
In addition to
mustalso cover the liquidity
shortfalls, the credit support
All
be
outstanding must
credit support.
insured against by means of
reserve.
is
credit support must
the bond
be in place at
closing.
real estate is not a
S&P recognizes that
that funds are
to insure
So
liquid asset.
redemption at
available for bond
maturity, they require the posting
of a liquid asset credit
facility, equal to the redemption
value of the bonds,in the
form
of a
letter
of
government securities.
to
bond
credit, surety
This must
value(LTV) ratio of 67.5% at
the
posting
be
can
that time.
until
deferred
U.S.
be posted two years prior
property
the
maturity, unless
cash or
bond,
meets a
loan
to
Passing this test,
one
year
prior
to
until six months prior if
7the property still meets the LTV test one year prior .
Posting can be delayed
maturity.
Meeting the requirements of this rating test will assist the
borrower in
However,
the rating
efficiency
gained
requirements it
the
through
imposes.
definition, be
of the
pricing
and
reserve
restrictions
costs of
The
are discussed in Chapter VI.
by
offsets some
process
the bond.
possible rate on
obtaining the best
these restrictions
While the rating system must,
conservative, over
56
time it
is expected
criteria may
that the
increased
become less
availability of
fundamentals.
impact
of the
estate
appraisal
and
the
on
familiarity with real estate
for
A topic
rating systems
to the
performance data
historical
rated properties and increased
market
restrictive due
further
on both
the method
underwriting
conventional lenders.
57
study is
the
of real
guidelines
of
NOTES TO CHAPTER V.
1.
the Rating
Industrial Bonds and
Belkaoui, Ahmed,
Process, Westport Conn: Quorum Books,1983, 13-14.
2.
ibid.,
15.
3.
ibid.,
16.
4.
Adler, Tamara L.,
Bonds", The Real
"Pricing Rated Commercial Mortgage
Estate Finance Journal,Summer 1987,
20.
5.
Edith H.Shwalb and David B. Smith,
Conway, Janet V.,
"Commercial Mortgage Ratings Credit Review", Supplement
to Credit Week by Standard & Poor's, November 24, 1986,
3.
5.
6.
ibid.,
7.
Adler, 22.
58
COSTS OF CAPITAL
CHAPTER VI.
Cost of securitized offerings
must
costs
and
identified
be
determine the effective
and opportunity
deferred costs
Indirect costs,
Direct and
any securitized
to
the borrower of
cost of capital to
The basic cost
funds raised through a securitized offering.
structure of
order
in
aggregated
or private,
offering, public
consists of the following components:
Base
Rate -
rate
This
is set
by
treasury
cost of
the
securities of the same maturity as the proposed bonds plus a
premium.
This
measure reflects
the cost
of funds
to the
issuer.
Spread Over Base
treasury rate.
the coupon rate
Rate - This rate is a
The combined
base rate and spread represent
for the bond offering.
the lending rate for the
percentage over the
It also represents
mortgage placed with the borrower.
The exact percentage is determined through market testing by
the issuer of investors' willingness
to pay for the type of
offering proposed.
Placement Fee
- This is the
placing the offering in
to
as
the
structuring
fee charged by the
the capital markets.
fee or
59
underwriters
issuer for
Also referred
fee,
it
is
Fees
typically equal to a percentage of the bond principal.
have been found to average
for underwriting corporate bonds
Professionals
1%, for bond issues in excess of $50 Million.
also the range
paper indicate this is
interviewed for this
for commercial mortgage bonds, although the variance is plus
or minus 30 basis points.
is charged by an agency in
Credit Enhancement Fee - The fee
return
for
the pledge
of
of
principle
and
payment
Credit Enhancement
credit
to support
interest
may be required
the
to
on a rated
the
timely
bondholders.
security to
support any possible shortfalls or disruption to the project
of
The amount
cashflow.
achieve a given rating is
enhancement required
credit
to
determined by the rating agencies
through their evaluation process.
Credit
enhancement
magnitude
or
guarantee
irrevocable
amount.
may
either case
In
and
Enhancement
provide
the fee
of
paid both
transaction structuring,
unconditional
be limited
may
vulnerability
fees are
an
to
charged will
the
a
Credit
initiation of
form of commitment
as a
specific
reflect the
liability.
at the
the
fee, and
quarterly for each year until redemption.
Credit enhancement may take several forms:
* Cash or other liquid asset reserves placed in trust.
60
and
*
Letter of Credit (LC) issued by domestic or foreign banks.
*
Surety Bonds issued by Insurance companies.
As described in earlier chapters, there are ways to achieve
credit enhancement without incurring direct costs, such as:
*
-
Over
collateralization;
the reduction
loan to
of the
value (LTV) ratio by increasing collateral assets.
*
Senior /
the reduction
Subordinated Structuring;
of the
LTV ratio by reduction of the loan amount.
The cost of credit enhancement have fallen sharply in recent
months.
to the major Japanese Banks,
This is primarily due
determined to
which seem
foothold in
the credit
aggressive pricing.
They have
obtain a
enhancement
market through
chosen this
strategy to overcome the
disadvantage of being
an unknown entity to most domestic borrowers, who may show a
preference for dealing with familiar organizations, all else
being equal.
and highest
worlds'ten largest
is the
Citibank
only
rating designation.
with a
some
AAA rating
AAA
favor is that six
Currently in their
rated
rated banks
U.S. bank
to
Those offerings
must purchase
organization.
61
of the
are Japanese. 1
maintain the
highest
desiring to issue debt
the credit
worthiness of
EXHIBIT 6.1: YIELD SPREADS BETWEEN AAA AND AA RATED
CORPORATE BONDS, FEBRUARY 1985 TO MARCH 1987
90
70
I-
z0
0
40
20
10
IIIII1III11III1IIIIIII1I1IIIII1I1III1II1I
I 111111
83 AMJ JASON 84 MAMJJASON 85 MAMJJASON 86 MAMJJ ASON 87 M
Source: Federal Reserve Bulletin
62
30bp
to
payments
ranged between
enhancement annual costs have
Recent credit
the amount
of
40bp
interest
6.1, the
in Exhibit
shown
As
protected.
and
principal
of
yield
corporate debt varies greatly but
spread between AAA and AA
during the period February 1985 to March 1987 spreads ranged
from
spreads
the
of
representation
an
not
is
Although this
59bp.
to
34bp
accurate
similarly
between
rated
commercial mortgage backed securities, the relationships are
To the
similar.
extent that
credit enhancement
fees are
less than or equal to these spreads, their cost benefits the
borrower.
Fees
Legal and Accounting
drafting
and coordination
mortgage
and offering
fees
may
also
investors as to the
prepayment
rights,
importance to
are
also
regarding
for
the
of all
the
as review
and
as well
conform to
the rating
In the case of a private placement,
for
be incurred
negotiations
with
specific details of credit enhancement,
reseve
accounts
the investors security.
the
charged for the
documents including
documents to
agencies' requirements.
legal
These are fees
statements,
of these
modification
-
procurement
offering
of
documents.
and
The
other
items
of
accounting fees
certified
These
statements
costs
vary
principally with the complexity, rather than the size, of an
offering.
Estimates range from $700,000 to $1,300,000.
63
printing
of
and
prospectus
the
costs of
- These represent
Advertizing Costs
Printing and
requirements
other
of
Estimates range from $75,000
notification of the offering.
to $100,000.
for rating services as described in Chapter 5.
Rating Fees -
amount of
the
.04% of
approximately
the
These
fees are
bonds,
plus a nominal amount annually to update the rating.
-
Trustee fees
the
Collection
and principal
interest payments
certificate holders.
the basis
payments
mortgage
of
receipt
maintained for
accounts must be
distribution
and
repayments to the
of
bond or
These fees are typically calculated on
of activity in
the accounts.
In any
event they
are an insignifcant fraction of the costs.
Title Insurance -
As with any real
estate transaction, the
be protected from claims
mortgagee must
The cost
in the title.
against or defects
of title insurance are estimated at
$150,000 to $250,000 for larger transactions.
Appraisal fee -
Typically about $40,000 to
$60,000 plus an
annual update fee.
Liquid Asset
Credit Facility -
rated offerings
this
is a
require the
future cost,
As described in
posting of this
it is
64
dependent on
Chapter 5,
facility.
As
unforeseeable
market
therefore
and
conditions,
bond has call privileges prior
However, if a rated
priced.
accurately
be
cannot
to maturity, it is conceivable the posting requirement would
avoid the additional cost.
trigger early redemption to
bonds have
whether the
is dependent on
this occurrence
potential for
provisions and
yield maintainance
The
the interest
rate environment for reinvestment at that point in time.
Base Rate and Spread
The
a
choice of
base rate
is dependent
on
the cost
of
capital for the issuer of the bonds and underlying mortgage,
as well as the proposed structure of the bond offering.
The
interest
and
supports
mortgage
It is therefore desirable to
principle to the bondholders.
match
the
principle
maturities of the
only,
bonds.
1,
3,
Or a
5
of the
payments
mortgage
For example, a
bonds.
balloon mortgage
of
payment
timely
the
is
matched with
10
is matched
with
a
the
10 year, interest
10 year
mortgage with principle payments
and
with
group
treasury
due in years
of
treasury
instruments of the same maturity and par value.
By surveying potential investors,
the issuers determine the
expected yield demanded for the proposed bond offering.
The
yield required is influenced by several factors:
Liquidity - Rated Commercial Mortgage Bonds are not actively
65
traded, principally
instruments.
in
few instances the issuer
In a
for its
own
The investor
some liguidity.
to create
in order
account
makes a market
sell
buy and
to
offering
the security,
of the
the recent introduction
due to
demands a higher return on investments of less liquidity.
by a physical
As an instrument supported
Prepayment Risk -
asset, the bonds are at risk of prepayment of the underlying
mortgages
to
due
investors yield to maturity will drop.
and the
instruments
the mortgage
of
acts may
the repayment of principle, the
be covered by insurance for
of
act
or
Although these
as condemnation.
government, such
loss
catastrophic
some
tendency to
include
the event of prepayment at
yield maintainance provisions in
the borrowers choice, property
Due to the structure
specific financings are less
affected by this risk.
Reinvestment Risk - Accompanying prepayment risk is the risk
of finding suitable investments offering the desired returns
to maintain the yield that
would have been achieved had the
bond not been prepaid.
Historic
rates
Rate
have
indicative of
related
liquid
- Traditionally,
Spreads
been
higher
a perception
investments.
trading instruments,
corporate
than
of higher
Despite
mortgage
the
66
risk in
advent
investors
lending
lending
rates,
real estate
of ratings
still carry
and
higher
and returns for mortgage backed
expectations about the risk
investments.
Comparison to Bullet Loans
capital to
cost of
the effective
Evaluating
the borrower
requires a comparative analysis with
respect to the cost of
funds available through conventional
lenders such as banks,
insurance companies
stated earlier,
As
and pension funds.
these sources are usually limited to loan amounts between $5
million and
the
overlap
in the
inherent
offerings are
while securitized
of $25
a minimum
limited to
within
$200 million 2,
Borrowers
million.
may choose
whether
securitized offering
the
who fall
restrictions
are warranted
by an
advantageous effective cost of capital.
Exhibit 6.2
illustrates the average interest
rates for ten
year,interest only bullet loans offered by thirty major U.S.
the yields
lenders,
of ten
yield spreads between
to March 1987.
are typically
spread
year Treasury
the two for the
Since ten
an
interest rate
period February 1983
ten year treasury,
margin within
costs of the securitzed transaction
have
the
year mortgage bond interest rates
indexed to the
represents the
bonds, and
advantage
67
which the
the yield
additional
must remain in order to
over
bullet loans.
EXHIBIT 6.2:
YIELDS ON TEN YEAR BULLET LOANS
VERSUS
TEN YEAR TREASURY BONDS
14
13
12
11
10
wi
I-
9
8
7
z
4
3
2
1
0
83 AMJ JASON 84 MAMJJ ASON 85 MAMJJ ASON 86 MAMJ JASON 87 MAM
0 INTEST SPEAD
+ 10 YER TEA9)RY
A 10 - 12 YR MORTGAGE
Source:
Barron's/John B. Levy National Mortgage Survey,
Federal Reserve Bulletin
68
It
should be
Exhibit
year
6.2,
through
costs
security
loan
originations
these
rates
this
scope of
One can expect
of this
narrowing of
for
spreads
of
occurence can
be
the
narrow
to
Evidence
lenders.
which
securitzed offerings
from
tend
will
recent
the
for further research.
increased competition
in the
beyond
offerings is
within
borrowing
to
in
indicated
Estimating
compete.
comparing them
that
found
than
margin
wider
can
and
paper, and is a topic
conventional
is higher
a
providing
offerings
securitized
additional
treasuries
as
such
Subsequently the spread
raise the effective borrowing rate.
ten
a
reports, which
appraisals and engineering
commitment fees,
above
rate,
lending
to the
addition
in
loan
bullet
costs to
there are
that
noted ,however,
spreads between
bullet
3
loans and ten year treasuries.
opportunity Costs
Time and timing are the most significant determinants of the
magnitude of the opportunity costs of securitized offerings.
The time required to
complete a securitzed transaction from
inception is estimated
to range from seven
By comparison, a bullet
to 90 days
loan transaction typically takes 60
to complete, and can be as
This extensive lead time
borrower to
to nine months.
interest rate
little as two weeks.
for security offerings exposes the
risk.
69
As
the market
for these
securities
matures,
standardized,
nature
time
of the
the
lead
sales and
required to
thirty to
and
the
time may
become
shorten.
However,
disclosure requirements,
rating analysis,
complete the
ninety days, limit the
the
and the
typically
potential for improvement
in lead time needed to execute such transactions.
70
more
products
NOTES TO CHAPTER VI.
1.
Feldman and Arthur K.
Robert A.
Zisler, Randall C.,
Real Estate Report,
The
Research,
Selender, Real Estate
1987, 3.
30,
April
Sachs,
New York, NY: Goldman
2.
Crittendon Report Real
28, July 13, 1987, 1.
3.
Zisler, 3-5.
Estate Financing,Vol.
71
13, No.
CHAPTER VII. CASE STUDIES
Lincoln Property Associates
Limited, a
1985, Lincoln Properties Associates
In December
subsidiary of Lincoln Property of Dallas, Texas, issued $146
Million in fully registered, first mortgage bonds to finance
commitment of two office
the take out
buildings then under
issuer was organized primarily
construction.
The
the bonds and
to serve as managing general
project
that
partnerships
The
buildings.
bonds were
would
to issue
partner for two
construct
placed privately
and
own
the
without third
party credit enhancement.
Lincoln Liberty, a Pennsylvania limited partnership, was the
Pittsburgh, Pa., which
will be 32 stories
615,360 leasable square feet.
Allegheny Corporation
agreement
to masterlease
$31.50
per
another
square
in
and will contain
the time of the offering,
At
ten year lease
under a
to
located
42% of
had commited to approximately
the space
$26.50
Tower,
Allegheny
for
partnership
project
from completion
11%.
foot.
plus an
Rents range
The
from
anticipated
completion date is August 1987.
The appraised market value at completion was $137.5 Million.
Construction cost was estimated
of
the appraised
value.
at $97.44 Million, or 70.9%
Allegheny
72
Tower received
$114.6
Million (78.5%) of the bond proceeds.
North,
project
partnership
The
leasable
square feet.
Bank,
in the
Actual
1986.
July
value at
Construction cost was estimated
completion was $45 Million.
The FHLB
at $28.5 Million, or 63.3% of the appraised value.
received
Building
the
of
or 21.5%
Million,
$31.4
from
years
for ten
appraised market
The
property.
Home Loan
North has a fee simple
Midland
completion was on schedule.
interest
as
estimated
originally
completion,
space
the
of
contains 240,907
The Federal
The tenant,
leased 62%
has
11 stories and
building is
Georgia.
the
Atlanta
in
Building
FHLB
the
for
was
partnership,
limited
Georgia
a
Midland
bond
proceeds.
Lincoln
Liberty
two properties.
mortgages on the
are secured by
The bonds
its leasehold
mortgaged
rights of the groundlessee, including
to receive rent
the right
payments.
fee
collateral
simple
proceeds
interest.
assignments
construction, and
mortgage on the FHLB Building is
evidencing a
secure debt
a deed to
North's
The
is also
The mortgage
UDAG loan originated in 1984
subordinate to an $8.5 Million
and maturing in 2066.
a
The mortgage
groundlease from Penn-Liberty Holding Company.
is subordinate to the
under
estate
of
the
The
bonds
leases
also
and
have first security interest
until construction
completion.
73
on Midland
first lien
received
rents
after
in the bond
Limitations
were
on
placed
lease
leins and
refinancing,
or
project sale
terms.
Limited guaranteed construction
Lincoln Property Associates
costs,
without
overruns
cost
including
reimbursement, and guaranteed funds
right
to
for bond redemption, in
proportion to each project's proceeds, if either project was
not completed
issuer also guaranteed
The
within one year.
to make loans to the partnerships prior to and for two years
after the break even
The managing general partners
points.
defered their development fees.
The
bonds
seni-annually.
and
2000
in
mature
make
interest
a fixed coupon rate
They have
payments
of 10.5%, an
increment of 50% of
net cash flow
of the partnerships,
and 50% of the residual
value of each
project at maturity.
Maximum
additional variable rate
at
22.5%
compounded
allowable interest was capped
semi-annually.
underwritten by Drexel Burnham
The
bond
issue,
Lambert, had a three percent
underwriting discount and incurred approximately $651,000 in
transactions costs, equal to an additional 45 basis points
The FHLB
six
months after
Early sale of the project
order
to
of the
completion
capitalization rate at time
in
January, 1987, approximately
Building was sold in
maximize
building shell.
The
of sale was approximately 8.5%.
was encouraged by the underwriter
bondholders
the
74
return,
while
The yield to the bondholders
shortening the bond duration.
the
the 50%
and
redemption
early
was due in large part to
This
was estimated to exceed 30%.
participation
However,
was capped
at 22.5% compounded, The
the
the bondholders
payment to
since the
residuals.
in
additional return from
net sale proceeds was held in abeyance until the maturity of
the balance of the bonds.
The bonds'
participation features created a
tantamount
to
a
fourfold.
project
First
would probably
individual lenders.
developer,
or possibly
conventional lenders.
electing the securitized structure
Their stated reasons for
were
that equivalent,
available through
terms were
better
The
participating mortgage.
Properties, believed
Lincoln
debt structure
the
reguirements
capital
exceed the
lending limits
of
the
of most
capital markets,
Second, by using the
the developer hoped to expand the ownership pool beyond that
of a limited partnership structure.
the
opportunity
for
business relationships
national
development
buildings
the
as well
and strengthen
access the
by
financing
two
economies.
Fourth,
The company
to learn
how to
believes the best
way to accomplish this is through direct experience.
75
as a
realize
the opportunity
capital markets.
new
hoped to
developer
as realize scale
develop
its reputation
Third,
company.
transaction afforded
to
Properties
Lincoln
simultaneously; the
time savings
This expansion afforded
transaction.
the
Notably, the issue raised all the funds before
take out
needed to
they were
to
drawbacks
certain
identified
developer
The
the construction
loans.
An
agreement was negotiated for the underwriter to reinvest the
reinvestment
They also had
needed.
to
to guarantee the principal
be available when
This agreement shifted the reinvestment risk to the
underwriter.
have
amount of principal.
security of the full
coupon, plus the
bonds fixed
to the
10.5%, identical
rate of
to guarantee a
The underwriter had
needed.
proceeds until
consider
as
part
issue
was
risk
this
developer would
agreement, the
Without this
his
of
cost
of
capital.
A second
feature
approximately
nine
of
the
months
days which
conventional
must
also be
developer.
simultaneously
They
expect
transpire before
lenders.
finance
the
in
the cost
of
through
of this
time
capital to
the
to
Lincoln
Properties
intends
multiple
projects in
the
future.
not
incrementally
for issuance and economies
of scale will
additional
increase the time
receiving funding
opportunity cost
The
considered
However,
complete
and
took
This compares to the typical 60 to
complicated transaction.
90
to organize
It
time.
projects
be realized.
76
will
Bank of Boston
In December, 1986, Equitable Federal Street Funding Company,
general partnership formed
a bancruptcy-proof Massachusetts
by The Equitable Life Assurance Society, issued $270 Million
secured by a first mortgage
in non-recourse, ten year notes
on
the Bank
Boston, which
Street by
Equitable Federal
Partnership.The issue
letter
Completed in 1971,
(1,474,150
82,900
S.F.
comprises
district.
gross square
entire
an
building
The
that is
this district
tenant is Bank of
The major
of
the
building.
commercial bank
term debt
of
block
is
one
over 25
It's
the
of
site,
city's
only
12
stories tall.
Bank of Boston, which leases
of
Bank
headquartered in
is rated AA by
feet).
Boston Corporation's principal
subsidiary, The First National
77%
1,355,610 rentable
and contains
below grade
feet
buildings in
Bank
stories above grade,
the property is 37
square
financial
Algemene
No other guarantees were provided.
Nederland N.V.
three stories
irrevocable,
a
by
credit issued
of
100 Federal
$30,680,000 credit
of
form
the
for $363
Company Limited
Street Realty
was provided with
in
collateral
unconditional
to refinance
were issued
The bonds
support
Equitable in 1985
was purchased by
million.
Street in
100 Federal
Building at
of Boston
Boston
is
New England and
Standard & Poor's.
77
the
largest
its long
in the downtown area
comparable properties
for all buildings, seasoned
office
rentable
prime
was 2.9%, while
properties as well as completed
space
by
1987
was
projected
at
feet of which approximately
approximately 22 million square
at the offering date.
19 million was on line
Total
9.1%.
vacancy rate was
lease-up, the
properties in
in 1985
for seasoned
The vacancy rate
rate was 3.1%.
the average
2.5%;
1986, the vacancy rate stood at
On August 1,
Approximately
14 million was contained in 23 buildings.
Office
rents ranged
expenses.
from
$33 to
$41,
plus pass
through
Estimated net cash flow before debt service was:
1996
1988
1987
692$---------------------------------------6% Inflation
3%
Inflation
$29,191,000
$32,364,000
$51,252,000
$29,174,000
$32,086,000
$38,515,000
The appraised market value of the building and land was $405
The loan
million.
Dividing
the
$29,716,000 by
to
was therefore
value ratio
estimated 1986
unlevered
the appraised value yields
net
66.67%.
cash flow
of
a capitalization
rate of 7.34%.
The
bonds were
coupons and zero
of current pay
issued at
par in
two series,
,or accrued interest
notes were redeemable
78
coupons.
at par,
current pay
$245 million
with a 9.271%
Annual debt service for these notes was
semi-annual coupon.
The zero notes were sold at two accrual rates:
$22,713,950.
$15 million at 9.428%, yielding $37,456,000 at maturity; and
$10
or cost
borrowing rate,
The effective
maturity.
&25,358,000 at
9.589%, yielding
million at
is the
of capital,
blended rate of the three coupons, or 9.29%.
In
The bonds are call protected for years one through five.
but
accrued interest
calculated
full amount
the
part, for
not in
of principal
to the redemption date,and
equal the
to
at redemption
in whole,
bonds may be redeemed
through ten the
years six
plus
a bond premium
original yield
to
maturity.
was equal to the 1986 net
The unlevered return to the owner
cash flow
$363,000,000,
return equaled the 1986 net
6.95%.
The
the
offering,
the
cash flow after debt service of
by the remaining $93
$6,460,000 divided
yielding
After
8.19%.
yielding
price of
by the purchase
of $29,717,000 divided
yield
reduced
million in equity,
is
the
result
of
the negative leverage created by borrowing money at a rate
higher than the unlevered
furthe increased by
bonds.
The
effect
return.
the high interest rates
of
the
the
lower
on the accrual
return
must
be
reinvestment rate of the $270
compensated for either by the
million in proceeds,
The negative leverage is
which must earn in excess
rate, or by the residual value.
79
of the bond
The
accrual notes
value of
small.
are essentially
the property.
total
The
initial equity after
equal $400,814,000.
the
owners
appreciate
initial
at
on the
value
with
the
the
of
value
residual
is relatively
However, their risk
redemption
Combined
$307,814,000.
a bet
of
the
notes
is
owners'
million the total
the offering of $93
In order to redeem the bonds and return
equity
approximately
in
one
80
1996,
the
percent
property
annually.
must
NOTES TO CHAPTER VII.
1.
and
Market
Secondary
The
Eric,
Stevenson.
Mortgages,
Property
Income
for
Securitization
Washington, DC: The Mortgage Bankers Association, 1986.
2.
Equitable Federal Street Funding Company, "Bank of
Private
Massachusetts"
Boston,
Building,
Boston
Placement Offering, Salomon Brothers,September 1986.
81
CONCLUSION
CHAPTER VIII.
Real
estate investors
before
several issues
must address
choosing property specific commercial mortgage securities as
size
the deal,
of
they must
In particular,
a funding vehicle.
restrictions placed
borrower.
on the
and
the offering,
of
costs
the
consider the
In return
the
for these
limitations, the borrower is able to access much larger sums
of capital
than through conventional sources,
typically at
competitive interest rates.
Securitized transactions are large scale transactions, which
use the
They
capable
This
of raising
capacity far
$25
excess of
in
typically raise
their source
markets as
global capital
$1 billion
over
that
exceeds
of funds.
million, and
are
offerings.
in single
lenders,
of conventional
which usually loan from $5 million to $200 million.
Scale economies play a significant role in the cost of funds
of securitized transactions.
structuring fees paid
Although the underwriting and
to the security issuer
are usually a
percentage of the amount raised, many additional costs, such
as
legal
counsel,
appraisals
and
constant.
As the
fixed costs
administrative
size
translate to
the cost of funds to the
of an
advertising,
printing,
financial
expense,
are
relatively
offering diminishes,
an increasing percentage
borrower.
82
these
load on
There is a threshold at
which
the
eliminate
these costs
funds available through
with the cost of
issues to compete
securitized
ability for
conventional sources.
In
facilities,
reserve
asset
of property
reinvestment risk
bond payments
semi-annual
credit
be
of liquid
the
and
support,
cash flows until
should
can
offerings
Posting
the borrower.
costs on
impose indirect
securitized
direct costs,
to
addition
payment of
to
Loan
evaluated.
value ratios may be lower than those allowed by conventional
forcing the borrower to
lenders, thereby
invest additional
equity.
Borrowers
seeking to
million must
cost
of
between $25
raise
compare the effective
available through
capital
$200
million and
to the
cost of capital
lenders.
conventional
This comparison must include all costs, including direct and
indirect costs, deferred costs and opportunity costs.
Limitations and Further Study
To date
less than
transactions are
30 PSCMS
have occured.
Most of these
the euromarket
or through
of
requirement
public
securities have been
private placements,
disclosure.
specific information regarding the
limited.
Of
twelve
estimated to
organizations
83
Therefore
sold in
without the
access
to
costs of transactions is
directly
involved
in
which
securitized
transactions
paper, only
two were willing
issues
the
limiting
thereby
offering,
placement
and private
into these transactions will
source of
Those who
find the best
banking houses
be the investment
information to
the
of
examination
characteristics of these instruments performance.
choose to enter
initial
the
after
trading activity
limited
have
of their
to disclose details
Furthermore, euromarkets
offering.
this
for
contacted
were
which underwrite the deals.
With time, the ability to amass comprehensive data regarding
involve the
borrower
rating
by making
costs of
issuing
these
a
This cost of
detailed
their yield
conventional
increased frequency of issuance
actual
respect to
when first
lenders
to
their
issued.
the cost of
capital could then be compared to
through
capital to
comparison of
securities with
classification and
capital
effective cost of
determination of
may
securities
research in this area would
One topic for further
improve.
the
mortgage
commercial
specific
property
determine
if
of these securities fosters
pricing efficiency.
Another topic for study is
on
both
the
method
of
the impact of the rating systems
real
estate
appraisal
underwriting guidelines of conventional lenders.
84
and
the
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88
ADDITIONAL SOURCES
I wish to acknowledge the following people
gave their time and assistance during the
this thesis.
Adducci, Manager,
Dominic J.
CNA
Portfolio Management Section,
Chicago, Ill.
Tamara Adler, Vice President,
who graciously
preparation of
Financial Guarantee
Insurance Companies,
Goldman Sachs, New York,
NY.
Specialist,
Andrew Berman, Rating
Corporation, New York, NY.
Ernest T. Elsner, Senior
Inc.,Chicago Ill.
Standard &
Poor's
Vice President, Duff & Phelps
Harwood, Senior Vice President,
C. J.
Estate Investment Management, Boston ,MA.
Equitable Real
David Hartzell, Salomon Brothers Inc, New Yory, NY.
Lawrence
York, NY.
Chemical
J. Langs,
Realty Corporation,
Thomas McKinenery, Vice President, Aetna
Surety Company, Hartford, CN.
New
Casualty and
Robert Perriello, Vice President, The Beacon Companies,
Boston, MA.
&
Poor's
Paul Stevens, Vice President, Equitable Real
Investment Management Company, Boston, MA.
Estate
David Smith, Rating
Corporation, New York, NY.
Margaret
Chicago Ill.
David
York, NY.
Stueben,
Welch, Vice
Specialist,
Credit
Broker,
Standard
Marsh
President, Lincoln
89
McClennan,
Properties, New