Commercial
Mortgage-Backed Securities
National University of Singapore
July 27, 2001
Notes from lecture given by Brent Ambrose at
National University of Singapore – July 2001
July 2001
Brent W. Ambrose, University of Kentucky
1
COMMERICAL MORTGAGEBACKED SECURITIES
What is a CMBS?
• A commercial mortgage-backed security
(CMBS) is a financial asset.
– created when an issuer places a commercial
mortgage (or collection of mortgages) into a
trust
– the trust issues classes of bonds backed by the
underlying principal and interest payments.
July 2001
Brent W. Ambrose, University of Kentucky
2
Objectives for this Session
• This session will cover the following topics:
–
–
–
–
–
–
–
–
July 2001
Differences between CMBS and MBS.
The anatomy of a CMBS deal.
Prepayment penalties on commercial mortgages.
CMBS risks (prepayment & default)
CMBS underwriting and the role of rating agencies.
The role of CMBS servicers.
Empirical studies of CMBS default and loss severity.
How CMBS deals are rated.
Brent W. Ambrose, University of Kentucky
3
CMBS vs. MBS
• Basic difference between residential MBS
and commercial MBS:
– PREPAYMENT
• Commercial mortgages have prepayment lockouts
and penalties.
• This changes the termination options.
• Default is now paramount.
July 2001
Brent W. Ambrose, University of Kentucky
4
U.S. CMBS Legalities
• Real Estate Mortgage Investment Conduits
(REMIC)
– U.S. tax code provision that allows the pooling
and securitization of mortgages. Once pool is
formed, not allowed to substitute mortgages.
July 2001
Brent W. Ambrose, University of Kentucky
5
U.S. CMBS Legalities
• Financial Asset Securitization Investment
Trust (FASIT)
– created in 1997
– allows issuers to substitute and add collateral
after securitization
• now issuer can add mortgages to pool as they are
originated
July 2001
Brent W. Ambrose, University of Kentucky
6
U.S. CMBS Legalities
FASIT – Allow securitization of a broader
class of assets including:
1.
2.
3.
4.
5.
July 2001
construction loans
commercial property bridge loans
automobile loans
credit card receivables
home equity loans
Brent W. Ambrose, University of Kentucky
7
CMBS Anatomy
•
•
•
•
•
•
•
•
•
Cash Flows
Subordination
Prepayment Penalties
CMBS Risks
Call Protection
Property Diversification
Credit Enhancements
Underwriting
Role of Servicers
July 2001
Brent W. Ambrose, University of Kentucky
8
Typical CMBS Structure
Whole Loan Pool
Rating
BBB
Sub
0%
DSCR
LTV
1.40
75%
Borrower Equity
CMBS
Spread
250 BP
Rating
Sub
DSCR
LTV
Spread
AAA
30%
2.00
52.50%
136 BP
AA
24%
1.84
57.00%
156 BP
A
18%
1.71
61.50%
176 BP
BBB
11%
1.57
66.75%
240 BP
BB
6%
1.49
70.50%
535 BP
B
NR
3%
0%
1.44
1.40
72.75%
75.00%
825 BP
2200 BP
Interest Principal
Borrower Equity
Losses
Source: Anthony Sanders
July 2001
Brent W. Ambrose, University of Kentucky
9
Actual CMBS Examples
• GMAC Mortgage Pass-through Certificates
• NationsLink Commercial Mortgage Passthrough Certificates Series 1998-1
July 2001
Brent W. Ambrose, University of Kentucky
10
GMAC Mortgage Pass-through Certificates, Series 1997- C1
DMG was the Lead Manager of a $1.7 Billion conduit securitization - the largest of its kind at the
time of issuance
Co-Lead Managers:
Servicer:
Sellers:
Issuance Date:
Collateral:
Deutsche Morgan Grenfell Inc.
Lehman Brothers Inc.
GMAC Commercial Mortgage Corporation
ContiTrade L.L.C.
German American Mortgage Corporation
GMAC Commercial Mortgage Corporation
September 25, 1997
Geographic distribution
Mortgage pool characteristics
Initial pool balance
No. of mortgage loans
No. of mortgaged properties
Avg. Cut-off date balance
Wtd. Avg. Mortgage rate
Wtd. Avg. Cut-off date LTV
Wtd. Avg. DSCR
$1,696,984,278
355
380
$4,780,237
8.62%
71.04%
1.33x
California
New York
Pennsylvania
Connecticut
New Jersey
Texas
17.29%
12.25%
7.54%
6.07%
6.01%
5.41%
Major property types
Retail
Multifamily
Office
Industrial
Hospitality
Skilled nursing
Mixed use
Self-storage
Mobile home park
Congregate care/assisted living
Other
July 2001
25.51%
18.79%
18.06%
10.21%
9.42%
7.13%
4.29%
2.86%
2.65%
0.98%
0.10%
The other remaining mortgaged properties are
located throughout 37 other states, Puerto Rico
and the District of Columbia
Source: Anthony Sanders
Brent W. Ambrose, University of Kentucky
11
GMAC Mortgage Pass-Through Certificates, Series 1997-C1
Bonds:
Class
A-1
A-2
A-3
B
C
D
E
F
G
H
J
K
X
Initial Cert.
Balance or
Notional Amt.
$261, 582,000
$227, 661,000
$724,100,000
$67,879,000
$50,909,000
$50,909,000
$93,334,000
$25,454,000
$84,849,000
$59,394,000
$16,969,000
$33,944,278
$1,696,984,278
Total
Securities
Spread
48
62
65
70
75
85
100
118
Notional Amt
Rating
(Moody's/
Fitch)
Percent of
Initial Pool
Balance
Ass/AAA
Aaa/AAA
Aaa/AAA
Aa2/AA+
A1/AA
A2/A+
Baa2/BBB
Baa3/BBBBB/BB
B
BUnrated
Aaa/AAA
15.4%
13.4%
42.7%
4.0%
3.0%
3.0%
5.5%
1.5%
5.0%
3.5%
1.0%
2.0%
N/A
Initial Pass- Weighted
Through Rate Average Life
Sub-ordination
(approx.)
(yrs)
28.5%
28.5%
28.5%
24.5%
21.5%
18.5%
13.0%
11.5%
6.5%
3.0%
2.0%
0.0%
N/A
6.830%
6.853%
6.869%
6.918%
6.898%
6.997%
7.085%
7.222%
7.414%
6.600%
6.600%
6.600%
1.629%
4.00
7.50
9.71
9.94
9.96
10.01
11.45
13.53
14.93
17.99
19.78
22.0
N/A
Payment
Window
1 - 75
75-108
108-119
119-120
120-120
120-125
125-158
158-170
170-195
195-235
235-242
242-358
1-358
$1,696,984,278
Source: Anthony Sanders
July 2001
Brent W. Ambrose, University of Kentucky
12
NationsLink Pass-through Certificates Series 1998-1
$ 1 Billion (approximately) of CMBS
Class
Rating
Principal
A-1
A-2
A-3
A
B
C
D
E
F
G
IO
“AAA”
“AAA”
“AAA”
“AAA”
“AA”
“A”
“BBB”
“BB”
“B”
unrated
“AAA”
$ 200mm
$ 82mm
$ 434mm
$ 716mm
$ 54mm
$ 56mm
$ 80mm
$ 60mm
$ 20mm
$ 40mm
notional
July 2001
Coupon Subordination
6.49%
6.43%
6.40%
6.44%
6.60%
6.90%
7.00%
7.00%
7.00%
0.90%
Brent W. Ambrose, University of Kentucky
101.00%
101.00%
101.00%
30%
25%
20%
12%
6%
2%
0%
na
101.00%
100.75%
100.50%
85.00%
75.00%
45.00%
4.75%
13
CMBS Anatomy
• Cash flow prioritization:
– 1) Principal repayments (both scheduled amortization
and unscheduled prepayments) go to retire senior class
debt first.
•
•
•
•
•
CF go to senior classes AAA through BBB
Intermediate class
Junior class
Unrated
Equity holder
– 2) Coupon interest paid to all classes
July 2001
Brent W. Ambrose, University of Kentucky
14
CMBS Anatomy
• Loss prioritization:
– Principal and interest due the most junior class
bondholder must be completely exhausted
before any loss is assigned to the class above it.
July 2001
Brent W. Ambrose, University of Kentucky
15
The Anatomy of a CMBS
Required Subordination
The required level of subordination is computed as the expected loss
in the event of a recession in the real property market. More
specifically,
required subordination = probability of loss (given a recession)
x severity of loss (given a default)
The probability of loss varies from small (say 10%) to large (say
50%), depending on the magnitude of the real property recession.
The severity of loss is the amount of the loss conditional on a default.
For example, a “Class B” real property recession will result in loan
losses with a 10% probability. The severity of the loss is typically
20% of the loan balance. Therefore, the required subordination for a
“Class B” real property recession is 10% x 20% = 2%.
July 2001
Brent W. Ambrose, University of Kentucky
16
The Anatomy of a CMBS
Example of Required Subordination Level Calculation
(NationsLink Example)
July 2001
Type of
Recession
Probability
of Loss
x
Severity
of Loss
“AAA”
“AA”
“A”
“BBB”
“BB”
“B”
50%
45%
40%
30%
20%
10%
x
x
x
x
x
x
60%
55%
50%
40%
30%
20%
=
Brent W. Ambrose, University of Kentucky
Required
Subordination
30%
25%
20%
12%
6%
2%
17
The Anatomy of a CMBS
The Unrated Piece
 The unrated piece is used to provide subordination for the lowest
rated junior piece.
 The size of the unrated bond reflects rating agency requirements for
loans that are not cross-collateralized and cross-defaulted.
 The unrated piece is sold privately and typically purchased by the
special servicer.
July 2001
Brent W. Ambrose, University of Kentucky
18
The Anatomy of a CMBS
The Interest Only (IO) Piece
 The notional balance of the IO piece is initially the aggregate
issue amount ($ 1 billion in the example)
 The notional balance of the IO piece equals the sum of the
certificate balances for the sequential pay certificates.
 The IO piece typically pays a small coupon (e.g. 90bp) and sells
at a steep discount.
July 2001
Brent W. Ambrose, University of Kentucky
19
CMBS Anatomy
•
Expected Cash Flows – Review
– Principal repayment
•
•
Scheduled amortization
Unscheduled prepayment
– Interest
– Penalties
•
•
•
July 2001
Hyperamortization
Prepayment Penalty
Balloon Default
Brent W. Ambrose, University of Kentucky
20
CMBS Anatomy (Penalties)
A. Hyperamortization (cash trap):
•
•
all cash flows in excess of operating expenses go
to retire debt.
Triggered by
i.
ii.
iii.
iv.
July 2001
Delinquency
failure to maintain required DSCR
failure to maintain debt rating
failure to maintain adequate reserves
Brent W. Ambrose, University of Kentucky
21
CMBS Anatomy (Penalties)
B. Prepayment penalty:
» penalty assessed the borrower for early repayment
of debt.
» Penalty may be computed in various ways.
July 2001
Brent W. Ambrose, University of Kentucky
22
CMBS Anatomy (Penalties)
C. Balloon default:
• penalty assessed the borrower for failing to
refinance at the end of the loan term.
July 2001
Brent W. Ambrose, University of Kentucky
23
CMBS Anatomy (Penalties)
•
Prepayment Penalties
1. A (declining) percent of the outstanding balance
(e.g. 5-4-3-2-1) paid when the loan is prepaid
2. Yield maintenance: the prepayment penalty is
computed as the difference between the book value of
the loan and the PV of the remaining contractual
payments discounted at some required interest rate.
The required interest rate is expressed as some spread
over the rate prevailing on comparable maturity
Treasuries.
A.
B.
July 2001
300bp over Treasuries
zero spread: Treasuries flat
Brent W. Ambrose, University of Kentucky
24
CMBS Anatomy (Penalties)
•
Prepayment Penalties:
3. Lockout – complete prohibition of prepayment
of principal. Usually only in effect during the
first few years of the mortgage.
July 2001
Brent W. Ambrose, University of Kentucky
25
Simple Prepayment Example
• Mortgage Assumptions:
– Two year, $10 million interest only mortgage
• 10% interest rate on the loan at date of issuance
• Loan is repaid after 1 year when interest rates fall to
8%.
July 2001
Brent W. Ambrose, University of Kentucky
26
Simple Prepayment Example
• Prepayment Penalties
– Yield Maintenance penalty provision
• Penalty = ($1,000,000 - $800,000) / (1+0.08)
•
= $185,185
– Percent of Prepaid Amount penalty provision
• Assume 1% penalty in this example
• Penalty = 1% * $10 million = $100,000
July 2001
Brent W. Ambrose, University of Kentucky
27
Allocation of Prepayment Penalties
• Allocation is based on the language in the
CMBS prospectus
– Ultimately determined by investment bankers
and lawyers during the creation of CMBS
– Underwriters have a great deal of latitude
– No standard approach exists
July 2001
Brent W. Ambrose, University of Kentucky
28
Yield Maintenance Calculations
•
One bullet loan tranched into two classes:
–
Assumptions:
1. Underlying loan is a ten year bullet loan priced at
par and pays a 9% coupon
2. Multi-class structure:
•
•
Senior class is $90 million and pays an 8% coupon
(priced at par).
Subordinate class is a $10 million classs that pay an 18%
coupon (priced at par).
3. Borrower prepays in full at at year 3. Current
interest rates are 100bps lower than in year 0.
July 2001
Brent W. Ambrose, University of Kentucky
29
CMBS Prepayment Example
Whole Mortgage Prepayment Calculation -- Bullet Loan
Principal
Loan Type
Term of Loan
$
100 Year Prepaid
Non-amortizing Original Interest Rate
10 New Interest Rate
Discount Rate
8%
Year
1
2
3
4
5
6
7
8
9
10
$
$
$
$
$
$
$
$
$
$
Original
Coupon
Payments
9.00
9.00
9.00
9.00
9.00
9.00
9.00
Penalty (Difference in Cash Flows)
July 2001
3
9%
8%
Discounted
Cash
Flows
$
$
$
$
$
$
$
$
$
$
$
8.33
7.72
7.14
6.62
6.13
5.67
5.25
46.86
$
5.21
Brent W. Ambrose, University of Kentucky
Reinvested
Interest
Payments
$
$
$
$
8.00
$
8.00
$
8.00
$
8.00
$
8.00
$
8.00
$
8.00
Discounted
Cash
Flows
$
$
$
$
7.41
$
6.86
$
6.35
$
5.88
$
5.44
$
5.04
$
4.67
$
41.65
30
•
Allocation of Penalty:
1. Percentage Prepayed
Senior Class (90%)
Junior Class (10%)
July 2001
$
$
$
Brent W. Ambrose, University of Kentucky
4.69
0.52
5.21
31
Principal
Loan Type
Term of Loan
Using a Make-whole Calculation
Senior Tranche
$
90 Year Prepaid
Non-amortizing Original Interest Rate
10 New Interest Rate
Discount Rate
7%
Year
1
2
3
4
5
6
7
8
9
10
$
$
$
$
$
$
$
$
$
$
Original
Coupon
Payments
7.20
7.20
7.20
7.20
7.20
7.20
7.20
Penalty (Difference in Cash Flows)
July 2001
3
8%
7%
Discounted
Cash
Flows
$
$
$
$
$
$
$
$
$
$
$
6.73
6.29
5.88
5.49
5.13
4.80
4.48
38.80
$
4.85
Reinvested
Interest
Payments
$
$
$
$
6.30
$
6.30
$
6.30
$
6.30
$
6.30
$
6.30
$
6.30
Brent W. Ambrose, University of Kentucky
Discounted
Cash
Flows
$
$
$
$
5.89
$
5.50
$
5.14
$
4.81
$
4.49
$
4.20
$
3.92
$
33.95
32
Principal
Loan Type
Term of Loan
Using a Make-whole Calculation
Junior Tranche
$
10 Year Prepaid
Non-amortizing Original Interest Rate
10 New Interest Rate
Discount Rate
17%
Year
1
2
3
4
5
6
7
8
9
10
$
$
$
$
$
$
$
$
$
$
Original
Coupon
Payments
1.80
1.80
1.80
1.80
1.80
1.80
1.80
Penalty (Difference in Cash Flows)
Total Penalty Payment (Junior + Senior)
Difference in Penalty Payments
July 2001
3
18%
17%
Discounted
Cash
Flows
$
$
$
$
$
$
$
$
$
$
$
1.54
1.31
1.12
0.96
0.82
0.70
0.60
7.06
$
$
$
0.39
5.24
(0.04)
Reinvested
Interest
Payments
$
$
$
$
1.70
$
1.70
$
1.70
$
1.70
$
1.70
$
1.70
$
1.70
Brent W. Ambrose, University of Kentucky
Discounted
Cash
Flows
$
$
$
$
1.45
$
1.24
$
1.06
$
0.91
$
0.78
$
0.66
$
0.57
$
6.67
33
CMBS Anatomy – Risk
Rating
Sub
DSCR
LTV
Price
Prepayment
Risk
Credit/De
fault Risk
Premium
30%
2.00
52.50%
102
AA
24%
1.84
57.00%
101
A
18%
1.71
61.50%
100
BBB
11%
1.57
66.75%
98
BB
6%
1.49
70.50%
75
B
NR
3%
0%
1.44
1.40
72.75%
75.00%
65
35
Discount
AAA
Extension
Risk
Credit/De
fault Risk
Source: Anthony Sanders
July 2001
Brent W. Ambrose, University of Kentucky
34
CMBS Anatomy
• CMBS Risk impacted by:
– property quality
– geographic location
– tenant creditworthiness
July 2001
Brent W. Ambrose, University of Kentucky
35
CMBS Risks
• Default risk:
– Income property loans are typically
nonrecourse.
• Borrower has the financial incentive to default when
the market value of the property falls below the
outstanding balance of the loan (negative equity).
• Also referred to as “optimal”, “strategic”, or
“financial” default.
July 2001
Brent W. Ambrose, University of Kentucky
36
CMBS Risks
• Balloon risk:
– income property mortgages typically have
terms that are less than the loan amortization
period, thus the borrower must refinance to
continue making mortgage payments.
– Circumstances in the property and capital
markets may have changed in ways that make
refinancing difficult or even impossible.
• Also referred to as “refinancing risk”
July 2001
Brent W. Ambrose, University of Kentucky
37
CMBS Risks
• Prepayment risk:
– Many income property mortgages provide some
call protection.
• lock-out provisions
• prepayment penalties
• Treasury defeasance
– Some income property mortgages do not have
any of these features.
July 2001
Brent W. Ambrose, University of Kentucky
38
CMBS Call Protection
• Lock-out provisions:
– prohibit loan prepayment over given period
• Prepayment penalties:
– paid in a lump sum at the time of prepayment;
– Cash flows are proportionally allocated to
remaining certificate classes.
• See previous examples of a (declining) percent of
the outstanding loan balance or yield maintenance
agreements
July 2001
Brent W. Ambrose, University of Kentucky
39
CMBS Call Protection
• Treasury defeasance:
– the borrower must purchase a series of
Treasuries that provide the same future cash
flows assuming the loan not prepaid.
• Property release provision:
– prohibits asset substitution;
– prevents the issuer/lender from removing the
stronger properties from the pool.
July 2001
Brent W. Ambrose, University of Kentucky
40
Property Diversification
• Diversification across:
– Loan size:
• usually no single loan exceeds 5% of the aggregate issue
amount.
• An exception to this is a fusion deal, where a single large loan
is packaged with several smaller loans.
– Property type
– Property location
• State
• metropolitan area
July 2001
Brent W. Ambrose, University of Kentucky
41
Loan Diversification
Table 2. The twenty largest loans underlying the GMAC 1999-C3 deal.
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
Name
Biltmore Fashion
Prime Outlets
Equity Inns
One Colorado
Comerica Bank
120 Monument
125 Maiden
Texas Development
Sherman Plaza
Alliance TP
Bush Tower
County Line
Sherwood Lakes
Laurel Portfolio
Sweet Paper
Sheraton Portsmouth
Trinity Commons
Village Square
Golden Books
Air Touch
Location, MSA
Phoenix, Arizona
Niagara Falls, New York
Various
Pasadena, California
San Jose, California
Indianapolis, Indiana
New York, New York
Houston, Texas
Van Nuys, California
Various
New York, New York
Jackson, Mississippi
Schererville, Indiana
Various
Various
Portsmouth, New Hampshire
Fort Worth, Texas
Indianapolis, Indiana
Fayetteville, North Carolina
Dublin, Ohio
Category
Retail
Retail
Hotel
Retail
Office
Office
Office
Apartment
Office
Apartment
Office
Retail
Apartment
Apartment
Warehouse
Hotel
Retail
Apartment
Warehouse
Office
Loan Amount
$80,000,000
$62,835,426
$46,511,317
$42,628,093
$33,640,510
$28,955,362
$28,500,000
$26,926,701
$25,984,904
$24,888,157
$23,000,000
$20,990,264
$20,162,442
$17,950,331
$17,420,000
$15,949,087
$15,242,981
$14,993,950
$14,493,350
$13,992,523
Source: Charter Research.
July 2001
Brent W. Ambrose, University of Kentucky
42
Geographic Diversification
Table 4. Aggregate loan amounts by state for GMAC 1999-C3 deal.
State
California
Texas
New York
Arizona
Indiana
Ohio
Mississippi
New Jersey
Other
Total
Loan Amount
$257,522,410
$162,355,125
$130,070,471
$99,942,794
$68,623,516
$44,982,528
$23,067,864
$22,983,973
$342,473,371
No. of Loans
33
26
7
5
5
5
2
5
50
% of Pool
22.35%
14.09%
11.29%
8.68%
5.96%
3.90%
2.00%
2.00%
29.73%
$1,152,022,052
138
100.00%
Source: Charter Research.
July 2001
Brent W. Ambrose, University of Kentucky
43
Property Type Diversification
Table 5. Aggregate loan amounts by property type for GMAC 1999-C3 deal.
Property Type
Apartment
Office
Retail
Warehouse
Hotel
Other
Total
Loan Amount
No. of Loans
% of Pool
$259,779,802
$322,053,844
$350,683,062
$99,126,075
$105,832,139
$14,547,130
39
36
34
15
8
6
22.55%
27.96%
30.44%
8.60%
9.19%
1.26%
$1,152,022,052
138
100.00%
Source: Charter Research.
July 2001
Brent W. Ambrose, University of Kentucky
44
Credit Enhancements
• Subordination
• Cross collateralization:
– properties that collateralize individual loans are
pledged against all loans in the pool
• Cross default:
– allows the lender to call ALL LOANS in the
event a single loan is in default.
July 2001
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Credit Enhancements
• Lock box:
– Gives the trustee control of the property gross revenues.
The trustee assigns priority in the following order:
•
•
•
•
•
•
July 2001
(1) taxes and insurance;
(2) operating expenses;
(3) debt service;
(4) management fees;
(5) reserves for replacements;
(6) equity investor
Brent W. Ambrose, University of Kentucky
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Credit Enhancements
• Overcollateralization:
– When the book value of the loans exceed the
par value of the bonds issued.
– Most common in residential MBS
• Especially common in CMO structure
July 2001
Brent W. Ambrose, University of Kentucky
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Reserve Funds
• Established at loan closing to:
– Provide liquidity:
• to pay interest for investment grade bonds
– Service the asset:
• to pay
–
–
–
–
July 2001
property taxes
property insurance
legal fees
Maintenance
Brent W. Ambrose, University of Kentucky
48
Standardized CMBS
Underwriting
• Key Underwriting Characteristics
–
–
–
–
–
Debt Service Coverage Ratio (DSCR)
Loan to Value Ratio (LTV)
Average loan size
Max loan not to exceed certain percentage (e.g. 5%)
Diversification across
• Property types
• Geographic locations
– Prepayment terms
– Loan maturities
July 2001
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Role of rating agencies
• Establish different rating criteria for various
property types.
• Negotiate subordination levels with issuers.
• Track property performance/delinquencies
• Servicer and trustee report ongoing loan level
performance
– Monthly/quarterly DSCRs
– occupancy levels
– updated bond information
July 2001
Brent W. Ambrose, University of Kentucky
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Role of Servicers
• Master Servicer:
– Oversees the deal and servicing agreements
– Facilitates timely payment of principal and
interest
– May provide (servicer) advances for
delinquent/defaulted loans
• Sub-Servicer:
– loan originator in a conduit deal who retains
servicing
July 2001
Brent W. Ambrose, University of Kentucky
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Role of Servicers
• Special Servicer:
– Becomes engaged when loan more than 60 days
delinquent.
– Has the authority to
• Extend the loan
• Modify/restructure the loan (based on an appraisal)
• Foreclose
July 2001
Brent W. Ambrose, University of Kentucky
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Pricing CMBS
• Unlike residential MBS, the underlying mortgages have little
prepayment risk.
• However, default risk is now relevant due to these risks:
– Lease termination risk
– Lease rollover risk
• Imperative to monitor developments in the overall real estate
market.
– For example, low vacancy rates may lead to additional
construction.
• This additional supply can result in reduced real lease rates in future
years.
• Has implications on the ability of the property to service the debt in
future years.
July 2001
Brent W. Ambrose, University of Kentucky
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Pricing CMBS
• Rating agencies play a critical role in the CMBS
pricing process.
– S&P, Moodys, and Duff & Phelps maintain internal models of
collateral risk in order to rate default risk associated with
CMBS deals.
• In addition to having to price deals in accordance with
rating agency opinions, it is wise to understand the
underlying real estate markets in order to anticipate
payments delays or defaults.
– Example. Lease rates and vacancy rates may look great at
the moment, but will these indicators prompt
developers/banks into another frenzy of construction?
July 2001
Brent W. Ambrose, University of Kentucky
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Pricing CMBS
• Remember – CMBS product is part
of the fixed-income universe.
– Capital markets are linked such that
shocks in one market impact others.
• For example – Russian debt crises in
1998
– See following charts.
July 2001
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July 2001
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NCREIF Total Returns
0.04
0.03
0.02
Return
0.01
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
-0.01
-0.02
-0.03
-0.04
-0.05
Date
July 2001
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July 2001
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July 2001
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July 2001
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Bond Market Yields
12
10
8
%
AAA
6
BBB
Treas
4
2
0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Date
July 2001
Brent W. Ambrose, University of Kentucky
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Bond Spreads
Bond Credit Spreads
3
2.5
Spread
2
AAA
1.5
BBB
1
0.5
0
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Date
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
*
• What do we know about income property
default and loss severity?
–
–
–
–
1.
2.
3.
4.
Fitch ICBA, Inc. (1998)
Corcoran and Kao (1998)
Vandell, Barnes, Hartzell, Kraft, and Wendt (1993)
Snyderman (1994)
*-these notes are based on lecture material provided by Thomas Thibodeau at Southern Methodist University.
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
Study examines Fitch rated transactions between 1991 and 1996
 18,839 loans (in 33 CMBS transactions)
 total principal $16.1 billion
 84% thrift loans (mostly RTC)
 16% conduit loans
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
Examines relationship between default/loss severity and:








Debt service coverage ratio (DSCR)
Property type
State
Loan Size
Fixed/floating rate loan
Loan type (e.g. amortizing, balloon)
Servicer flexibility
Foreclosure type
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
 Default:
> 60 days past due on debt service
or
> 90 days past due on balloon payment
 3,134 lifetime defaulted loans (16.64%)
 3,002 RTC loans (96% of defaults)
 annual default rate 4.3%
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
 Loss =
loan balance at securitization
+ interest advanced
+ property protection expenses
- loan amortization
- property income
- net sales proceeds
Losses reported as a percent of loan balance at securitization for loans
COMPLETELY resolved (e.g. properties sold).
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
Source of losses:
Decrease in property value
+ advanced interest
+ advanced property protection expenses
- amortization
- property income (combined)
35.8%
10.5%
7.7%
Average Loss Rate:
39.1%
July 2001
Brent W. Ambrose, University of Kentucky
14.9%
68
Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
DSCR
0.01-0.49
0.50-0.79
0.80-0.89
0.90-0.99
1.00-1.14
1.15-1.24
1.25-1.34
1.35-1.49
1.50-1.74
1.75+
July 2001
Default Rate
Loss
8.0%
7.0%
6.6%
6.5%
4.4%
2.6%
2.4%
2.8%
3.1%
2.9%
47%
52%
42%
41%
29%
48%
27%
36%
41%
22%
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
Property Type
Lodging
Multifamily
Nursing
Office
Industrial
Other
Retirement
Warehouse
July 2001
Default Rate
Loss
4.2%
3.9%
4.0%
4.8%
4.7%
4.2%
4.7%
2.5%
27%
46%
11%
38%
27%
46%
34%
29%
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
State
Default Rate
Loss
Highest 5:
New York
Louisianna
New Mexico
Arizona
Massachusetts
6.8%
5.8%
5.5%
5.2%
5.2%
32%
69%
25%
22%
40%
Lowest 5:
Iowa
Florida
Texas
Washington
Oregon
3.5%
3.1%
3.1%
2.4%
1.9%
65%
44%
45%
25%
34%
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
Loan Size
Default Rate
Loss
$0.0M - $0.5M
4.0%
38%
$0.5M - $1.0M
5.5%
42%
$1.0M - $5.0M
4.9%
39%
$5.0M - $10M
3.9%
37%
> $10M
2.0%
34%
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Fitch IBCA, Inc. (1998)
Other Results
Default Rate
Loss
5.4%
3.5%
42%
35%
Interest Rate:
Floating rate
Fixed rate
Loan Type:
Amortizing
Balloon
2.6%
6.0%
Judicial foreclosures take longer and cost (between 8% and 26%)
more than nonjudicial (e.g. power of sale states) foreclosures.
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Vandell et. al. (1993)
 Use a proportional hazards model to examine the joint effect of loan,
borrower, property and market characteristics on the length of time to
default.
 The hazard function is the conditional probability of default in the next
period given the loan is currently a performing loan.
 Data: 2,899 completed loans originated during 1962-1989:3 period
175 defaults (6%)
 Use the Frank Russell Company Index to market property values to
market over time.
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Vandell et. al. (1993)
Estimation results:
 Higher L/V
 higher default rate
 Higher interest rate  higher default rate
 DSCR is not a contributing influence
 All property types have higher default rates RELATIVE TO RETAIL
 Greatest risk: hotel, office, apartment
 Least risk:
retail, industrial
 Partnerships exhibit greater default risk compared to alternatives
July 2001
Brent W. Ambrose, University of Kentucky
75
Income Property Debt:
Default and Loss Severity
Snyderman (1994)
Snyderman examines:
(1) incidence of lifetime default for 10,955 Insurance Co. loans:
a. originated between 1972 and 1989
b. tracked over 1972-1991 period
c. 1,512 lifetime defaults (13.8%)
(2) severity of losses:
a. defaults that end in foreclosure (46% of defaults)
b. defaults resolved some other way (e.g. workout)
(3) estimates “yield cost” of default between 31 and 52 basis points
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Snyderman (1994)
Average Loss Severity:
 for foreclosed loans:
 for other loans:
36%
(assumed to be) 18%
Foregone interest a major component of loss severity (average time between
default and disposition was 3.5 years).
July 2001
Brent W. Ambrose, University of Kentucky
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Income Property Debt:
Default and Loss Severity
Corcoran and Kao (1998)
 Examine deliquency experience for Life Insurance Company loans
 Regress deliquency rate on:
 Regional price index (NCREIF Regional Index for 8 Regions)
 Sector (e.g. property type) price (NCREIF Sector Price Index)
 Conclusions: Delinquencies INCREASE with DECREASING
 regional prices (more important)
 national sector prices
July 2001
Brent W. Ambrose, University of Kentucky
78
Income Property Debt:
Default and Loss Severity
Corcoran and Kao (1998)
Risk-Neutral Credit Spread
Promised cash flow
Discount rate with credit risk spread

Promised cash flow  Credit loss adjustment
Treasury discount rate
July 2001
Brent W. Ambrose, University of Kentucky
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Corcoran and Kao (1998)
Example: Risk-Neutral Credit Spread
Commercial Mortgage @ 8.5% Coupon, 10-Year Term, 20 Year Amort
Year
Ending Balance
Credit Loss @ 27bp
1
$980.0977
2.6463
2
958.4362
2.5828
3
943.8600
2.5241
4
909.2000
2.4548
5
881.2719
2.3794
6
850.8751
2.2974
7
817.7915
2.2080
8
781.7836
2.1108
9
742.5930
2.0050
10
699.9383
1.8898
“Fair or intrinsic” value of credit loss is $16.19 = PV @ Treasury rate of 7.5%
July 2001
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Default and Loss Severity
• To summarize, the studies show that:
– Commercial mortgage default estimates are
highly dependent upon the data source.
– Most CMBS deals were originated during
period of unprecedented economic growth and
expansion.
• Loans have not been tested through full economic
cycle.
July 2001
Brent W. Ambrose, University of Kentucky
81
Rating CMBSs
•
•
•
•
Property Cash Flow Adjustments
Capitalization Rate Adjustments
Pool analysis
Ideal Pool for Small Income Property Loans
July 2001
Brent W. Ambrose, University of Kentucky
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Rating CMBSs
Property Cash Flow Adjustments
Rental income
=
min {contract rent, market rent}
Non-rental income
=
frequently ignored
Vacancy loss
=
max {actual, market, 10%}
Operating expenses
=
max {historical, industry standards, appraisal}
Management fees
=
=
max {historical, appraisal, 5% for MF}
max {historical, appraisal, 4% for commercial}
Capital reserves
=
=
=
=
$250 - $450 per unit for MF
$0.15 - $0.30 per square foot for office
$0.15 - $0.25 psf for retail
4-5% of Gross Revenues for hotel
July 2001
Brent W. Ambrose, University of Kentucky
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Rating CMBSs
Property Cash Flow Adjustments
Sources of Information for Industry Standard Operating Expenses
(1) Building Owners and Managers Association (BOMA)
(2) Institute of Real Estate Management (IREM)
(3) Urban Land Institute (ULI)
a. Dollars and cents of shopping centers
b. Dollars and cents of retail
c. Etc.
July 2001
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Rating CMBSs
Property Cash Flow Adjustments
 Expected property cash flows also adjusted for:
(1) Average lease term (by property type)
(2) Tenant retention (50-60%)
a. new tenant improvements
b. renewal tenant improvements
(3) Leasing commissions
a. new leasing commissions (4-6%)
b. renewal leasing commissions (varies by property type)
July 2001
Brent W. Ambrose, University of Kentucky
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Rating CMBSs
Property Cash Flow Adjustments
 Financing cash flows adjustments:
(1) below market interest rates increased
(2) loan term adjusted for remaining economic life of the property
July 2001
Brent W. Ambrose, University of Kentucky
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Rating CMBSs
Property Capitalization Rate Adjustments
 Cap rates can be adjusted down 50-75bp for net cash flow after adjusting
cash flows for capital items, tenant improvements and leasing
commissions.
 Cap rates adjusted up50-150bp for non-cured environmental impairments
and for lower quality properties.
 Cap rates adjusted up to reflect market conditions.
July 2001
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Rating CMBSs
Pool Analysis
 Probability of loss: the probability that any loan will default, be
foreclosed on, and be liquidated.
 Probability of loss = f(LTV, DSCR, property type, loan structure,
fixed/floating rate, loan quality, seasoning,
management, ownership structure, barriers to
entry (loan to replacement cost, CF volatility,
recourse)
 Loan loss = f (cost to obtain the asset, time to sell, cost to sell)
July 2001
Brent W. Ambrose, University of Kentucky
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Rating CMBSs
Ideal Pool for Small Income Property Loans
 At least 500 loans
 No one loan > 1% of loan balance
 Geographically diversified
 Taxes, insurance, and capital reserves escrowed
 Full recourse
July 2001
Brent W. Ambrose, University of Kentucky
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CMBS in Singapore
• MAS declared that real estate securitization is a strategic goal.
• Current debt securitization programs:
– Mortgage-Backed bonds
• Similar to single mortgage securitization.
• Typical deal will have additional credit enhancements from mortgage
borrower.
• Does not have credit rating or credit enhancements from 3rd parties.
– Asset-Backed Securitization
• One step further than mortgage-backed bonds in that property securing the
debt is transferred to a “special-purchase vehicle”.
July 2001
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