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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,14-,*,Chapter 14,Commercial Mortgage Loans and Commercial Mortgage-Backed Securities,14-,1,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Learning Objectives,After reading this chapter, you will understand,how commercial mortgage loans differ from residential mortgage loans,the different property types for which commercial mortgage loans are obtained,the two indicators of performance used for evaluating commercial mortgage loansdebt-to-service coverage ratio and loan-to-value ratio,the different types of call protection provided for in commercial mortgage loans and in a commercial mortgage-backed security,what balloon risk is for a commercial mortgage loan and a commercial mortgage-backed security,14-,2,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Learning Objectives,(continued),After reading this chapter, you will understand,differences in structuring a commercial mortgage-backed and residential mortgage-backed securities transaction,the structural features of a commercial mortgage-backed security deal,how prepayment premiums may be distributed among bondholders in a commercial mortgage-backed security,the difference between a single borrower/,multiproperty,deal and a conduit deal,the different types of,servicers,in a commercial mortgage-backed securities deal factors to consider in the analysis of the collateral of a commercial mortgage-backed security,why it is important to stress test a deals structure,14-,3,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,Commercial mortgage loans are for income-producing properties.,These properties include,multifamily properties,office buildings,industrial properties (including warehouses),shopping centers,hotels,health care facilities,Commercial mortgage loans are,non-recourse loans,.,This means that the lender can only look to the income-producing property backing the loan for interest and principal repayment.,14-,4,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Indicators,of Potential Performance,If there is a default on a commercial mortgage loan, the lender looks to the proceeds from the sale of the property for repayment and has no recourse to the borrower for any unpaid balance.,Two measures have been found to be key indicators of the potential credit performance:,debt-to-service coverage ratio,loan-to-value ratio,14-,5,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Indicators of Potential Performance,The,debt-to-service coverage ratio,(DSC ratio) is the ratio of a propertys,net operating income,(NOI) divided by the debt service.,NOI is the rental income reduced by cash operating expenses (adjusted for a replacement reserve).,A ratio greater than one indicates that the cash flow from the property is adequate to cover debt servicing.,14-,6,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Indicators of Potential Performance,Studies of residential mortgage loans suggest that the key predictor of default is the,loan-to-value ratio,.,For income-producing properties, the value of the property is based on the principle that the value of an asset is the present value of the expected cash flow.,In valuing commercial property, the expected cash flows are the future,NOIs,.,A discount rate or “capitalization rate,” reflecting the risks associated with the cash flows, is used to compute the present value of the future,NOIs,.,14-,7,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Call Protection,For residential mortgage loans, only prepayment penalty mortgages supply protection against prepayments.,For commercial mortgage loans, call protection includes:,prepayment lockout,defeasance,prepayment penalty points,yield maintenance charges,14-,8,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Call Protection,A,prepayment lockout,is a contractual agreement that excludes any prepayments during the lockout period.,After the lockout period, call protection usually comes in the form of either prepayment penalty points or yield maintenance charges.,With,defeasance, the borrower provides ample funds for the,servicer,to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments.,14-,9,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Call Protection,Prepayment penalty points,are predetermined penalties that must be paid by the borrower if the borrower wishes to refinance.,Prepayment penalty points are not always an effective means for discouraging refinancing.,Yield maintenance charge,makes the lender indifferent as to the timing of prepayments.,The simplest and most restrictive form of yield maintenance charge (“Treasury flat yield maintenance”) penalizes the borrower based on the difference between the mortgage coupon and the prevailing Treasury rate.,14-,10,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage Loans,(continued),Balloon Maturity Provisions,Commercial mortgage loans are typically balloon loans requiring sizeable principal payment at the end of the balloon term.,If the borrower fails to make the balloon payment, the borrower is in default.,During the work-out period for the loan, the borrower is charged a higher interest rate, which is called the,default interest rate,.,The risk that a borrower will not make the balloon payment is called,balloon risk,or,extension risk,.,14-,11,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,Many types of commercial loans can be sold by the originator as a commercial whole loan or structured into a,commercial mortgage-backed security,(CMBS) transaction.,A CMBS,is a security backed by one or more commercial mortgage loans.,The whole loan market, which is largely dominated by insurance companies and banks, is focused on loans between $10 and $50 million issued on traditional property types (multifamily, retail, office, and industrial).,CMBS transactions, on the other hand, can involve loans of virtually any size and/or property type.,14-,12,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Issuers of CMBS,As with residential mortgage-backed securities (RMBS), CMBS can be issued by,Ginnie,Mae, Fannie Mae, Freddie Mac, and private entities.,All of the securities issued by,Ginnie,Mae, Fannie Mae, and Freddie Mac are consistent with their mission of providing funding for residential housing.,While securities backed by,Ginnie,Mae and issued by,GSEs,constitute the largest sector of the RMBS market, it is the securities issued by private entities that are by far the largest sector of the CMBS market.,Typically, it is less than 3% of the market.,Our focus in this chapter is on CMBS issued by private entities.,14-,13,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),How CMBS Trade in the Market,One might think that because CMBS and RMBS are backed by mortgage loans, they would trade in a similar manner in the marketplace.,That is not the case, and the primary reason has to do with the greater prepayment protection afforded to investors in CMBS compared to RMBS.,CMBS trade much like corporate bonds.,14-,14,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Differences Between CMBS and,Nonagency,RMBS Structuring,The structure of a CMBS transaction is the same as in a,nonagency,RMBS in that most structures have multiple bond classes (,tranches,) with different ratings, and there are rules for the distribution of interest and principal to the bond classes.,The three major differences due to the features of the underlying loans are:,the prepayment terms for commercial mortgages differ significantly from residential mortgages,the significant difference between commercial and residential mortgages with respect to the role of the,servicer,when there is a default,the role of the buyers when the structure is being created so as to remove certain loans from the pool,14-,15,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Differences Between CMBS and,Nonagency,RMBS Structuring,The,first difference,in structuring involves the fact that the prepayment terms for commercial mortgages differ significantly from residential mortgages.,CMBS transactions impose prepayment penalties or restrictions on prepayments.,While there are RMBS transactions with prepayment penalties, they are a small fraction of the market.,14-,16,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Differences Between CMBS and,Nonagency,RMBS Structuring,The,second difference,in structuring is due to the significant difference between commercial and residential mortgages with respect to the role of the,servicer,when there is a default.,In commercial mortgages, the loan can be transferred by the,servicer,to the special,servicer,when the borrower is in default, imminent default, or in violation of covenants.,There is no equivalent feature for a residential mortgage in the case of an imminent default.,There can be differences in loans as to how to deal with defaults due to a failure to meet the balloon payment.,While balloon risk must be taken into account in structuring a CMBS transaction, it is not something that has to be dealt with in structuring an RMBS.,14-,17,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Differences Between CMBS and,Nonagency,RMBS Structuring,The,third difference,in structuring between CMBS and RMBS has to do with the role of the buyers when the structure is being created so as to remove certain loans from the pool.,More specifically, typically potential buyers of the junior bond classes are first sought by the issuer before the deal is structured.,The potential buyers first review the proposed pool of mortgage loans and in the review process may, depending on market demand for CMBS product, request the removal of some loans from the pool.,14-,18,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Structural Features of a CMBS Transaction,To understand the features of a CMBS transaction, one can look at an actual deal.,In doing this, one can observe:,the issue date,the number of,tranches,in the deal,the details (such as ratings and coupon rates) for all,tranches,the distributions of interest and principal from the supplementary prospectus,and so forth.,14-,19,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Structural Features of a CMBS Transaction,When there are mortgage loan losses, they are allocated in ascending order to the bond classes.,Because Class X is an interest-only security, no principal payments or loan losses are allocated to that class.,However, the notional amount for Class X is reduced by principal payments or loan losses.,The credit enhancements for,nonagency,RMBS can be used in CMBS structures.,Typically, the primary form of credit support is the senior-subordinated structure.,14-,20,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Prepayment Protection and Distributions of Prepayment Premiums,In a CMBS structure, there are two levels of prepayment protection.,The loan level where there are various forms of prepayment protection provided (lockouts, prepayment penalty points, yield maintenance, and defeasance).,The structure level, e.g., the senior,tranches,can be structured to pay off sequentially as in a CMO structure.,When a defeasance occurs, there is no distribution made to the bondholders.,Since there are no penalties or charges, there is no issue as to how any penalties paid by the borrower are to be distributed among the bondholders in a CMBS structure.,14-,21,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Prepayment Protection and Distributions of Prepayment Premiums,When there are prepayment penalty points, there are rules for distributing the penalty among the CMBS bondholders.,In the case of loans with a yield maintenance provision, several methods are used for distributing the yield maintenance charge.,Depending on the method specified in a deal, not all bondholders in a CMBS may be made whole.,Prepayment penalties and yield maintenance charges are referred to as,prepayment premiums,.,14-,22,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Balloon Risk in CMBS Deals,CMBS with senior subordinated structures face the risk that all loans must be refinanced to pay off the most senior bondholders.,The balloon risk of the most senior,tranche,may be equivalent to that of the most junior bond class in the deal.,There are two types of structural provisions that can be present in CMBS transactions to mitigate balloon risk:,The,internal tail,calls for the borrower to document efforts to refinance the loan within one year of the balloon maturity date.,With an,external tail, the maturity date for the CMBS issue is set to be longer than the balloon payment for the pool of commercial mortgage loans.,14-,23,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Types of Deals,The two major classifications for CMBS deals are:,single borrower/multi-property deals,multi-property conduit deals,In a single borrower/multi-property deal there is one borrower and multiple properties.,Three key structural features in such deals are:,the cross-collateralization feature,cross-default feature,property release provisions,14-,24,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Types of Deals,The,cross-collateralization feature,is a mechanism whereby the properties that collateralize the individual loans in the mortgage pool are pledged against each loan.,The,cross-default feature,permits the lender to call each loan within the mortgage pool when any one property defaults.,By including these two features, the principal and interest payments of all the properties are available to meet the obligations of all the loans.,Because there is a single borrower, there is concern that the borrower can benefit by removing the best properties from the mortgage pool by prepaying the balance and selling those properties.,This action would result in a deterioration of the structural protection afforded the bondholders.,14-,25,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Types of Deals,The objective of,property release provisions,is to protect the investor against borrower removing the best properties from the mortgage pool by prepaying the balance and selling those properties.,Two examples of a property release provision involve:,a requirement that if any property is sold, the borrower must retire more than the initial mortgage balance in the pool (say, 125%),a sale may not take place if the DSC ratios after a proposed sale are less than prior to the sale,14-,26,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Types of Deals,Besides a,single borrower/multi-property deal, a second type of deal is a,multi-property conduit deal, which involves loans by conduits.,Conduits are commercial-lending entities that are established for the sole purpose of generating collateral to securitize, and the CMBS transactions that result are called,conduit deals,.,The rating agencies refer to conduit transactions as,multi-borrower deals,.,When a conduit deal contains one large property for more than $50 million and then smaller loans, it is referred to as a,fusion conduit deal,.,14-,27,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Services,As with a,nonagency,RMBS, a,servicer,is required and plays an important role.,The responsibilities of the,servicer,include:,collecting monthly loan payments,keeping records relating to payments,maintaining property escrow for taxes and insurance,monitoring the condition of underlying properties,preparing reports for the trustee,transferring collected funds to the trustee for payment to bondholders,14-,28,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Services,Depending on the transactions, there are several types of,servicers,with the three most common transactions for CMBS being:,The,sub-,servicer,collects all payments and gathers property information, which is then sent to the master,servicer,.,The,master,servicer,is responsible for overseeing the deal, verifying that all servicing agreements are being maintained, and facilitating the timely payment of interest and principal.,The,special,servicer,has duties that arise only when a loan becomes more than 60 days past due.,Typically, the,special,servicer,has the authority to extend the loan, make loan modifications, restructure the loan, or foreclose on the loan and sell the property.,14-,29,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Analysis of the Collateral,The unique economic characteristics of each income-producing property in a pool backing a CMBS deal require that credit analysis be performed on a loan-by-loan basis not only at the time of issuance, but also be monitored on an on-going basis.,The starting point in the analysis is an investigation of the underwriting standards of the originators of the loans in the mortgage pool.,For all properties backing a CMBS deal, a weighted-average DSC ratio and a weighted-average LTV is computed.,An analysis of the credit quality of a CMBS structure will also look at the dispersion of the DSC and LTV ratios for the underlying loans.,14-,30,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Commercial Mortgage-Backed Securities,(continued),Analysis of the Collateral,In analyzing the collateral, the types of income-producing properties are examined.,In general, investors prefer deals that are not concentrated in one property type.,For the Banc of America Commercial Mortgage, Series 2001-1, the distribution of property type for the initial pool balance is shown in Exhibit 14-6 (,see Overhead 14-32,).,Investors are also interested in the geographical dispersion of the properties.,The concern is that if the properties were concentrated in one geographical region, investors would be exposed to economic downturns that may be unique to that geographical region.,14-,31,Copyright 2010 Pearson Education, Inc. Publishing as Prentice Hall,Exhibit 14-6,Distribution of Property Type for Banc of America Commercial Mortgage, Series 2001-1,Property Type,Initi
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