1、Chapter 14 Commercial Mortgage Loans and Commercial Mortgage-Backed Securities Learning ObjectivesAfter reading this chapter,you will understandq how commercial mortgage loans differ from residential mortgage loansq the different property types for which commercial mortgage loans are obtainedq the t
2、wo indicators of performance used for evaluating commercial mortgage loansdebt-to-service coverage ratio and loan-to-value ratioq the different types of call protection provided for in commercial mortgage loans and in a commercial mortgage-backed securityq what balloon risk is for a commercial mortg
3、age loan and a commercial mortgage-backed securityLearning Objectives(continued)After reading this chapter,you will understandq differences in structuring a commercial mortgage-backed and residential mortgage-backed securities transactionq the structural features of a commercial mortgage-backed secu
4、rity dealq how prepayment premiums may be distributed among bondholders in a commercial mortgage-backed securityq the difference between a single borrower/multiproperty deal and a conduit dealq the different types of servicers in a commercial mortgage-backed securities deal factors to consider in th
5、e analysis of the collateral of a commercial mortgage-backed securityq why it is important to stress test a deals structureCommercial Mortgage Loansq Commercial mortgage loans are for income-producing properties.oThese properties includei.multifamily propertiesii.office buildingsiii.industrial prope
6、rties(including warehouses)iv.shopping centersv.hotelsvi.health care facilitiesq Commercial mortgage loans are non-recourse loans.oThis means that the lender can only look to the income-producing property backing the loan for interest and principal repayment.Commercial Mortgage Loans(continued)q Ind
7、icators of Potential Performanceo 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.o Two measures have been found to be key indicators of the potential credit pe
8、rformance:i.debt-to-service coverage ratioii.loan-to-value ratioCommercial Mortgage Loans(continued)q Indicators of Potential Performanceo 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
9、 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.Commercial Mortgage Loans(continued)q Indicators of Potential PerformanceoStudies of residential mortgage loans suggest that the ke
10、y predictor of default is the loan-to-value ratio.oFor 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.oIn valuing commercial property,the expected cash flows are the future NOIs.oA discount rat
11、e or“capitalization rate,”reflecting the risks associated with the cash flows,is used to compute the present value of the future NOIs.Commercial Mortgage Loans(continued)q Call Protectiono For residential mortgage loans,only prepayment penalty mortgages supply protection against prepayments.o For co
12、mmercial mortgage loans,call protection includes:i.prepayment lockoutii.defeasanceiii.prepayment penalty pointsiv.yield maintenance chargesCommercial Mortgage Loans(continued)q Call Protectiono A prepayment lockout is a contractual agreement that excludes any prepayments during the lockout period.Af
13、ter the lockout period,call protection usually comes in the form of either prepayment penalty points or yield maintenance charges.o 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 th
14、e absence of prepayments.Commercial Mortgage Loans(continued)q Call ProtectionoPrepayment 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.oYield m
15、aintenance 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.Commercial M
16、ortgage Loans(continued)q Balloon Maturity ProvisionsoCommercial mortgage loans are typically balloon loans requiring sizeable principal payment at the end of the balloon term.oIf the borrower fails to make the balloon payment,the borrower is in default.oDuring the work-out period for the loan,the b
17、orrower is charged a higher interest rate,which is called the default interest rate.oThe risk that a borrower will not make the balloon payment is called balloon risk or extension risk.Commercial Mortgage-Backed Securitiesq Many types of commercial loans can be sold by the originator as a commercial
18、 whole loan or structured into a commercial mortgage-backed security(CMBS)transaction.q A CMBS is a security backed by one or more commercial mortgage loans.q The whole loan market,which is largely dominated by insurance companies and banks,is focused on loans between$10 and$50 million issued on tra
19、ditional property types(multifamily,retail,office,and industrial).q CMBS transactions,on the other hand,can involve loans of virtually any size and/or property type.Commercial Mortgage-Backed Securities(continued)q Issuers of CMBSoAs with residential mortgage-backed securities(RMBS),CMBS can be issu
20、ed 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.oWhile securities backed by Ginnie Mae and issued by GSEs constitute the largest sector of
21、 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.Commercial Mortgage-Backed Securities(continued)q How CMBS Trade in the Mar
22、keto 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 corpor
23、ate bonds.Commercial Mortgage-Backed Securities(continued)q Differences Between CMBS and Nonagency RMBS StructuringoThe 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 di
24、stribution of interest and principal to the bond classes.oThe three major differences due to the features of the underlying loans are:i.the prepayment terms for commercial mortgages differ significantly from residential mortgagesii.the significant difference between commercial and residential mortga
25、ges with respect to the role of the servicer when there is a defaultiii.the role of the buyers when the structure is being created so as to remove certain loans from the poolCommercial Mortgage-Backed Securities(continued)q Differences Between CMBS and Nonagency RMBS Structuringo The first differenc
26、e 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
27、the market.Commercial Mortgage-Backed Securities(continued)qDifferences Between CMBS and Nonagency RMBS Structuringo 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
28、.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
29、 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.Commercial Mortgage-Backed Securities(continued)q Differences Between CMBS a
30、nd Nonagency RMBS StructuringoThe 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 th
31、e 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.Commercial Mortgage-Backed Securities(continued)q Structural Features
32、 of a CMBS Transactiono To understand the features of a CMBS transaction,one can look at an actual deal.o In doing this,one can observe:i.the issue date,ii.the number of tranches in the deal,iii.the details(such as ratings and coupon rates)for all tranches,iv.the distributions of interest and princi
33、pal from the supplementary prospectusv.and so forth.Commercial Mortgage-Backed Securities(continued)q Structural Features of a CMBS TransactionoWhen 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 paym
34、ents or loan losses are allocated to that class.However,the notional amount for Class X is reduced by principal payments or loan losses.oThe credit enhancements for nonagency RMBS can be used in CMBS structures.Typically,the primary form of credit support is the senior-subordinated structure.Commerc
35、ial Mortgage-Backed Securities(continued)q Prepayment Protection and Distributions of Prepayment PremiumsoIn a CMBS structure,there are two levels of prepayment protection.i.The loan level where there are various forms of prepayment protection provided(lockouts,prepayment penalty points,yield mainte
36、nance,and defeasance).ii.The structure level,e.g.,the senior tranches can be structured to pay off sequentially as in a CMO structure.oWhen 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 t
37、he borrower are to be distributed among the bondholders in a CMBS structure.Commercial Mortgage-Backed Securities(continued)q Prepayment Protection and Distributions of Prepayment PremiumsoWhen there are prepayment penalty points,there are rules for distributing the penalty among the CMBS bondholder
38、s.oIn the case of loans with a yield maintenance provision,several methods are used for distributing the yield maintenance charge.oDepending on the method specified in a deal,not all bondholders in a CMBS may be made whole.oPrepayment penalties and yield maintenance charges are referred to as prepay
39、ment premiums.Commercial Mortgage-Backed Securities(continued)q Balloon Risk in CMBS DealsoCMBS 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
40、 junior bond class in the deal.oThere are two types of structural provisions that can be present in CMBS transactions to mitigate balloon risk:i.The internal tail calls for the borrower to document efforts to refinance the loan within one year of the balloon maturity date.ii.With an external tail,th
41、e maturity date for the CMBS issue is set to be longer than the balloon payment for the pool of commercial mortgage loans.Commercial Mortgage-Backed Securities(continued)q Types of Dealso The two major classifications for CMBS deals are:i.single borrower/multi-property dealsii.multi-property conduit
42、 dealsIn a single borrower/multi-property deal there is one borrower and multiple properties.Three key structural features in such deals are:i.the cross-collateralization featureii.cross-default featureiii.property release provisionsCommercial Mortgage-Backed Securities(continued)q Types of DealsoTh
43、e 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
44、 two features,the principal and interest payments of all the properties are available to meet the obligations of all the loans.oBecause 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 sellin
45、g those properties.oThis action would result in a deterioration of the structural protection afforded the bondholders.Commercial Mortgage-Backed Securities(continued)q Types of DealsoThe objective of property release provisions is to protect the investor against borrower removing the best properties
46、 from the mortgage pool by prepaying the balance and selling those properties.oTwo examples of a property release provision involve:i.a requirement that if any property is sold,the borrower must retire more than the initial mortgage balance in the pool(say,125%)ii.a sale may not take place if the DS
47、C ratios after a proposed sale are less than prior to the saleCommercial Mortgage-Backed Securities(continued)q Types of DealsoBesides a single borrower/multi-property deal,a second type of deal is a multi-property conduit deal,which involves loans by conduits.oConduits are commercial-lending entiti
48、es that are established for the sole purpose of generating collateral to securitize,and the CMBS transactions that result are called conduit deals.oThe rating agencies refer to conduit transactions as multi-borrower deals.oWhen a conduit deal contains one large property for more than$50 million and
49、then smaller loans,it is referred to as a fusion conduit deal.Commercial Mortgage-Backed Securities(continued)q ServicesoAs with a nonagency RMBS,a servicer is required and plays an important role.oThe responsibilities of the servicer include:i.collecting monthly loan paymentsii.keeping records rela
50、ting to paymentsiii.maintaining property escrow for taxes and insuranceiv.monitoring the condition of underlying propertiesv.preparing reports for the trusteevi.transferring collected funds to the trustee for payment to bondholdersCommercial Mortgage-Backed Securities(continued)q ServicesoDepending
