14.1.1 Five Potential Advantages of Real Estate

There are five common attributes of real estate that can encourage its inclusion in an investment portfolio:

1. Potential to offer absolute returns
2. Potential to hedge against unexpected inflation
3. Potential to provide diversification with stocks and bonds
4. Potential to provide cash inflows
5. Potential to provide income tax advantages

These potential advantages, the first three of which are related to portfolio risk, do not necessarily come without costs. In particular, to the extent that markets are competitive and efficient, market prices of real estate will tend to adjust, such that any risk-reducing advantages will be offset by lower expected returns. However, some of the disadvantages of private real estate ownership may lead to higher expected returns in the form of premiums for bearing risks, such as liquidity.

This list of potential advantages to real estate investment is not comprehensive. For example, another motivation could be to own all or part of a trophy property that offers name recognition, prestige, and enhanced reputation to the owner, such as a large, high-quality office property in a prominent location.

14.1.2 Three Potential Disadvantages of Real Estate

There are also aspects of real estate that can discourage its inclusion in an investment portfolio (unless the investor receives appropriate compensation in the form of higher expected returns). Included are these three potential disadvantages:

1. Heterogeneity
2. Lumpiness
3. Illiquidity

Real estate is a highly heterogeneous asset. Not only are the physical features of the individual properties unique in terms of location, use, and design, but varying lease structures can lead to large differences in income streams. This heterogeneity may be particularly burdensome in the initial and ongoing due diligence processes.

The second potential disadvantage to private real estate is lumpiness. Lumpiness describes when assets cannot be easily and inexpensively bought and sold in sizes or quantities that meet the preferences of the buyers and sellers. Listed equities of large companies are not lumpy, because purchases and sales can easily be made in the desired size by altering the number of shares in the transaction. Direct real estate ownership may be difficult to trade in sizes or quantities desired by a market participant. The indivisible nature of private real estate assets leads to problems with respect to high unit costs (i.e., large investment sizes) and relatively high transaction costs.

The final major disadvantage relates to the liquidity of private real estate. As a non-exchange-traded asset with a high unit cost, private real estate can be highly illiquid, especially when compared to stocks and bonds. An important implication of illiquidity is its effect on reported returns as well as its added risk challenges.

14.1.3 Real Estate Styles

The premier approach to organizing private commercial real estate is through styles of real estate investing. Styles of real estate investing refers to the categorization of real estate property characteristics into core, value added, and opportunistic. In 2003, the National Council of Real Estate Investment Fiduciaries (NCREIF) defined these three styles as a way to classify real estate equity investment or real estate managers. Real estate investment styles assist an asset allocator in organizing and evaluating real estate opportunities, facilitate benchmarking and performance attribution, and help investment managers monitor style drift.

The three NCREIF styles divide real estate opportunities from least risky (core) to most risky (opportunistic), with value added in the middle. In terms of risk, core properties are most bond-like, and opportunistic properties are most equity-like. Core properties tend to offer reliable cash flows each year from rents and lease payments, whereas opportunistic properties offer potential capital appreciation and typically have little or no currently reliable income. Each of the three styles is more fully described in the following paragraphs.

Core real estate includes assets that achieve a relatively high percentage of their returns from income and are expected to have low volatility. Core real estate contains five specific categories: Office, Retail, Industrial, Multi-Family, and Hotels. Core properties are the most liquid, most developed, least leveraged, and most recognizable properties in a real estate portfolio. Though these properties have the greatest liquidity, they are not traded quickly relative to traditional investments. Core properties tend to be held for a long time to take full advantage of the lease and rental cash flows that they provide. The majority of their returns comes from cash flows rather than from value appreciation, and very little leverage is applied. Core properties are somewhat bond-like in the reliability of their income.

Value-added real estate includes assets that exhibit one or more of the following characteristics: (1) achieving a substantial portion of their anticipated returns from appreciation in value, (2) exhibiting moderate volatility, and (3) not having the financial reliability of core properties.

Value-added properties begin to stray from the more common and lower-risk real estate investments included in the core real estate style. The value-added real estate style includes hotels, resorts, assisted-care living facilities, low-income housing, outlet malls, hospitals, and the like. These properties tend to require a subspecialty within the real estate market to be managed well and can involve repositioning, renovation, and redevelopment of existing properties.

Relative to core properties, value-added properties are anticipated to produce less current income and to rely more on property appreciation to generate total return. However, property appreciation is subject to substantial uncertainty, and value-added properties as a whole have experienced prolonged periods of poor realized appreciation. Value-added properties can also include new properties that would otherwise be core properties except that they are not fully leased. A value-added property can also be an existing property that needs a new strategy, such as a major renovation, new tenants, or a new marketing campaign. These properties tend to use more leverage and generate a total return from both capital appreciation and income.

Opportunistic real estate properties are expected to derive most or all of their returns from property appreciation and may exhibit substantial volatility in value and returns. The higher volatility of opportunistic properties relative to the other two styles may be due to a variety of characteristics, such as exposure to development risk, substantial leasing risk, or high leverage.

Opportunistic real estate moves away from a core/income approach to a capital appreciation approach. The majority of the returns from opportunistic properties comes from value appreciation over a three- to five-year period, at which time the investor exits or refinances the property. The capital appreciation of opportunistic real estate can come from development of raw property, redevelopment of property that is in disrepair, or acquisition of property that experiences substantial improvement in prospects through major changes, such as urban renewal.

14.2.1 Fixed-Rate Mortgages

A fixed-rate, constant payment, fully amortized loan has equal monthly payments throughout the life of the loan. These loans give the residential mortgage market some of its unique characteristics, as discussed later in the chapter. The fixed-rate and constant payment nature of these loans make the value of the loans subject to interest rate risk and inflation risk. The monthly payments of a fixed-rate loan can be calculated using the formula for the present value of a constant annuity, with the payment amount factored into the left-hand side of Equation 14.1:

(14.1)

where MP is the constant monthly payment, MB is the mortgage balance or total amount borrowed, i is the monthly interest rate (defined as the stated annual rate divided by 12), and n is the number of months in the term of the loan.

An important feature of the fixed-rate mortgage is that the proportion of the monthly payments that is applied against the principal and the proportion that consists of interest charges change over the lifetime of the loan, as the outstanding principal balance declines. In the early years of the mortgage, the largest portions of the payments represent interest payments rather than principal repayments. The interest component is equal to the monthly interest rate multiplied by the outstanding loan amount from the beginning of the current month or the end of the previous month. The principal repayment component of the monthly mortgage payment is the residual between the total payment and the interest portion. Reduction in principal due to payments is known as amortization. Exhibit 14.1 illustrates the amortization schedule for the example just presented: a $100,000 mortgage with a fixed-rate (0.5% a month) constant payment ($644.30 per month) that is fully amortized. An asset is fully amortized when its principal is reduced to zero.

As can be seen in Exhibit 14.1, the first interest payment is equal to $100,000 × 0.5% = $500.00. Given that the fixed monthly mortgage payment is $644.30, the principal repayment in the first month will be $644.30 − $500.00 = $144.30, and the end-of-month mortgage balance will decline from $100,000 to $99,855.70.

Fixed-rate residential mortgages are valued similarly to bonds. As the market level of interest rates increases, the present value of the future payments declines. If the appropriate market interest rate remains at 6% per year, the market value of the mortgage would be equal to the outstanding principal balance. However, at a new and higher market interest rate, the value of the mortgage would drop below the principal balance.

Exhibit 14.1 illustrates the amortization of a fixed-rate mortgage in the absence of unscheduled principal repayments. If the borrower makes unscheduled principal payments, which are payments above and beyond the scheduled mortgage payments, the mortgage's balance will decline more quickly than illustrated in Exhibit 14.1, and the mortgage will terminate early. In traditional mortgages, payments that exceed the required payment reduce the principal payment but do not lower required subsequent payments until the mortgage is paid off.

Unscheduled principal payments cause a wealth transfer between the borrower and the lender, depending on the relationship between the mortgage's interest rate and current market interest rates. When market rates are lower than the mortgage rate, unscheduled principal payments generally benefit the borrower and harm the lender. The lender receives additional cash flows that, if reinvested at prevailing interest rates, will earn less return than the mortgage offers. Borrowers can make unscheduled prepayments to reduce the total interest costs of their mortgage by an amount greater than the amount that they could earn from interest income in the market. Thus, borrowers have an incentive to make prepayments on mortgages when interest rates decline below the mortgage's rate.

When market rates are higher than the mortgage rate, unscheduled principal payments generally benefit the lender and harm the borrower. The lender receives additional cash flows that can be reinvested at prevailing interest rates that will earn more return than the mortgage offers. Borrowers are harmed by prepaying a low-rate mortgage when they could earn more by investing in the market at the new and higher rates. Borrowers may make such payments due to idiosyncratic reasons, such as selling the property, refinancing due to liquidity problems, or other personal reasons.

The ability of the borrower to make or not make unscheduled principal payments is an option to the borrower: the borrower's prepayment option. The option is a call option in which the mortgage borrower, much like a corporation with a callable bond, can repurchase its debt at a fixed strike price. Therefore, a mortgage borrower benefits from increased interest rate volatility. The lender, on the other hand, has written the call option and suffers from increased interest rate volatility. The key point is that fixed-rate mortgage investing has interest rate risk that includes the interest rate risk of the borrower's prepayment option. While the prepayment option may be viewed as a call option on the value of the debt, the option may also be viewed as a put option on interest rates. Just like a call option on a price, a put option on a rate rises in value when rates fall and prices rise. Both option views illustrate that during times of declining interest rates and rising fixed-income prices, it may be to the borrower's advantage to refinance the loan, replacing the current high-interest-rate, high-priced debt with a new loan at a lower interest rate.

It must be remembered, however, that options are not free goods. The lender demands compensation for writing the prepayment call option to the borrower. Although the option may not be explicitly priced as part of the loan, it is implicitly priced in the form of a higher interest rate on the mortgage loan or in up-front points, or fees, charged to the borrower.

14.2.2 Interest-Only Mortgages

Some fixed-rate mortgages are interest-only mortgages, which means that the monthly payments consist entirely of interest payments for some initial period. The two most widely used interest-only loans are both 30-year mortgages. The first begins with a 10-year interest-only period, followed by a 20-year fully amortizing period; this type of loan is known as 10/20. The second begins with a 15-year interest-only period, followed by a 15-year fully amortizing period; this type of loan is known as 15/15. A 25-year mortgage with a 10-year interest-only period would be referred to as a 10/15 interest-only mortgage. In each case, the interest-only payments are equal to the product of the principal balance and the monthly rate. When the mortgage commences amortization, the payments are computed like fixed-payment mortgages except that they are based on the remaining and shorter period of the mortgage's life.

Interest-only mortgages have the potential advantage that the monthly payments during the interest-only period are lower than those in the case of a fully amortized loan ($500 versus $644.30). However, during the amortization period the monthly payments are higher ($843.86 versus $644.30), as the borrower has fewer years to amortize the loan (15 years versus 25 or 30 years).

14.2.3 Variable-Rate Mortgages

Particularly during the period from 2004 to 2006, mortgage markets shifted toward increased use of variable-rate or adjustable-rate mortgages (ARMs) and away from fixed-rate mortgages. Although the initial payments in the case of ARMs are calculated in the same manner as conventional fixed-rate loans, the payments are not necessarily constant during the life of the loan, as the interest rate is periodically adjusted by the lender, generally to reflect changes in underlying short-term market interest rates, as prescribed in the mortgage agreement.

Consider a hypothetical variable-rate mortgage in which the interest rate changes each month and is set equal to the one-month interest rate prevailing at the time. In this extreme and hypothetical example, the mortgage lender would receive the same interest as if the lender had placed funds in a series of short-term (one-month) interest-bearing accounts. Therefore, investors in this hypothetical variable-rate mortgage would have the same interest rate risk that investors face in the short-term money market. In effect, and ignoring default and reset limits, a variable-rate mortgage that fully resets every X months behaves to the lender or mortgage investor like a series of investments in short-term fixed-income accounts, each with a maturity of X months.

The market value of a variable-rate mortgage (absent default) behaves like a money market account to the extent that the mortgage's rate adjusts quickly and without limits. Therefore, an obvious advantage of a variable-rate type of mortgage to a lender is that it protects the lender from the valuation fluctuations due to interest rate changes experienced with fixed-rate mortgages. An obvious disadvantage of variable-rate loans is the risk to the borrower that interest rates will increase. A variable-rate loan provides the advantage to the borrower of substantially lower initial interest rates.

Exhibit 14.2 demonstrates the payment changes for a variable-rate mortgage. Suppose that a $100,000, 25-year mortgage is taken out. The initial interest rate that will apply for the first full year is 7%, compounded monthly. This implies that the monthly mortgage payment during the first year is $706.78 (n = 12 × 25 = 300, i = 7%/12, PV = +/−$100,000, FV = $0, solve for PMT) and that at the end of the first year, the mortgage balance will be $98,470.30 (n = 12 × 24 = 288, i = 7%/12, PMT = $706.78, FV = $0, solve for PV). The variable-rate mortgage begins the same as a fixed-rate mortgage in terms of computational methods, although it usually has a lower initial rate. The payments change when the variable rate changes, as illustrated in Exhibit 14.2.

The monthly payments of the variable-rate mortgage in Exhibit 14.2 are based on an adjustable rate that can vary from the 7% initial rate beginning in month 13 (end of year 1). This variable rate, which applies for the whole next year, is based on an index rate. An index rate is a variable interest rate used in the determination of the mortgage's stated interest rate. Index rates fluctuate freely in the money markets and can be based, for example, on the yield of one-year Treasury securities. Variable rates typically include a margin rate. A margin rate is the spread by which the stated mortgage rate is set above the index rate. (This should not be confused with the same term used to describe a rate associated with margin debt in a brokerage account.) This example uses a margin rate of 1.5%. This margin rate is determined as part of the original terms of the mortgage and is added to compensate for the expected or assessed degree of risk, including interest rate risk and the riskiness of the borrower. The total interest rate is the sum of the index rate and the margin rate.

The process of determining payments continues into the third year, with the interest rate and longevity of the mortgage being adjusted at each reset in order to determine the new payment. The mortgage balance at the end of the second year is equal to $97,430.75, which is determined from the amortization, assuming no unscheduled principal payments (using a financial calculator: n = 12 × 23 = 276, i = 10%/12, PMT = $903.36, FV = $0, solve for PV). The mortgage balance at the end of the second year, $97,430.75, is then used, along with the third-year mortgage rate, 11.5%, to compute the payments for the third year. This process of computing the remaining mortgage balance and using that balance to compute the new monthly payments, considering the new interest rate that applies each year, continues over the life of the variable-rate portion of the mortgage.

It is also common for interest rates on ARMs to be capped. An interest rate cap is a limit on interest rate adjustments used in mortgages and derivatives with variable interest rates. In the previous example, suppose that the increase in interest rates was capped to 2% during any one year and to a total increase of 4% during the life of the mortgage. The effect of these interest rate caps on the mortgage balance and on the monthly payments would be to prevent the mortgage's rate from rising above the annual or lifetime caps. Thus, with the given 2% cap, the mortgage rate for the second year would be capped at 9% and would be used in place of 10% for the second-year calculations. Further, the mortgage rate for the third year would be capped at 11% and would be used in place of 11.5% for the third-year calculations due to the limitation of lifetime interest rate increases to 4% over the mortgage's lifetime (7% + 4% = 11%) as well as the 2% per year limitation. Obviously, the borrower must pay for these caps in the form of a higher initial mortgage rate or index rate to compensate the lender for the potential negative effects that the cap rates may have on the lender's future income from the mortgage if future uncapped interest rates were to rise above the mortgage's cap.

14.2.4 Other Types of Mortgages

Fixed-rate and variable-rate mortgage loans have other variations as well. For example, it is common, particularly with variable-rate mortgages, for the initial interest rate to be low when compared to short-term market rates and for that low rate to be fixed for an initial period. After this period, the mortgage rate is calculated based on the lender's standard variable interest rate. Another type of loan with relatively low initial payments is a graduated payment loan. This loan is made at an initially fixed interest rate that is relatively low but scheduled to increase slowly over the first few years. Both of these variations are designed to help borrowers qualify for the loan and be able to make the initial payments on the loan. Historically, defaults on mortgage loans tend to be concentrated in the first few years of a loan. Therefore, by offering a reduced rate for the initial years, the lender is not only using the lower rate as a tool for attracting business but also attempting to mitigate the default risk in the early years of the mortgage. Note that in an environment of steadily increasing housing prices, if a mortgage defaults several years after being initiated, the losses to the lender should be minimal, since the collateral would most likely exceed the loan amount.

Another variation in variable-rate mortgages provides payment flexibility. An option adjustable-rate mortgage (option ARM) is an adjustable-rate mortgage that provides borrowers with the flexibility to make one of several possible payments on their mortgage every month. The payment alternatives from which borrowers may select each month typically include an interest-only payment, one or more payments based on given amortization periods, or a prespecified minimum payment amount. Thus, borrowers are granted flexibility to make lower payments than would be required in a traditional mortgage. Option ARMs typically offer low introductory rates and may allow borrowers to defer some interest payments until later years.

One feature of option ARMs that can exacerbate default risk is that they may not be fully amortizing. In fact, when an option ARM allows payments that are below the interest charged on the loan, the loan has negative amortization. Negative amortization occurs when the interest owed is greater than the payments being made such that the deficit is added to the principal balance on the loan, causing the principal balance to increase through time. This negative amortization can generate higher probabilities of default from borrowers taking on too much debt or failing to prepare for future payments.

A further mortgage variation is a loan that includes some form of balloon payment. A balloon payment is a large scheduled future payment. Rather than amortizing a mortgage to $0 over its lifetime (e.g., 25 years), the mortgage is amortized to the balloon payment. In other words, at the end of the loan, there is an outstanding principal amount due that is equal to the balloon payment. The balloon payment allows for a lower monthly payment, given the same mortgage rate, since the mortgage is not fully amortized to $0. Balloon payments due in a relatively short time period (compared to traditional mortgage maturities of 15 to 30 years) may lower the interest rate risk to the lender and permit a lower mortgage rate.

An extreme example of a balloon payment mortgage is when the loan payments are only interest, which means that no regular principal repayments are required. Therefore, at the end of the loan, all the capital is due. In the previous example, the mortgage's initial value of $100,000 would be inserted as the balloon payment, or FV. The remaining payment would simply be the interest on $100,000 at 6% per year, or $500 per month. This interest-only form reduces monthly payments. In an ideal scenario, the capital appreciation of the actual property's value will be substantial, and the borrower will gain substantial equity in the property even though the principal amount of the mortgage remains constant.

14.2.5 Residential Mortgages and Default Risk

Default risk is dispersion in economic outcomes due to the actual or potential failure of a borrower to make scheduled payments. For most residential mortgages, the full repayment of the mortgage is backed by a public or private guarantee, such that mortgage investors are focused on interest rate risk rather than default risk. Insured mortgage loans are generally extended based on an analysis of the underlying property and the creditworthiness of the borrower. However, especially in the years prior to the 2007 global credit crisis, increasing percentages of newly issued mortgages were uninsured and had borrowers with relatively high credit risk. Uninsured mortgages with borrowers of relatively high credit risk are generally known as subprime mortgages.

Analysis of the creditworthiness of the borrower and the protection provided to the lender by the underlying real estate asset is fundamental analysis that generally relies substantially on ratio analysis. Ratios regarding the creditworthiness of the borrower often focus on the ratio of some measure of the borrower's housing expenses to some measure of the borrower's income. For example, a debt-to-income ratio is computed as the total housing expenses (including principal, interest, taxes, and insurance) divided by the monthly income of the borrower, and it might be required to be below a specified percentage for the borrower to qualify for mortgage insurance. The front-end ratio, including only housing costs, may be limited to 28% of gross income; the back-end ratio, including both housing costs and other debts, such as credit cards and automobile loans, may be limited to 36% of gross income. The exact definitions of these types of ratios vary and are part of a larger fundamental analysis that includes indicators of creditworthiness, such as credit scores and credit history.

Fundamental analysis of the real estate property underlying the mortgage typically includes an appraisal and analysis of factors regarding the property, such as availability of services and structural integrity. Ratio analysis is also important in the analysis of the property. Specifically, the loan-to-value ratio (LTV ratio) is the ratio of the amount of the loan to the value (either market or appraised) of the property. Residential mortgages with LTV ratios of 80% are often viewed as being very well collateralized. LTV ratios of up to 95% are commonly allowed for insured residential mortgages.

14.3.1 Commercial Mortgage Characteristics

Mortgage loans on commercial real estate differ in a number of respects from those in the residential market. Almost all commercial loans involve some form of balloon payment on maturity, since the loan term is almost always shorter than the time required to fully amortize the loan at the required payment. Furthermore, due to the large size of commercial real estate projects, few individuals participate in this market as borrowers or lenders. Most of the borrowers are commercial or financial firms that possess greater financial sophistication than the average homeowner.

An important distinction when examining commercial mortgages is the nature of the loan and, in particular, whether it is for completed projects or for development purposes. Most development loans are shorter-term and phased, wherein the developer draws down funds only as required during the construction phase. This is in contrast to loans for existing properties, which tend to have a longer horizon, usually in the region of 5 to 10 years, and for which the full amount of the loan is drawn immediately.

14.3.2 Commercial Mortgage Default Risk

Whereas residential mortgage investors are primarily concerned about interest rate risk and prepayment rates, commercial mortgage investors typically face substantial default risk related to the credit risk of the borrower as well as the price risk of the underlying collateral (i.e., property). Default risk is related to covenants and recourse.

In general, the covenants in a commercial mortgage are more detailed than those in a corresponding residential loan document. Covenants are promises made by the borrower to the lender, such as requirements that the borrower maintain the property in good repair and continue to meet specified financial conditions. Failure to meet the covenants can trigger default and make the full loan amount due immediately. The view that covenants benefit lenders at the expense of borrowers is naïve. Although covenants lower the credit risk to the lender, they are presumably offered by the borrower in exchange for better terms on the loan (e.g., a lower interest rate). The severity and details of covenants required by lenders vary across firms. To some extent, borrowers choose to offer particular covenants by selecting lenders that demand those covenants, because they prefer the lower rates of loans attached to those covenants.

Commercial loans tend to contain far more detail concerning such issues as the seniority of the loan. As with all debts, particularly at the corporate level, lenders need to know their position with respect to seniority in the event of default or financial difficulty. For instance, it may be the case that if the loan is senior or is the original debt (also called the first lien or first mortgage) on the property, the lender has to provide permission before subsequent debts (such as second liens or second mortgages) can be incurred. Another key element in any commercial debt deal is the recourse that the lender has to the borrowing entity. Recourse is the set of rights or means that an entity such as a lender has in order to protect its investment. Recourse may include how the loan is secured, such as the potential ability of the lender to take possession of the property in the event of a default and the potential ability of the lender to pursue recovery from the borrower's other assets. Another type of covenant included in many commercial mortgages but not included in residential mortgages is restriction on the distribution of the rental income from the property, with perhaps a specified proportion being redirected to a reserve account rather than paid straight to the owner. A lender may also insist on a minimum deposit or balance to be maintained in an account with the lender.

In addition to explicit covenants with regard to the debt, commercial mortgages may come attached with a proviso (i.e., condition or limitation) relating to the management and operation of the property. Lenders may insist that minimum levels of cash flow, net operating income, and earnings before interest and taxes need to be achieved or that rental levels may not fall below a previously specified level. Such provisions are designed to ensure that the property is able to generate sufficient income on an ongoing basis for the borrower to service the loan. Lenders may even insist on having some form of either control or consultation with regard to leasing policies, such as examination of new lease terms or credit checks on potential tenants.

Finally, in order to mitigate the risk to which they are exposed, lenders commonly use a cross-collateral provision, wherein the collateral for one loan is used as collateral for another loan. For example, say a corporation has borrowed twice, securing each loan with a property; with a cross-collateral provision, both properties would be used as collateral for both loans. If the corporation fully pays off one of the loans and wishes to sell the related property, the lender may prevent the sale because the property is still serving as collateral to the other loan.

14.3.3 Financial Ratios for Commercial Mortgages and Default Risk

Whereas a large number of residential mortgages are insured against default risk, commercial mortgages are generally exposed to default risk. Therefore, commercial mortgage investing usually involves fundamental analysis of default risk. Further, while fundamental analysis of residential mortgage default risk focuses on the credit risk of the borrower, fundamental analysis of commercial mortgage default risk focuses primarily on the role of rental income from the property in covering the mortgage payments.

As with residential loans, the LTV ratio, both at the origination of the loan and on an ongoing basis, is a key measure used by lenders. The LTV ratio at which a lender will issue a loan varies depending on the lender, the property sector, and the geographic market in which the property is located, as well as the stage of the real estate cycle and other circumstances, such as the borrower's creditworthiness. Financial institutions tend to lend at lower LTV ratios in the commercial sector than in the residential sector. It would be rare for senior debt in commercial properties to be lent at an LTV ratio in excess of 75%. Commercial borrowers, then, typically need a larger down payment or equity contribution than do borrowers purchasing residential real estate.

Given that commercial real estate generates rental income, lenders also examine a variety of income-based measures, in addition to the LTV ratio, when assessing the credit risk of a loan. For instance, lenders typically examine the interest coverage ratio, which can be defined as the property's net operating income divided by the loan's interest payments. The interest coverage ratio allows lenders to analyze the level of protection they have in terms of a borrower's ability to service a debt from the property's operating income. Senior secured debt lenders usually require that borrowers meet a minimum coverage ratio of 1.2 to 1.3. This means that the projected net income must be at least 20% to 30% greater than the projected interest payments. A related measure is the debt service coverage ratio (DSCR), which is the ratio of the property's net operating income to all loan payments, including the amortization of the loan. A final typically used key ratio with an even broader definition of expenses is the fixed charges ratio. The fixed charges ratio is the ratio of the property's net operating income to all fixed charges that the borrower pays annually.

The risk of default needs to be constantly monitored by mortgage investors. Research by Esaki notes that default rates of commercial mortgages are highly cyclical and tend to be explained by both market conditions and lender policies.¹ Loans taken out, for example, during the real estate booms of the late 1980s and mid-2000s—periods that witnessed not only a booming real estate market but also liberal lending policies (including LTV ratios greater than 100%, along with fewer or weaker covenants)—eventually recorded high default rates. In contrast, loans issued during the 1990s experienced much lower default rates, due in part to more conservative lending policies during that period. A major difference between residential and commercial lending is that it is far more likely that defaulting commercial loans will be restructured rather than moved directly to foreclosure, due in part to the size of the individual loans. Esaki, for instance, finds that 40% of defaulting commercial loans were restructured.²

14.4.1 Residential Mortgage Prepayment Options

Residential mortgage markets have been dominated in size by insured mortgages for which there is little or no risk of default to the lender. Most mortgages have scheduled principal repayments that amortize the mortgage's principal value from the initial mortgage amount to zero over the mortgage's scheduled lifetime. Most mortgages also allow the borrower the option to make additional and unscheduled principal payments without penalty. Future unscheduled prepayments are the key unknown variable in determining the values of insured mortgages and mortgage pools.

Residential mortgages are callable bonds. The lender is short a call option on the value of the loan, which may also be viewed as being short a put option on mortgage rates. Borrowers may exercise this option by refinancing if interest rates decline. Exercise of this prepayment option when interest rates fall acts to the detriment of lenders, which presumably must reinvest the prepaid principal at the lower rates.

Unscheduled mortgage principal payments include full mortgage prepayments (e.g., when a loan is refinanced or when it is repaid because a homeowner is moving) and partial repayments, when borrowers decide to make one or more mortgage payments that exceed the minimum required payment (e.g., when the mortgage rate is higher than the interest rate that the borrower can earn on excess cash).

The main problem with unscheduled principal repayments is that the mortgage investor cannot predict the size of the prepayments or the rate at which the unscheduled principal repayments will be received and can be reinvested. Unscheduled repayments on a mortgage issued at an interest rate of 6% cease earning 6% to the mortgage investor and presumably begin earning current interest rates, which may be higher or lower than 6%.

The option to make or not make unscheduled principal repayments rests with the borrower. Mortgage borrowers have an incentive to make unscheduled mortgage payments when interest rates are low, for several reasons. First, borrowers are more likely to refinance when rates are low. Second, borrowers are more likely to move and fully prepay mortgages when rates are low. Finally, borrowers are more likely to use excess cash to prepay mortgages when the interest rate on their mortgages substantially exceeds the rate at which the excess cash can be invested. The same incentives reverse when interest rates are high, making borrowers less likely to prepay mortgages. Simply put, borrowers have a prepayment option, and they tend to exercise that option in their favor based on interest rates. However, there are also idiosyncratic factors related to the borrower, such as ability to make prepayments and decision to sell a house, that affect prepayment decisions. These factors are not fully driven by interest rates, and they may cause or prevent otherwise optimal exercise of the prepayment option based purely on interest rates. Thus, mortgage prepayments are difficult to predict even under specific interest rate scenarios.

Mortgage lenders write the prepayment options at the initiation of the mortgage, and therefore the lenders, and any subsequent mortgage investors, are short those options until the mortgage is fully repaid. Mortgage investors suffer losses when the borrower's prepayment option moves into-the-money relative to an investor in a similar fixed-income security without the prepayment option. The borrower harvests gains by exercising the prepayment option. Specifically, rational exercise of the prepayment option by borrowers tends to generate higher unscheduled prepayments to lenders when interest rates are low and reinvestment opportunities are least desirable. Unscheduled principal payments to lenders when interest rates are high and reinvestment opportunities are most desirable would be made only due to the borrowers' idiosyncratic factors. Although they would typically work to the advantage of the mortgage investor, such unscheduled principal payments would be relatively less likely.

Each long-term mortgage has hundreds of scheduled future payments and hundreds of future potential prepayment options. The cash flows, or payments, of individual mortgages are aggregated and form the available cash flows of the mortgage pools underlying the RMBS. These cash flows include the unscheduled principal payments that are passed from the mortgage pool to the RMBS investors. Thus, the main risks of RMBS with insured underlying mortgages involve the prepayment behavior of the underlying pool and its relationship with reinvestment opportunities. These unscheduled payments create uncertainty on the part of investors regarding both the timing of the principal repayments they will receive and the longevity of the interest payments they will receive.

14.4.2 Measuring Unscheduled Prepayment Rates

Mortgage returns that are not driven by default risk are primarily driven by the interest rate risk inherent in prepayment risk. Mortgage investors therefore focus on the unscheduled principal payments and the forecasted speed of prepayments.

In essence, the market value of each mortgage or pool of mortgages is a function of its anticipated rate of prepayment. Attempts to earn superior rates of return are generally exercises in predicting prepayment rates and investing in those mortgages or pools of mortgages that will experience more desirable rates of prepayment than are reflected in the current price. With stable interest rates, high rates of prepayment are usually beneficial to the mortgage investor because they reduce the expected longevity of the cash flow stream. However, when mortgages have interest rates higher than prevailing market interest rates, slower prepayment rates may be desirable to the mortgage investor.

More sophisticated insured mortgage analysis focuses on models that combine interest rate behavior with unscheduled principal payment rates. The secondary mortgage market has developed models for deriving interest rate scenarios, correlating those interest rate scenarios with prepayment scenarios, and using the framework to price MBS. This section describes the major metric by which unscheduled principal payments are expressed.

The annualized percentage of a mortgage's remaining principal value that is prepaid in a particular month is known as the conditional prepayment rate (CPR). The exact computation of the CPR involves principal balances and specifies such details as the use of monthly compounding. But the CPR for a particular month is clearly intuitive: It roughly reflects the annual reduction in the mortgage principal that would be anticipated if the same percentage of principal were repaid each month for 12 consecutive months. For example, if 1% of a mortgage's remaining principal payment is prepaid in a particular month, the CPR for that month would be 11.4% (which is less than 12% due to compounding with a declining balance).

The Public Securities Association (PSA) established the PSA benchmark, a benchmark of prepayment speed that is based on the CPR and that has become the standard approach used by market participants. The PSA prepayment benchmark is shown in Exhibit 14.3.

As indicated in Exhibit 14.3, the benchmark assumes that for a 30-year mortgage, a CPR of 0.2% will apply for the first month of the security. The monthly benchmark CPR then increases by 0.2% per month for the next 30 months until it reaches a level of 6%. The benchmark CPR is then assumed constant at this rate of 6% for the rest of the life of the mortgage. The reason behind the initially increasing CPR rate is that only a few borrowers will be expected to prepay in the early years of their loans (e.g., due to moving or refinancing), as their circumstances and market interest rates have had little time to change since they made the decision to take out the loan. However, as time passes, prepayments are assumed to pick up until they level off at a CPR of 6%.

The key to the benchmark is that it is used as a standard against which each mortgage or mortgage pool is indexed. If a mortgage experiences the same CPR for a particular month, as is listed in Exhibit 14.3, then it is described as prepaying at 100% PSA. For example, if Mortgage A has a steady CPR of 1% for every month, in month 2 it would be referred to as 250% PSA because the actual CPR (1%) is 2.5 times the PSA standard rate (0.4%) for the second month of a mortgage's life. In month 30 or beyond in the mortgage's life, a CPR of 1% would be referred to as 16.7% PSA because the actual CPR (1%) is one-sixth the PSA standard rate for those months (6%).

14.4.3 Pricing RMBS with PSA Rates

The cash flows of insured residential mortgage pools can be projected, assuming a given PSA speed. Those cash flows can then be discounted to form an estimated present value or price to the pool. However, the selection of an appropriate discount rate is complicated by the interest-rate-related options of mortgages. Expected cash flows cannot simply be discounted at expected interest rates, since larger cash flows (i.e., higher unscheduled principal repayments) tend to occur when interest rates are lowest. Thus, RMBS pricing models should be based on option pricing technology.

However, mortgage prepayment options are not exercised based purely on interest rates. Some mortgage borrowers prepay mortgages during high-interest-rate environments due to personal circumstances (e.g., moving due to a change in employment), and some mortgage borrowers fail to prepay mortgages even when interest rates are low and refinancing appears beneficial. Factors affecting prepayment decisions other than interest rates or other systematic factors are known as idiosyncratic prepayment factors. Idiosyncratic prepayment factors prevent the specification of a precise relationship between unscheduled prepayments and interest rate levels, and option pricing models that include this behavior should be used.

Mortgage prepayment rates can also vary due to systematic prepayment factors other than interest rates. For example, a rise in economic activity or higher housing prices can generate widespread prepayments as borrowers change residences to move into larger houses or accept new jobs. Changes in prepayment rates from systematic factors can also be due to interest-rate-related factors other than current interest rate levels, including the path that mortgage rates have followed to arrive at the current level. For instance, when mortgage rates drop further after having declined substantially in the recent past, refinancing may not occur at a rapid rate, since those who ascertain a benefit from refinancing at lower interest rates will probably have done so when the mortgage rate first dropped. Reduced refinancing speeds due to high levels of previous refinancing activity is known as refinancing burnout.

The prepayment rates experienced by mortgage pools will vary based on such factors as the characteristics of the underlying mortgage pool. These factors include the maturities of the mortgages, the rates of the fixed-rate mortgages, and the terms of any variable-rate mortgages. Another factor is the geographic location of the pool. There are regional prepayment tendencies, regional economic performance levels, and regional impacts on prepayment speeds even within the same country. Geography also comes into play in relation to factors such as the risk of destruction of properties. For example, if a large number of properties in the pool are located closer to major storm risks or earthquake risks, there can be substantial effects on the potential speeds of prepayments of insured and uninsured mortgages. Analysts build fundamental models of prepayment speeds based on these characteristics and include analysis of past prepayment rates to predict future prepayment rates.

Ownership of mortgage pools is often divided or structured into investment products that have widely varying exposures to prepayment risks. These structured products are discussed in detail in Part 5.

14.4.4 Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities (CMBS) are mortgage-backed securities with underlying collateral pools of commercial property loans. CMBS provide liquidity to commercial lenders and to real estate investors. Commercial lenders can sell commercial loans that they have issued into the CMBS pools. Real estate investors may purchase CMBS and enjoy higher liquidity and diversification than they would through direct ownership of commercial loans.

The emergence of the CMBS market in the United States in the early 1990s can be explained, at least partially, by a large market correction in the U.S. real estate market at that time, which caused a severe lack of liquidity in the sector. The correction damaged many traditional commercial lenders and decreased the level of activity of many others. At that point, CMBS facilitated investment by mortgage investors other than traditional commercial lenders. The use of CMBS rose over the years, along with real estate prices, leading to the financial crisis that began in 2007.

Compared to an insured RMBS, a CMBS provides a lower degree of prepayment risk because commercial mortgages are most often set for a shorter term. Fixed-rate commercial mortgages typically charge a prepayment penalty, which makes commercial borrowers substantially less likely to refinance than residential borrowers. However, CMBS are more subject to credit risk. Because they are not standardized, there are lots of details associated with CMBS that make default risks difficult to ascertain and thus make these instruments difficult to value. Many of these differences relate to the more heterogeneous nature of CMBS issues relative to RMBS issues and to their underlying real estate properties. In particular, default risks are complex and heterogeneous due to the unique risks of commercial real estate assets. Factors that may affect CMBS default probabilities include property type, location, borrower quality, tenant quality, lease terms, property management, property seasoning, and year of origination. Further, given the large size and indivisible nature of properties, CMBS issues tend to contain fewer loans. This means that investors in the CMBS market have concentrated risk to a relatively small number of potential defaults.

LTV ratios and debt yields (cash flow divided by the amount of the loan) play a big role in the analysis of CMBS issues, as they do for the underlying commercial mortgages. Most U.S. CMBS issues have had historical average LTV ratios in the 65% to 80% region, and CMBS issues with average LTV ratios greater than 75% would be viewed as risky. However, what is perhaps more important to consider is the percentage of the individual loans in a CMBS with LTV ratios above 75%. In many cases, rating agencies allow a maximum of 15% of loans with LTV ratios in excess of 75%. The risk of CMBS is also driven by the level of diversification in the pools' mortgages. For example, rating agencies often discourage issues (refuse to assign high ratings) when an individual loan is more than 5% of a specific CMBS issue.