Joseph F. DeMichele

Vice President Delaware Investments

William J. Adams, CFA

Vice President Massachusetts Financial Services

Duane C. Hewlett

Vice President Delaware Investments

Commercial mortgage-backed securities (CMBS) are collateralized by loans on income-producing properties. The CMBS market has grown dramatically from its modest beginnings in the mid-1980s. Issuance, liquidity, and the number of investors participating in the CMBS market have all increased substantially. This chapter gives a brief overview of the history and composition of the CMBS market. It also provides an introduction to the risks involving structure, optionality, and credit quality of CMBS that investors must be aware of when allocating assets to this market sector.

HISTORY

During the 1980s, a strong economy, the deregulation of the financial services industry, and preferential tax treatment led to an explosion in the level of capital flows into the commercial real estate markets. Total commercial debt outstanding grew from over $400 billion in 1982 to approximately $1 trillion by 1990. Inevitably, extreme overbuilding caused the bubble to burst, and the boom of the 1980s was followed by a severe recession in the commercial property markets during the early 1990s. From 1990 to 1993, returns on income-producing properties fell by 28% as reported in the NCREIF Property Index.¹

During the 1980s, the primary sources of commercial real estate funding were tax shelter syndicates, savings institutions, commercial banks, and life insurance companies. The Tax Reform Act of 1986 withdrew many real estate tax benefits and eliminated the tax shelter syndicates as a major source of funds. The severe devaluation of commercial property values in the early 1990s resulted in sizable losses among thrifts, banks, and insurance companies and led to a major retrenchment of lending activity by these traditional sources of commercial real estate funds. Two significant developments were born of this commercial real estate cycle downturn, one major and one minor, which precipitated the securitization of commercial loans.

The biggest contributing factor leading to the maturation of the CMBS market was the creation of the Resolution Trust Corporation (RTC). The RTC was created by Congress to facilitate the bailout of the ailing thrift industry. The mandate handed down from Congress was for the RTC to liquidate assets it acquired from insolvent thrifts as quickly and efficiently as possible. A large portion of the assets inherited by the RTC from the thrifts it acquired consisted of commercial mortgage loans. The RTC turned to the CMBS market to monetize its “investment.” Between 1991 and 1993 it issued nearly $15 billion multifamily and mixed property CMBS. The large number of loans in each deal led to a high level of diversification much like what was found in the widely-accepted residential MBS market. The presence of an over-abundant level of credit protection through subordination, often in the form of cash, made the securities very attractive to investors.

The other occurrence, albeit minor, was the introduction of stricter risk-based capital charges for insurance companies at year-end 1993. These guidelines required insurance companies to hold larger capital reserves for whole-loan commercial mortgages than for securitized commercial mortgages, thus giving insurance companies the incentive to securitize their commercial mortgage holdings.

Issuance has continued to expand since 1993, from $17.2 billion to $71.9 billion as of year-end 2001, although the contribution from the RTC has fallen dramatically.² As the RTC finished its job of liquidating insolvent thrifts, other issuers opportunistically stepped in to continue the growth of the CMBS market.

Witnessing the success of the RTC’s foray into the CMBS market, many insurance companies, pension funds, and commercial banks began to use the CMBS market as a means of restructuring their balance sheets. Institutions began to utilize the CMBS market as a means of liquidity for disposing of unwanted assets, to receive better regulatory treatment for holding securities in lieu of whole loans, or even simply to raise capital for underwriting more loans. As commercial real estate valuations rebounded through the latter half of the 1990s, these traditional lenders stepped up their commercial lending programs and became a consistent source of issuance in the CMBS market.

The emergence of the commercial mortgage conduits further fueled the expansion of CMBS issuance. Almost every major investment bank established a conduit arrangement with a mortgage banker to originate commercial loans for the specific purpose of securitization. The number of commercial mortgage conduits providing real estate funding increased from less than five at the start of 1993 to over 30 at the start of 1995.³ Conduit issuance has steadily grown as a percentage of total CMBS issuance. Conduit issuance now accounts for roughly 60% of the domestic CMBS market. Today, the market capitalization of the CMBS market exceeds $300 billion. Roughly 20% of all commercial mortgage loans are securitized into CMBS.

TYPES OF CMBS IN TODAY’s MARKET

Agency

All three of the government’s housing-related agencies (Ginnie Mae, Fannie Mae, and Freddie Mac) issue forms of CMBS. Because the mission of each of these agencies is to provide funding for residential housing, they have been involved in the issuance of multifamily housing loan securitizations. Ginnie Mae also issues securities backed by loans on nursing home projects and healthcare facilities. All agencies have issued these types of securities since 1985.

Ginnie Mae issues passthrough securities backed by loans on commercial projects insured by the Federal Housing Authority (FHA). The FHA has established numerous multifamily insurance programs since its inception. Each project pool will vary depending on the underlying FHA insurance program. Specific characteristics such as project type, loan limit, prepayment features, or the presence of rent subsidies, will affect the performance of a particular pool.

Ginnie Mae issues project pools as permanent loan certificates (PLCs) as well as construction loan certificates (CLCs). PLCs are generally backed by 35-year fully amortizing loans with 10 years of call protection. GNMA guarantees full and timely payment of all principal and interest. Project loans also exist with FHA guarantees. These pools carry FHA’s implicit government guarantee that only protects 99% of the principal. Data on the underlying loans are much harder to find and the certificates are physical. These attributes cause FHA project pools to be much less liquid than Ginnie Mae project pools.

Like Ginnie Mae, Fannie Mae is active in the multifamily market. Fannie Mae issues CMBS through various programs. The most popular Fannie Mae securities, are issued under the Delegated Underwriting and Servicing (DUS) Program. Specific underwriting guidelines are set by Fannie Mae for designated eligible lenders to originate loans. The loans are fixed rate-mortgages with 5- to 18-year balloon maturities and amortizing terms of 25 to 30 years. These loans are sold to Fannie Mae, which then issues securities. Fannie Mae DUS are differentiated by credit tiering, with each security assigned a rating from one to four. Each DUS is placed in a tier based on its loan-to-value ratio and minimum debt coverage ratio, with tier four being the highest quality. DUSs have stringent call provisions, which have led Fannie Mae to market these securities as substitutes for its bullet-pay agency debentures.

Freddie Mac was the dominant player of the three agencies before 1990. The commercial real estate recession led to a decrease in issuance from Freddie Mac. Since 1993, Freddie Mac has issued securities through its Program Plus which is very similar to the Fannie Mae DUS program.

Private Label

The majority of CMBS issued today are nonagency or private label securities. Some are collateralized by pools of seasoned commercial loans. The RTC deals were examples of CMBS backed by seasoned collateral. Newly-issued deals backed by seasoned collateral are generally the result of balance sheet restructuring by banks or insurance companies. These securitizations provide challenges for investors since many seasoned pools are characterized by a wide range of coupons and loan types and by widely varying prepayment protection.

Today, most private label CMBS are backed by newly originated loans. These CMBS fall into two major categories: those backed by loans made to a single borrower, and those backed by loans made to multiple borrowers. Single borrower deals can involve one property or a group. Usually, they are backed by large properties such as office buildings or regional malls. Although the transactions obviously lack diversity, information is generally more current and comprehensive. Generally, investors demand more stringent underwriting on single property deals to offset the increased risk brought on by the lower level of diversity. Insurance companies are the most common buyer, since many have the necessary real estate lending expertise to evaluate these deals. The attractiveness of the lower reserving requirement for CMBS over commercial whole loans also entices insurance companies.

Single borrower deals are also created with a variety of properties. Properties are run by a single management company. Real Estate Investment Trusts (REITs) sometimes issue this type of CMBS. Typically all the properties backing a particular deal are cross-collateralized and cross-defaulted. Should one property in the pool experience an impediment to cash flow, the cash generated from the other properties is used to support it. Should one property experience a default, all the remaining properties are defaulted. This is a strong incentive against defaulting, preventing the borrower from walking away from lower quality properties. In essence, this feature allows the cash flow from stronger properties to support weaker ones. Another important characteristic of single borrower pools is the presence of release provisions. A release provision requires a borrower to prepay a percentage of the remaining balance of the underlying loans if it wishes to prepay one of the loans and remove the property from the pool. Thus the bondholders are protected from the borrower being able to remove the strongest properties from the pool.

The most common type of private label CMBS is backed by loans underwritten by more than one unrelated borrower on various property types. Conduit deals are the most prevalent example of multiple borrower deals in today’s market.

Because the loans are underwritten with the intent of securitization, conduit deals possess certain characteristics that are favorable to investors. Loan types tend to be more homogeneous, and call protection is strong. They also have more uniform underwriting standards, and information on credit statistics is generally readily available.

Another kind of CMBS deal is one backed by leases on a property. These triple-net lease or credit tenant loan deals are collateralized by lease agreements between the property owner and a tenant. As long as the lease cannot be terminated, the CMBS created have the same credit as any debt obligation of the underlying tenant. Additionally the bonds are secured by the property. The majority of these securities have been collateralized by mortgages on retail stores with lessees, such as Wal-Mart, that are rated by one of the nationally recognized rating organizations. Recently, mortgages on large office buildings with publicly rated tenants such as Merrill Lynch and Chubb have also been securitized.

STRUCTURE OF CMBS

Senior/Subordinate Structure

The majority of private label CMBS created today utilize a senior/subordinate structure, whereby the cash flow generated by the pool of underlying commercial mortgages is used to create distinct classes of securities. Monthly cash flow is first used to pay the class with the highest priority, the senior classes. After interest and scheduled principal is paid to the senior classes, the remaining classes are paid in order of stated priority. Should cash flow collected from the pool be insufficient to pay off the bonds designated as senior, the loss will be incurred first by the class with the lowest priority.

In a senior/subordinate structure the lower priority classes provide credit enhancement for the senior securities. The amount of subordination is determined in conjunction with the rating agencies in order to obtain the desired rating on the senior securities. Exhibit 16.1 shows an example of a hypothetical CMBS structure with subordination levels typical in the market today. Note that the majority of securities created are senior classes. Subordination levels are set to attain a AAA credit rating on the senior class. This is the highest rating given by the rating agencies, and signifies bonds deemed to have minimal credit risk. Issuers set subordination levels such that the senior classes will receive this rating, thus being more attractive to investors. Rating agencies determine the appropriate amount of credit enhancement based on an analysis of the credit quality of the pool of commercial loans. This will be discussed in more detail later in the chapter.

In industry jargon, those non-senior securities receiving investment grade ratings are known as mezzanine bonds. Those rated non-investment grade are known as subordinate or “B” pieces. The class with the lowest payment priority is called the first loss piece. Any shortfall of cash flow on the commercial loan pool would affect this class first, thus putting it at the highest risk of a loss of principal. The risk profile of the other classes changes inversely to the priority of payment schedule.

A unique feature of the senior/subordinate structure is the fact that credit enhancement can grow over time. Since principal is paid to the senior classes first, if no losses occur these classes will pay down faster than the mezzanine or subordinate pieces. This has the effect of increasing the amount of non-senior classes as a percentage of the entire deal and thus providing more enhancement to the remaining senior classes.

Additional forms of credit enhancement are available. For some deals, such as the RTC originated transactions, a cash account, known as a reserve fund, will be maintained to absorb losses and protect investors. Overcollateralizing is another form of credit enhancement. It refers to the excess of the aggregate balance of the pool of commercial loans over the aggregate balance of the bond classes created. Like a reserve fund, losses would be absorbed by the amount of excess collateral before affecting any of the bond classes.

Paydown Structures

The most common principal paydown method used in CMBS is the sequential-pay method. All principal paydowns, both scheduled and prepaid, are allocated entirely to the most senior class outstanding. Occasionally, a variant of the sequential-pay structure is used. The pool of loans may be segregated into loan groups with each loan group collateralizing a specific set of bond classes. In either paydown structure, principal payments can be designated further to create different bonds within the same class. In Exhibit 16.2, we have altered slightly our hypothetical CMBS to illustrate this technique. The senior class has been further tranched to create two bonds, A1 and A2. Principal is allocated to A1 before A2, thus creating two senior bonds with different average lives.

Interest Payments

In a CMBS structure, all interest payments generated by the underlying commercial loans can be used to pay either interest or principal payments on the created securities. One alternative is to have all the interest received used to pay interest on the bonds. The principal weighted-average coupon on the bonds can be set to equal the principal weighted-average coupon on the pool of loans. In this case, as different loans with different coupons in the pool pay down, the principal weighted-average coupon on the pool will change. In turn, the amount of cash flow available to pay interest on the bonds will vary. Thus, the coupons on the bonds will be variable. CMBS classes from this structure are said to have WAC coupons.

In order to create fixed coupon bonds, the most common method used in CMBS structures is to set the highest coupon on the securities lower than the lowest coupon of the underlying loans. This will ensure that there will be a sufficient amount of interest payments generated by the pool to make all interest payments on the securities. This will lead to a higher level of interest cash flow from the pool of loans than is required to pay interest on the bonds. This extra cash flow is known as excess interest.

In some cases excess interest is used to pay down principal on the most senior bonds outstanding. Under this type of structure, the more senior classes will amortize at a rate faster than the junior classes, thus leading to overcollateralization and providing additional credit enhancement for the deal.

More frequently, the excess interest is used to form an interest-only or IO class. The IO class receives no principal. Its yield is determined solely by the interest cash flow generated by the pool of loans. If the principal balance of a loan is paid prior to its maturity, the yield of the IO will fall. Should a principal payment extend beyond maturity for a loan, the yield will rise. The majority of prepayments in CMBS are generated by defaulted loans and the subsequent recovery on that loan. For this reason the yield on IO securities is very much dependent on the credit quality of the underlying pool of loans.

Underlying Mortgage Type

There are several mortgage loan types that back CMBS deals. The most common are fully amortizing loans, amortizing balloon loans, and interest-only balloons. All else being equal, the faster the amortization of the loan, the faster equity is built up in the property, and the less risk of default. Fully amortizing loans provide the best credit profile. Balloon mortgages also introduce the notion of extension risk, which will be discussed later.

Commercial mortgage loans may have fixed or variable interest rates. If variable rate loans are uncapped and rates rise substantially, the income generated by the property may not be enough to service the debt. Also, if variable rate mortgages are used to structure CMBS with fixed rate classes, basis risk will exist, and interest on the loans may not cover coupon payments on the bonds.

OPTIONALITY

Prepayment Risk

As with most mortgage-backed securities, CMBS have inherent prepayment risk. The underlying commercial mortgages may be prepaid by the borrower. Prepayments on CMBS will affect the yield and average lives of the bonds issued, particularly interest-only securities. Fortunately for investors, most commercial mortgages have explicit provisions that preclude borrowers from prepaying.

The most onerous to a borrower is the prepayment lock-out. Written into the loan agreement, a lock-out is a provision preventing any prepayments for a set time period. The time may vary, but generally will range from three to five years.

Another form of prepayment protection in CMBS structures is called yield maintenance. The yield maintenance provision is designed to create an incentive for the borrower not to prepay. If the borrower chooses to prepay, the lender must be compensated for any lost yield. If market interest rates are lower than when the loan was originated, the borrower must reimburse the lender for any lost interest income. The yield maintenance penalty would be equal to the income that would have been earned by the lender less what would now be earned by reinvesting the prepaid proceeds at the risk-free Treasury rate.

A third form of prepayment protection is the prepayment penalty in the case of a prepaid loan. This will typically take the form of a fixed percentage of the remaining principal balance of the loan. The most common penalty in today’s market is the “5-4-3-2-1” penalty. During the first year of the penalty period, the prepayment penalty would be equal to 5% of the unpaid principal balance of the loan. In year two, the penalty would decline to 4%, and so on.

Today, most commercial mortgages backing CMBS possess some combination of these three prepayment provisions. However, many loan agreements allow for prepayment penalties to decrease over time with the loans becoming freely prepayable during the last six to nine months of the life of each loan.

During the time that these prepayment provisions are in place, the predominant cause of prepayments will be defaults. After these provisions have expired, the prevailing interest rate environment will become a determinant of prepayments as in the residential mortgage market. Other factors, such as retained equity, will affect the level of prepayments. If capital improvements are needed and cheaper financing cannot be found, the owner will most likely prepay the loan in order to refinance. If the property has appreciated sufficiently in value or net operating income has grown enough to cover additional leverage, the owner will most likely do an equity take-out refinancing.

Unfortunately, the amount of data available on prepayments in the CMBS market pales in comparison to the residential mortgage market. Data available are mostly from the RTC deals. Underwriting standards as well as the current real estate market environment are much different today and bring the validity of comparisons on prepayments into question. Additionally, the lack of a dominant, measurable variable, such as interest rates, makes option analysis much more difficult than with residential mortgage-backed securities. Fortunately, the call protection provided by the various prepayment provisions in CMBS helps to significantly offset these factors.

Extension Risk

The majority of CMBS issued today are collateralized by balloon mortgages. In order to meet the balloon principal payment the borrower will have to either sell the property or refinance the loan. Should neither be possible, the servicer usually has the option to extend the loan beyond the balloon date. The extension option varies but typically cannot exceed three years. Rating agencies generally require the stated final maturity of the bond to be four or five years beyond the maturity of the underlying loans. This would allow time for foreclosure and workout should refinancing be unavailable.

Factors that affect extension risk are loan-to-value (LTV) and the interest rate environment at the balloon date. Should property values fall, LTV will rise, and refinancing will be more difficult, thus increasing extension risk. Likewise, if interest rates are high enough such that the income produced by the property does not generate an acceptable debt service ratio, refinancing may not be obtainable.

EVALUATING CREDIT QUALITY IN COMMERCIAL MORTGAGE-BACKED SECURITIES

As the commercial mortgage-backed securities market continues to grow in both dollar amount and investor acceptance, a move toward an acceptance of standardization appears evident. This may prove to be an alarming trend if investors in these securities are lowering credit standards or reducing their level of analysis in exchange for yield and favorable regulatory treatment. Prudent investors must remember that these securities require a consistent level of credit and cash flow analyses, well beyond that of standardized structured collateral. The best analysis for the securities must combine elements of both structured finance and fundamental collateral and credit analyses. Therefore, in this section, we attempt to build a basic, analytical framework for CMBS transactions, which starts with the previously discussed development and appreciation of the forces which created this market. Next, the inherent volatility and cash flow variability of the underlying commercial mortgages are described. Finally, a means of dealing with the unique characteristics of the collateral, including underwriting standards and structural features, is presented. The point of this section is to focus investor attention on relative value and issues affecting the quality of various CMBS transactions in the market.

Earlier, we discussed the development of liquidity in the CMBS market from direct real estate lending to securitization. Readily available capital for the asset class led to excessive development which culminated in the early 1990s real estate recession. The RTC was created to monetize problem commercial real estate. It did so through structured securities, thereby broadening the investor base and creating many of the structural and legal features of the market today. During this time, a black cloud formed over commercial real estate as an investment. Traditional real estate investors left the market, creating both a liquidity crisis for any new and/or existing financing and an oversupply of additional product due to a reduction in exposure to the asset class. In this void, Wall Street’s expertise and capital was required, thereby fueling the CMBS market as we know it today.

The current commercial real estate market combines the two elements described above: the RTC’s structure and Wall Street’s capital. Despite weak economic environment at the time of this writing, commercial real estate has recovered from the problems of the early 1990s. Fewer banks and insurers are selling the asset class (in fact, many traditional long-term real estate investors have returned to the market), and, most important, Wall Street’s capital remains in the market in the form of conduits. Conduits are now the (re)financing vehicle of choice for real estate owners and developers starved for regular sources of capital. Conduits originate and then securitize real estate loans, rather than maintain the credit risk on their own balance sheet. Typically, conduits take the form of mortgage brokers/bankers backed by an investment bank or commercial banks. Mortgage brokers originate and underwrite commercial mortgages using the capital, warehousing, and distribution channels of the investment bank. A commercial bank provides all such functions, thereby offering it a viable commercial real estate operation, while maintaining significantly lower levels of direct real estate exposure on its balance sheet.

As the CMBS market has evolved, the commercial mortgage market has taken an interesting turn (or return, in this case). With traditional real estate lenders returning to the market along with the capital provided by real estate investment trusts, the highest quality properties (Class A) are rarely available for conduit programs. As such, most commercial real estate underwritten by conduits is average, at best, typically Class B and C quality. Historically, this asset class was the domain of the S&Ls. Wall Street’s capital, therefore, is filling a financing void left by the S&Ls, while securitization is transferring risks. These two points are key. It is important to understand the issues and reasons why S&L collateral became RTC collateral and avoid those mistakes again. By structuring commercial real estate mortgages, investors best suited to manage real estate risks are those investors getting paid for it, while investors without the necessary real estate analysis capabilities receive the benefits of the asset class without having to staff a complete real estate operation.

While this brief description of the evolution of commercial real estate lending is obviously simplified, we discuss the nature and role of conduits to raise specific points about evaluating CMBS. This is a highly competitive business involving many constituencies with conflicting interests. The competition is likely causing both spread compression (cheaper capital) and lower quality underwriting standards and/or property quality; these are two inconsistent forces. However, demand for the securities from the investment community remains strong, and, as such, issuance is likely to continue its current rapid pace. Therefore, within this environment, it is even more important to provide a proper framework for credit analysis for CMBS.

THE UNDERLYING COMMERCIAL REAL ESTATE MORTGAGES

If Wall Street’s conduit programs have truly replaced S&L’s historical financing role, obviously the historical performance of this class of commercial mortgage assets should be assessed when analyzing today’s conduit product. However, the lack of historical information on the CMBS market is problematic. The traditional real estate asset is far from standardized, varying significantly by property type, market, transaction, and ownership structure. As such, consistent and standardized historical performance information is not available to the market, and, therefore, credit ratings and valuation decisions are often driven largely by generalizations about the collateral, near-term performance of the assets, and analysis of small, non-uniform portfolio characteristics. While this market is often standardized under the CMBS heading, it is crucial to consider the significant differences among the variety of assets found in a pool, as well as the resulting differences in underwriting criteria demanded. Thus, investors will have a better sense of the differences found in today’s CMBS pools and the stability of the individual cash flows and valuations.

Multifamily

Multifamily housing generally is considered to be a more stable real estate investment. Cash flows typically are quite consistent, and valuations are much less volatile than other types of income producing properties, due to the stable demand for rental housing. However, the asset also tends to be the most commodity-like income-producing property type, making it more susceptible to competitive pressures and rapid changes in supply and demand. Multifamily properties are unique in that they combine elements of both commercial, income-producing real estate, and residential housing. As such, the traditional analysis of commercial real estate (location, property quality, market dynamics, etc.) is an important consideration for the properties, while the impact of its residential characteristics also needs to be recognized.

The primary difference between multifamily properties and other types of income-producing properties involves the lease term of the typical tenant, and the diversification provided by the large number of available units for rent relative to office or retail space. Residents in multifamily properties are obligated on short-term leases, ranging from six months to two years. This is a positive characteristic of the projects in that it permits the property to adjust quickly to improving market conditions, and also provides owners with regular opportunities to pass through increased operating costs. However, the inverse is also true, as multifamily properties are susceptible to increased supply or competitive pressures and weakening economic or demographic trends within the market. This is especially true in strong multifamily markets, as the barriers to entry are low enough for multifamily developers to quickly bring supply into any given market.

These characteristics demand an understanding of key housing trends in the local geographic areas, and the age and condition of the individual property, as well as its ability to remain competitive within its market. Property owners and underwriters must allocate money for maintenance spending. Absent such upkeep, apartments can quickly deteriorate and show significant underperformance of cash flows. Also, consider historical performance of the market (boom/bust versus conservative capital allocation) as well as the outlook for markets in which the pool is heavily weighted. One year’s operating performance is the typical underwriting period for multifamily properties, often completed with little sense of the past or expected market conditions going forward.

Retail/Shopping Center

Retail real estate ranges from large super-regional malls to smaller neighborhood shopping centers. As implied by the names, this space is differentiated by its size. Regional and super-regional malls are typically enclosed structures, ranging from 500,000 square feet to upwards of 3 million square feet. These properties generally are well-known, high quality shopping centers within the property’s given market and surrounding area. The malls are anchored by nationally-recognized department stores and retail tenants, and maintain significant fill-in, small shop space. The assets are primarily the domain of long-term, direct real estate investors (such as insurers or pension funds) or equity REITs, and are rarely found in pooled CMBS transactions; those assets in the CMBS market primarily are in the form of single asset transactions. Given the unique positioning and retail exposure of most large malls, as well as high barriers to entry, cash flows are often quite stable for this asset class.

Community and neighborhood shopping centers are more likely to be found in today’s conduit transactions, and these properties’ cash flows can prove to be more volatile. The properties are usually an open-air format, ranging in size from under 100,000 square feet to 500,000 square feet, serving a smaller market area than the larger malls. The properties often are anchored by necessity-based retailers, such as national and regional discount chains, grocery markets, and drug stores. Smaller centers are sometimes unanchored. The anchors serve as a drawing point for customer traffic to the smaller, in-line stores, which also are often characterized by necessity shopping and convenience (banks, dry cleaners, video rental, small restaurants, for instance). The properties are standardized, non-descript neighborhood convenience centers, which implies that an accessible location is a key valuation feature. Also, the properties are susceptible to competition and new development, so regular maintenance spending is important in keeping the centers competitive.

When evaluating retail real estate, an investor should consider the following: the age and quality of the property, the presence and quality of anchors tenants in the center, location and accessibility, sales volume on a square foot basis, competitive development, sales trends, and occupancy costs in relation to sales volumes. Recognize the excessive growth in retail real estate space over the past ten years. According to some national surveys, the growth of retail space in the United States over the past decade increased almost 40%, exceeding annualized population growth by more than a full percentage point. Certainly, some space has been removed from service over this time as well. However, the growth trends remain striking. Of particular interest for conduit investors is the above-average growth of neighborhood and community centers. As stated earlier, retail exposure in today’s conduit transactions is typically neighborhood and community centers in the Class B and Class C quality range.

Office

Office space is a unique component of the commercial real estate market. Office buildings comprise over 25% of real estate space in the United States, but the exposure is highly fragmented and diverse. Significant differences between various classes of space exist, ranging from renowned Class A landmarks to poorly located, aging Class C space in need of both deferred maintenance spending and capital improvements. Properties are also classified by location, ranging from the central business district (CBD) to suburban space. CBD settings are tightly grouped on small parcels of land, typically representing the “downtown” business districts of the representative market. Suburban space, on the other hand, is more widely dispersed on larger areas of land often grouped in the business park setting. During the past decade nearly 70% of office space constructed in the United States was built in a suburban setting, due in part to cheaper construction and lower priced land costs, as well as the continued “suburbanization” of corporate America. These facts along with excellent, decentralized distribution locations will likely keep suburban office space competitive over the long term.

The office sector also presents unique credit issues to analyze. The sector experienced significant overbuilding in the 1980s and also proved susceptible to corporate downsizing. Rental rates are extremely volatile and occupancy levels can swing dramatically. The properties typically are subject to longer-term leases and require significant spending for maintenance and improvements, tenant buildouts, and leasing commissions. Information regarding lease rollover schedules, tenant quality and retention rates, down time between leases, and rental stream forecasting (effective rent versus straight line rents in periods of free rent and over/under market rent conditions) are necessary to understand the performance of office properties. Future market conditions are also important to consider, since markets can change dramatically with the addition of new, large projects. Given this cash flow volatility, both investors and rating agencies continue to demand strong debt service coverage ratios and adequate credit enhancement for office properties within conduit pools.

Hotel

Hotels are considered nontraditional real estate collateral because the performance of a hotel mortgage and the underlying collateral are largely dependent on the success of the hotel business operation at the property. The success of the hotel business operation will be influenced by a number of factors including: the popularity of the hotel franchise or brand, the quality of the hotel management, the amenities and condition of the hotel improvements, and the balance between supply and demand of rooms within the subject’s submarket. Because of the many “non-real estate” factors that determine the success of a hotel property, loans secured by hotel properties are subject to more stringent underwriting standards relative to other property types.

Hotel properties serve as collateral for approximately 10% of the outstanding balance of CMBS loans. The types of hotels serving as collateral can be characterized by the level of guest services the hotel provides. The most common hotel types include: limited-service, full-service, extended-stay, and resort. Each of these hotel types has advantages and disadvantages from a lender’s perspective. Limited-service hotels are the least management and capital intensive of the hotel types and are therefore considered to possess less barriers to entry than hotels providing more guest services. While this means limited-service hotels are more at-risk to new construction and periods of oversupply, from a loan workout perspective, limited-service hotels can typically be liquidated more quickly and with less required capital expense. On the other end of the spectrum are resort hotels which are very management and capital intensive because of the high level of guest service and extensive physical improvements and amenities. As a result, barriers to entry are high and this type of hotel is less likely to experience a rapidly oversupplied market. However, because of the management and capital requirements, an underperforming resort hotel takes much longer to turn around and is less liquid in a workout scenario.

Regardless of the hotel type, factors that determine the success of a hotel property and related mortgage include the franchise or branding of the hotel, the quality of management, and condition of the hotel. Hotels having the most popular branding in their respective service segment have a competitive advantage over other hotels in the market. The most popular hotel franchises can enforce the highest and most consistent quality standards. As a result, knowing a hotel’s franchise typically reflects the quality of management at the hotel and condition and quality of the hotel improvements. However, a CMBS investor must keep in mind that unless the quality of a hotel’s services and physical condition remain consistent over time with those of the franchisor, the franchise license can be terminated by the franchisor. For this reason, reviewing the most recent hotel property inspection reports as well as hotel operating results is a necessary part of investor due diligence and ongoing surveillance.

A final factor that will influence the success of a hotel property and related mortgage is the condition of the local hotel submarket. The relationship between room supply and room demand determine a hotel submarket’s overall occupancy levels and average daily rates. Depending on the level of hotel exposure in a CMBS pool, the investor should assess the condition of a local hotel submarket room supply and demand by referring to third-party venders such as Smith Travel Research as well as local sources such as a region’s convention and visitors bureau and local/regional hotel brokers.

Healthcare

Like hotels, healthcare properties are considered nontraditional real estate because their success is dependent upon a single business operation rather than the forces of supply and demand for space within a property type. Healthcare facilities are special-purpose facilities designed for providing one or more of the healthcare services along the healthcare continuum. The facilities are typically operated by a single healthcare provider who either owns the facility or leases the facility. In either case, the primary source of repayment for the mortgage loan is the cash flow of the healthcare business. While the secondary source of repayment is liquidation of the real estate collateral, the value of the real estate collateral is greatly diminished absent a viable healthcare business at the facility. For this reason, when evaluating healthcare exposure within a CMBS transaction, the investor needs to assess the quality and financial strength of the healthcare operating company at the facilities and the recent trend in occupancy and profitability of the collateral properties. Because of the business aspect of healthcare facilities, underwritten loan-to-value measures typically assume a successful business operation and, in a distressed situation, can prove unreliable.

Healthcare properties serve as collateral for about 5% of the overall outstanding balance of CMBS loans. The most common types of healthcare facilities found in CMBS transactions include skilled nursing facilities, assisted living facilities, and independent living facilities. These facility types are distinguished by the level of medical care provided at the facility.

Skilled nursing facilities (SNFs) provide care for residents requiring the highest acuity of care. SNF residents typically need full-time medical attention and skilled nursing care. Because of the level of medical care provided at SNF’s, these facilities are most heavily regulated by federal and state agencies and the majority of resident care is paid for by the federally funded Medicare and state funded Medicaid programs. The supply of SNFs is regulated to the extent that many states require operators to obtain a Certificate of Need (CON) license before they can open or expand a SNF facility. The demand for SNFs is largely influenced by the aging U.S. population and increase in elderly population, the population segment which represents the greatest demand for SNF beds. An offset to this increased demand is the proliferation of assisted living facilities (ALFs), a suitable and often preferable alternative to the SNF for certain residents. ALFs are designed for residents who do not require full-time medical attention and skilled nursing care but do need assistance with certain daily activities such as bathing, dressing, and/or eating. Because of the lower level of care acuity, the majority of resident occupancy and care cost is paid for from private sources rather than government funded Medicare and Medicaid. Also because of the lower level of care acuity, there is less regulation of facility development. As a result, during the second half of the 1990s, the number of new ALFs grew dramatically and as of this writing the sector is overbuilt.

Independent living facilities (ILFs) are designed for residents that are typically 65 and older and who require little or no medical attention. Residents typically choose to live in a ILF to benefit from increased social activities among a similar age group. Most ILF residents are private-pay residents.

UNDERWRITING CRITERIA

One method analysts use to evaluate cash flow volatility among different property types and property qualities is the analysis of mortgage underwriting standards. Clearly, the credit quality of any commercial mortgage pool is determined by the underlying collateral’s ability to function as an income producing, debt servicing property over a defined time period. Several financial ratios are available for determining the credit quality of the property, including a ratio of cash flow to the required debt service (DSC) and a ratio of the mortgage loan amount to the value of the property (loan to value or LTV).

In many ways, debt service coverage is a more important credit analysis tool available for real estate securities than is valuation. This cash flow ratio compares a property’s net operating income (NOI) to its required debt service payments, with NOI defined as income less property operating expenses and an allowance for maintenance capital spending or replacement reserves. Typically, NOI also will include other recurring expense items demanded by an individual property, such as leasing commissions for retail properties or tenant buildout costs for office properties. The data are often calculated on a trailing 12-month basis. However, shorter reporting periods are annualized or longer reporting periods averaged. Whatever the case, a true picture of normalized operating performance is required to understand the property’s ability to service its debt load.

More often than not, a reporting period may overstate NOI due to above-market leases, stronger than expected occupancy levels, or leasing commissions/tenant buildout costs not commensurate with the existing lease rollover schedule. In such a case, it is imperative to normalize operating cash flow, and consider its impact on the credit profile of the individual property or collateral pool. The credit rating agencies attempt to quantify the process of normalizing cash flow by reporting the agency’s variance figure. Expressed on a percentage basis, the variance figure calculates the rating agency’s re-underwritten (or normalized) cash flow figure relative to the cash flow reported by the mortgage originators.

Recently, the rating agencies have “haircut” reported NOI for a variety of reasons, including above-market rents and occupancy levels, below-market mortgage interest rates, normalized amortization, management fees, tenant buildout costs, leasing commissions, replacement reserves, and deferred maintenance.

Potentially volatile cash flows derived from a property or the pool must be accounted for in the initial valuation of the CMBS transaction. Additionally, when armed with both underwritten and normalized NOI, investors can determine the appropriate level of DSC for a given property or pool to account for volatility in the cash flows and its ability to service debt. This figure can be as low as 1.1 to 1.15 for stable properties with a positive outlook to greater than two times (2×) for properties subject to highly volatile cash flows.

Loan to value is another analytical tool used to compare the property’s debt level to its current valuation, as well as its loan balance at maturity. While third-party appraisals are used in this process, which are subject to significant interpretation, a general sense of a property’s or pool’s loan to value ratio allows one to address refinancing risks. Clearly, lenders and investors should require equity, in line with the property’s quality and cash flow volatility. Equally important is an acceptable level of debt amortization over the life of the loan. In doing so, investors protect themselves from shifts in valuation, whether driven by true changes in cash flows or the required rate of return demanded for the asset class.

The equity portion of a property’s capitalization also tends to give property owners the incentive to properly maintain the asset. Finally, investors protect themselves at maturity by reducing the LTV ratio over the life of the loan through amortization, thereby increasing the likelihood of refinancing the property when the loan is due.

If refinancing at maturity is unlikely, then investors must factor in principal shortfalls or extension risks. To repeat, standards for LTV ratios vary by property type with stable multifamily units pressing the 75% level and riskier hotels or offices sometimes as low as 50% to 55%.

Portfolio Issues

CMBS investors also must focus on a number of portfolio issues, especially those involving the composition of the total collateral pool. The benefits of the CMBS structure are derived from an ability to make real estate investments without the risks associated with direct mortgage or equity placements (i.e., diversification by property type, loan size and type, geography, borrower, and tenant). As discussed, diversification by property type should be evident, as a well-mixed pool clearly will overcome the cash flow volatility of any one property type. Geographic diversification is also important, because commercial real estate performance is a function of local and regional economics, demographics, and employment conditions.

Higher state concentrations increase the correlation amongst properties, thus offsetting the benefits of diversification. Loan size and borrower/ tenant concentration are also important features of a well-diversified mortgage pool, as greater loan diversity by size or borrower diminishes investor reliance upon and exposure to any one property, set of properties, or individual borrower or tenant performance.

STRUCTURING—TRANSFERRING RISKS AND RETURNS

We have attempted to provide a continuum of stability amongst the various property types typically found in today’s CMBS transactions, as well as the resulting underwriting issues created by cash flow variability. As discussed, the standard structure in today’s conduit deals is a senior/ subordinate structure which transfers significant risk to the underlying equity and support bonds. This risk is typically borne by the master or special servicers or some other real estate professionals, which will be discussed in more detail later. On a portfolio level, these issues are manifested by the level of credit enhancement demanded by the rating agencies for any given rating category. Therefore, one must recognize that varying levels of credit enhancement and the subsequent differences in valuation from one security to the next represent the ratings agencies’ and investment community’s attempt to cope with the cash flow and valuation variability of the underlying collateral. As such, excessive credit enhancement for a pool is not necessarily a good investment characteristic, but could indicate high expected cash flow volatility and/or poor property quality.

Compare standardized residential mortgage pools requiring 2.5% to 3% credit support at the AAA level, versus 15% to 22% credit support often found in commercial mortgage pools. The CMBS level of credit support is designed specifically to recognize the lack of standardization of the underlying collateral, cash flow volatility, and the higher default frequency and loss severity on commercial mortgage securities. As stated, some commercial properties require DSC ratios as high as 2×, indicating cash flow variability in excess of 40%. The property’s ability to service its debt load is driven by any number of controllable and noncontrollable factors. Residential housing, on the other hand, is owned by its occupants and holds a much more meaningful position to its occupants, other than holding a put option on the property. As such, volatility is significantly higher for commercial mortgages, and the level of credit support required to protect senior investors is more substantial.

Default frequency and loss severity are also important issues to consider when investing in commercial mortgage securities. Typically, individual assets are structured in bankruptcy-remote entities or some other type of isolation from third-party bankruptcy risks. Therefore, there is no recourse to the borrower’s assets beyond the equity in the property. While low LTV ratios alleviate some risks in this scenario, maintaining equity value when a commercial mortgage has reached the point of default is often futile. Often, property level cash flows have fallen, and, for properties underwritten with a low DSC ratio, debt service requirements may exceed cash flow. Additionally, property cash flow problems which are driven by macroeconomic issues (overbuilding or weakening economic conditions, for instance) will have a substantial impact on valuations. In this environment, equity withers and properties that do not cover debt service become uneconomical. Borrowers without a contractual obligation, incentive, and/or an ability to fund losses are forced to default, and the decision to do so is certainly easier than that of a residential mortgage.

Loss severity on the typical commercial real estate default is also impacted in this scenario and is often higher than residential mortgage losses. Valuation drops as the property’s performance weakens. However, this loss is exacerbated by market forces which demand either higher rates of return on the asset class and/or stronger equity coverage (i.e., more mortgage losses on the original loan balance). Finally, the costs of liquidating commercial mortgages exceeds those of residential mortgages. The assets are large and unique, and often in need of capital improvements or deferred maintenance. The investor population is smaller, more sophisticated, and specialized, while there are costs associated with the property (taxes, insurance, etc.) that must be carried often for extended marketing periods. As such, loss severities approaching 30% or 40% are not unreasonable.

Clearly, for this asset class, the original cash flows, debt service coverage, and loan to value ratios are mitigated by these risks, and, therefore, must be thoroughly analyzed and understood when the transactions are originated.

Master and Special Servicers

A final important structural feature of CMBS transactions is the presence of both master and special servicers. Master servicers manage the routine, day-to-day administration functions required by all structured securities or collateralized transactions, while special servicers are used to handle delinquent loans and workout situations. Assigned the task of maximizing the recovery on a defaulted loan, special servicers play an important role in CMBS transactions as both defaults and work-outs are frequent and specialized. Most often, the servicer’s interests are aligned with investors, as most servicers invest in non-rated and subordinate bonds within the deals they service. Thus, it is important to assess the quality and competency of the servicer. Investors should consider the level of latitude and advancing capabilities provided the servicer in a work-out situation, its financial condition, historical performance and experience within the commercial real estate asset class (and in work-out situations, if applicable), and the monitoring, reporting, and servicing capabilities (including cash management and collections operations). Investors must be comfortable with the servicer’s ability to function effectively in that role, as well as the outlook for the servicer’s continued viability.

Regulatory Issues

Increasingly, CMBS have been afforded favorable regulatory treatment. The National Association of Insurance Commissioners (NAIC) recognizes CMBS as securities rather than real estate. This allows for a capital reserve requirement ranging from 0.03% to 1.0% for investment grade fixed-income securities compared with 3.0% for commercial mortgages. In August 2000, the Department of Labor granted an ERISA exemption to CMBS allowing investment-grade CMBS to become eligible investments for ERISA-guided plans. Additionally, the Basel Committee of the Bank of International Settlements (BIS) has finally issued its long-awaited proposal on risk weightings for structured securities, including CMBS. Currently, the risk weighting for commercial real estate is 100%. Under the BIS proposal, highly rated CMBS will receive the same risk weighting as government sponsored enterprises (GSEs). GSEs carry a 20% weighting. Clearly, the growing CMBS market would benefit from these changes. Participation by investors should increase, allowing for new capital to support demand for the securities and improving liquidity.

CONCLUSION

In this chapter, we presented an overview of the development of the CMBS market and a discussion of the current issues facing investors today. Commercial real estate lending is evolving into sophisticated, structured securities that represent a growing portion of the fixed income market. Despite trading under the general CMBS heading, the securities and the underlying collateral are specialized and unique, thereby presenting investors with new challenges, as well as potentially higher returns. As pointed out, the securities must be recognized for the individual characteristics which differentiate them, thereby demanding prudent analysis. If recent issuance is any indication, this market should continue to expand, and new investors will continue to enter the market. With the continued expansion of available securities and investors, as well as new performance data, the market likely will differentiate the securities by quality. This chapter presents an introduction to those issues and security types that affect the quality of CMBS transactions and the market’s investment potential to go forward.