Seller

The seller is the originator of the commercial mortgage loans that are sold into a securitization. Sellers are typically banks, insurance companies, finance companies, and mortgage bankers. The seller generally enters into a mortgage loan purchase agreement (MLPA) to sell the loans to the securitization depositor (same process as in the RMBS market).

Depositor

This is an SPV set up by the underwriter sponsoring the securitization that purchases the mortgage loans and immediately sells the commercial mortgage loans to the issuance trust.

Servicer/Master Servicer

Pursuant to the PSA, the servicer is responsible for servicing the performing mortgage loans and acts for the benefit of the certificate holders. The servicer collects loan payments, escrow, and reserve payments from borrowers, advances funds on delinquent loans, and sends reports to the trustee, among other duties. The servicer passes collections on to the trustee, advances late payments to the trustee, provides performance reports to certificate holders, and sends nonperforming loans to the special servicer. In the event of servicer default, the trustee is generally obligated to find a replacement servicer or fulfill all responsibilities of the servicer itself, including advancing principal and interest.

The investor reporting process for CMBS has been in place for over two decades and is well known to most investors. A master servicer is appointed on each CMBS transaction per the terms of the related pooling and servicing agreement (PSA). One of the functions performed by the master servicer is to collect information regarding the loans in any given transaction so that it can be made available to CMBS investors. In some cases, the master servicers report the information directly to investors, and in all cases the master servicers deliver it to the trustee for dissemination to investors.

Special Servicer

Special servicers are appointed in the PSA for the purpose of servicing any loan that became “specially serviced.” The special servicer is responsible for servicing defaulted mortgage loans. The special servicer negotiates workouts and restructurings and works through the foreclosure process on defaulted loans. Special servicers are usually appointed because of their distressed asset expertise. The special servicer tries to maximize recoveries and has latitude to accept a discounted payoff of the loan, waive a particular breach, or agree to a consensual sale of the property with the borrower, among other things. They prepare reports on the specially serviced loans, which are then made available to investors via the trustee. The December 18, 2015, issue of Commercial Mortgage Alert (CMA) published a list of approved U.S. primary, master, and special servicers on pages 16–18. Among other information, the primary contact and phone number for each servicer is provided on the list.

Issuer

A CMBS issuer is typically a real estate mortgage investment conduit (REMIC); specifically, it is a trust that owns the pool of mortgage loans and elects to be treated as a REMIC for tax purposes. The REMIC trust is formed pursuant to the PSA and it holds the commercial mortgage loans on behalf of certificate holders. The trust issues multiple classes of notes and certificates with differing maturities and ratings. REMICs are not subject to federal income tax if they are in compliance with IRS rules. To qualify as a REMIC, substantially all of the assets of the trust must consist of qualified mortgages and permitted investments.⁵ REMIC provisions are built into the PSA so that the trust activities will not violate REMIC requirements.

Trustee

The trustee holds legal title to the collateral for the benefit of certificate holders. The trustee also ensures that the master servicer and special servicer act in accordance with the pooling and servicing agreement (PSA). The trustee is responsible for administering the loan pool on behalf of the REMIC trust. The trustee is responsible for replacing the servicer, if necessary, and the trustee has backup advancing obligations for principal and interest. Trustees' duties include preparing and delivering reports to investors, including acting as a portal through which the reports prepared by the master servicer and special servicer are provided to investors. Trustees provide the various reports and information via websites, as well as by response to email and telephonic inquiries. The top trustee, as of mid‐2015, was Wilmington Trust, which was trustee of over half the issuance at the time. Wells Fargo was the top certificate administrator for U.S. CMBSs during the same time‐period with 71.9% market share by dollar volume.⁶

Figure 20.2 is a diagram of key CMBS participants.

Underwriter

The underwriter has overall responsibility for structuring the CMBS, selling the notes/certificates to investors and maintaining secondary market liquidity for CMBS notes and certificates.

Ratings Agencies

Ratings agencies explicitly say that their ratings are merely informed opinions and that they should not be relied upon to make investment decisions. On top of that, the ratings agencies make a huge effort to explain the rating process for both corporate bonds and all types of asset‐backed securities (ABS), including CMBSs. Corporate bonds and CMBSs are different types of debt securities, with different risks and different ratings methodologies that by definition cannot be the same or equate to identical levels of risk.

The Credit Rating Agency Reform Act of 2006 requires that the SEC provide an annual report on Nationally Recognized Statistical Rating Organizations (NRSROs) to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives. The Rating Agency Act added Section 15E(a)(3) of the Exchange Act, which requires the Commission to issue rules requiring an NRSRO to make certain information publicly available on its website or through another comparable, readily accessible means. Exchange Act Rule 17g‐1(i) specifies that the information consists of the NRSRO's current Form NRSRO and Exhibits 1 through 9 to Form NRSRO. These exhibits contain information about each NRSRO's performance statistics; procedures and methodologies for determining credit ratings; procedures to prevent the misuse of material, nonpublic information; organizational structure; code of ethics (or explanation of why it does not have a code of ethics); conflicts of interest; procedures to manage conflicts of interest; credit analysts; and designated compliance officers. The Annual Report also lists Internet website links where detailed information is publicly available on ratings methodologies and models, and ratings transitions or ratings migrations for various ratings categories, including corporates and ABSs. It is a legal requirement that the ratings agencies' policies, procedures, methodologies, and performance be posted and available for all to see.

For most investors, ratings are simply a gatekeeper to what they may potentially invest in. Generally speaking, investors typically have investment guidelines that specify what types of securities they can purchase and what ratings those securities must have. Prudent investors, however, do not rely on credit ratings in lieu of fundamental credit analysis. A rating is really a checklist item that investors check off to make sure a security is eligible for purchase before they conduct their analysis to determine if they are comfortable with the securities' credit risk. In addition, virtually every prospectus, prospectus supplement, and/or offering circular for CMBS contains a section with a description of significant mortgage loans and the related mortgaged properties. Typically, this is a detailed write‐up of each of the 10 largest commercial mortgage loans and the properties associated with them, which includes pictures of the properties and all relevant information. I can't think of a better reality check than a detailed description and related cash‐flow and risk metrics for the largest loans/properties in a CMBS deal.

Properties

Before evaluating commercial properties, the commercial property market each property is located in must be considered. Within each commercial property market segment (office, retail, hotel, multifamily, etc.) the location, supply and demand, economic conditions and trends, and demographic trends will impact the viability of the property. In addition, analysis of planned new construction and construction underway should be considered.

The performance of the property within its market segment is critical. The cash flow, location, access, physical amenities, parking facilities, physical condition, occupancy (if applicable), and third‐party reports (engineering, environmental, appraisal) are some of the important information needed to assess the quality and viability of the property. If the property is a hotel, the number of rooms, restaurants, size of the gym, mix of business/leisure customers, and presence of conference facilities should also be considered. For office buildings and shopping centers, tenant creditworthiness, lease terms, expected rollover, and competitiveness of lease rates should be factored in. The net cash flow of the property is of paramount importance. In particular, the potential for cash flow volatility or deterioration must be assessed. Net operating income (NOI) is the cash flow generated through a property's normal operations, which is intended to reflect the property's typical cash flow performance.

Commercial property appraisals are governed by the Uniform Standards of Professional Appraisal Practice (USPAP). Valuation methodology under USPAP includes the sales comparison approach, the cost approach, and the income approach.⁷ The sales comparison approach incorporates the sales prices of comparable properties similar to residential mortgage appraisals. The cost approach evaluates the dollar amount it would cost to replace the property. The income approach is based on the property's cash flow. Appraisers using the income approach typically calculate the capitalization rate (cap rate)—the ratio of NOI to the property's value, in a given market. Dividing the NOI of the subject property by prevailing market cap rates is a common method of valuation. In developing the appraisal, “an appraiser must collect, verify, and analyze all information necessary for credible assignment results.”⁸ Commercial appraisers tend to favor the income approach, which requires the following information:⁹

• Analyze such comparable rental data as are available and/or the potential earnings capacity of the property to estimate the gross income potential of the property.
• Analyze such comparable operating expense data as are available to estimate the operating expenses of the property.
• Analyze such comparable data as are available to estimate rates of capitalization and/or rates of discount.
• Base projections of future rent and/or income potential and expenses on reasonably clear and appropriate evidence.¹⁰

Loans

Commercial mortgage loans are typically made by banks, insurance companies, conduits (bank and finance company conduits originating loans for securitization), GSEs, and REITs, among others. Underwriting commercial mortgage loans starts with an evaluation of the property market and the property itself, as described earlier. In addition to evaluating the property securing the loan, the quality, credit, and experience of the borrower must be evaluated. Due diligence on a prospective borrower (generally a company) includes understanding the company's business, financial structure, earnings, history, and competition, among other things. Ultimately, the stability of cash flow generated by the property and/or business is the most important factor.

The strength of the property and borrower must then be analyzed in the context of the loan structure. Although the classic commercial mortgage loan is a 10‐year fixed‐rate term loan with a 30‐year amortization schedule and a balloon payment due at maturity, most recent CMBSs have had a preponderance of 5‐year and 10‐year loan terms with either a 30‐year amortization or interest only (IO) payments and a balloon payment at maturity. However, any of several loan attributes are subject to negotiation, such as the loan amount, loan term, interest rate, amortization rate, recourse versus nonrecourse debt, up‐front fees and/or points, prepayment options and penalties, and so on. In addition, cash management safeguards, such as reserves (for taxes and insurance, capital expenditures, and tenant improvements), lockboxes, and triggers for trapping cash, are structural elements that can mitigate loan risks.

The primary measures used to evaluate commercial mortgage loans are debt yield (DY), debt service coverage ratio (DSCR), loan‐to‐value (LTV) ratio, cap rates (discussed earlier), reserves, credit support, and loan covenants. The DY is simply the cash‐on‐cash ratio of net cash flow (most conservative) or NOI divided by the mortgage loan amount. Essentially, the DY shows how much the property is earning relative to the size of the loan on the property. A high DY is less risky than a low DY.

DSCR is the net operating income (NOI) of the commercial property divided by interest and principal payments (debt service). DSCR measures how much cash flow is generated to service the debt on a given property. For example, a DSCR of 1.15 means that the cash flow can service the debt and has 15% excess cash flow; a 1.40 DSCR means that after a debt is serviced, cash flow equal to 40% of the debt is leftover. The trend of the DSCR on a given loan is highly correlated with the probability of default—as DSCR rises the probability of default decreases and as DSCR falls the probability of default increases.

LTV is simply the loan principal balance divided by the property value. A high LTV demonstrates higher risk to the lender—if the property value declines, the collateral value may be insufficient to pay off the loan balance. For example, a $5.4 million loan collateralized by a $6 million commercial property has a 90% LTV, which is relatively high. If the property value were to drop to $5 million, there would not be enough collateral to pay off the loan, if necessary. If the loan had been $4.2 million instead of $5.4 million, the LTV would have been 70%. With a 70% LTV, if the property declined in value from $6 million to $5 million, the LTV would rise to 84% and there would be sufficient collateral to pay down the loan. LTV is a strong indicator of whether the collateral value is sufficient to pay off the loan at maturity, which is particularly critical with balloon loans used for commercial properties.

As explained earlier in this chapter, cap rates can be used to calculate the implied value of a property. Calculating a property's cap rate based on actual performance and comparing it with prevailing market cap rates can be a good indicator of the loan risk within the property's market segment.

Credit support includes any additional collateral supporting the loan and any borrower guaranties. Reserve funds can help mitigate credit risk and are often in place to cover capital improvements (e.g., a new roof, paving parking lots, etc.) or unanticipated expenses. Sometimes two loans are issued to finance a given property. The senior “A‐note” is typically securitized, while the junior “B‐note” is targeted for investors seeking higher yields and willing to take on greater risk. Loan covenants are ongoing loan conditions such as minimum cash flow levels or maximum levels of leverage allowed. Any professional involved in the commercial property market is familiar with these risk considerations, and they also know that they are critical to understanding the value of the property that is supporting the loans. The underlying collateral is the building block for all CMBSs and any evaluation of CMBSs starts and ends with the underlying collateral.

Super‐Senior Aaa/AAA Classes

Prior to the financial crisis when triple‐A credit enhancement levels fell to less than 15%, many investors became less comfortable that they were adequately protected. To make investors more comfortable, issuers created two new classes with higher credit enhancement levels of 30% and 20%, respectively. The tranche with 30% credit enhancement was dubbed the “super‐senior” and the tranche with 20% credit enhancement was named the “mezzanine” triple‐A Class or AM Class. The tranche below the super‐senior and mezzanine classes was renamed the junior triple‐A or AJ class. As a result, prior to the financial crisis, you could see a CMBS transaction having super‐senior Aaa/AAA tranches with 30% credit support, an AM Aaa/AAA tranche with 20% credit enhancement, and an AJ Aaa/AAA tranche with 12% credit enhancement. Under this new paradigm, losses were allocated sequentially among triple‐A classes.

Every tranche below (junior to) the super‐senior provides credit enhancement to the super‐senior by absorbing credit losses prior to such losses being experienced by the super‐senior, thereby reducing the super‐senior's credit risk. The super‐senior has more credit enhancement than required by the ratings agencies to achieve a triple‐A rating (the enhancement available to the Class A‐S tranche in Table 20.1 example ahead), hence the super‐senior designation. The super‐senior's relatively reduced credit risk, as compared to the junior tranches, means that investors receive a lower interest rate and yield on that tranche than investors in the junior tranches. The size of a super‐senior tranche is determined substantially by the quality and diversification of the underlying collateral assets—the higher the underlying collateral asset quality, the greater in size the super‐senior tranche can be.

Table 20.1 is a representative structure from conduit deals in early 2016.

In the diagram in Table 20.1, the A‐1 through A‐6 classes are super‐senior classes with 30% credit enhancement, and the A‐S class is a senior tranche with 24% credit enhancement. In this structure, the super‐senior classes are time‐tranched to appeal to different investors (super‐senior tranches often have tranches with 3‐, 5‐, 7‐, and 10‐year average lives) and some classes are larger than others, which may provide greater liquidity.

Mezzanine Classes

Mezzanine classes constitute all classes rated below Aaa/AAA that are investment grade (rated no lower than Baa3/BBB–). In the representative conduit structure given earlier, the mezzanine classes are Classes B, C, and D. The mezzanine classes are subordinate to the Aaa/AAA rated classes and senior to the subordinated classes described ahead. These investment‐grade classes provide greater yield and risk than the highest rated tranches, but they are not considered high yield, which separates them from the subordinated classes described in what follows.

Subordinated Classes or B‐Pieces

Subordinate classes include all tranches rated below investment grade or unrated. In the representative conduit structure given earlier, the subordinate classes are Classes E, F, and G. Subordinate classes are the last bonds in the cash flow waterfall and the first bonds to absorb losses. Since B‐piece investors are in a first‐loss position, CMBS structures generally make them the “controlling class” under the governing documents. B‐pieces are not public securities so B‐piece investors are given access to more information than public investors in higher‐rated classes, and they have more control over distressed properties/loans managed by the special servicer.

CMBS IOs

Interest‐only (IO) classes can be created in CMBS in the same way as in other structured finance markets such as RMBS. A portion of the excess servicing spread from an individual class or the entire collateral pool is allocated to an IO class. Payments to IO investors are based on a notional balance of the class or collateral pool and the coupon on the IO.