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CMBS Market Overview

CMBS Market Overview. CMBS Vs. MBS. Both are backed by real estate loans but MBS are backed by residential loans, CMBS by loans on commercial properties(Office, Apts, Malls, Industrial etc) CMBS is have limited prepayment risk, due to prepayment penalties, lockouts etc

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CMBS Market Overview

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  1. CMBS Market Overview

  2. CMBS Vs. MBS • Both are backed by real estate loans but MBS are backed by residential loans, CMBS by loans on commercial properties(Office, Apts, Malls, Industrial etc) • CMBS is have limited prepayment risk, due to prepayment penalties, lockouts etc • However CMBS are subject to significantly more default risk • non-recourse loans • no GSE guarantee

  3. CMBS Issuance ($ bn)

  4. TYPES of CMBS Conduit or Pool Transactions • Multiple borrowers and multiple assets. • Various types but most popular include conduit, large loan and fusion. • Portfolio of mortgage loans sold and deposited into a trust either by originator or SPE depositor. • Trust issues securities backed by mortgages • In exchange for transfer of loans, originator or depositor receives proceeds from the sale of securities • Form of credit support: Subordination • Securities get paid sequentially from highest rated to lowest rated • All losses on pool go reverse sequential, from lowest rated to highest rated. • Servicer provides liquidity in the form of advancing. • Property Specific • Single borrower, single asset or single borrower, multiple assets • SPE borrows funds generated by sale of securities backed by mortgage lien on borrower’s real property • Form of credit support: Overcollateralization • Property value exceeds Debt Amount (Loan-to-value, LTV<100%) • Property cash flow exceeds Debt Burden Debt Service Ratio (DSC) >1.0x) • Servicer provides liquidity in form of advancing. • Credit Lease Transactions

  5. The Rise of the Conduit Loan Market • Pre 1990 • 1991 - 1994 - RTC turns to the capital market • 1995 - Conduits take over • Have conduits and the capital markets tamed the real estate boom bust cycle?

  6. Who Does What In A Securitization Loan Sellers Institutions that team up together to originate loans and aggregate them to make the CMBS pool Issuer Entity that aggregates all the loans from individual loan sellers in to a transaction and issues the certificates (bonds). GE is a loan seller and an issuer. Underwriters Investment banks that sell the bonds (may also be the issuer and/or a loan seller) Trustee Holds the aggregated loans in trust for the benefit of certificate holders – pays P&I to the certificate holders Master Servicer Collects P&I from the loans, issues reports on performance Special Servicer Manages defaulted loans and ensures maximum possible recovery of P&I from defaulted loans for certificate holders Rating Agencies Provide credit ratings for each tranche of the transaction based on credit quality, pool diversity and structural features.

  7. Securitization Steps • Identify and Optimize the Pool • Send out a tape and large asset summaries to the 3 rating agencies and potential B-Piece buyers • Choose agencies and a B-Piece buyer • Work with the agencies and B-Piece buyers while they underwrite the collateral • Negotiate agency rating levels and B-Piece buyer kick-outs/price adjustments • Finalize the pool • Print the “red herring” (preliminary prospectus) and term sheets – set the bond structure • Market the bonds-rating agency presales/term sheets • Close the deal

  8. Structuring a Conduit CMBS

  9. TYPICAL CMBS STRUCTURE

  10. Identify & Optimize the Pool Pool Optimization • Pool should be optimized from a B-Piece, Rating Agency and Investor Perspective; • Multi-Family favored by the Rating Agencies, and a combined multi/manufactured housing total of > 30% allows Government Agencies (e.g. Freddie Mac) to buy bonds • Aim for a good spread of the major use types – avoid “operating businesses” such as health care and assisted living (agencies and B-piece buyers prefer real estate risk to operating risk) • Theaters are not popular! • Hotels still a difficult sell post 9/11 – particularly luxury full-service in fly-to destinations-diversified pools more favorable Fitch 2002 CMBS Conduit Loan Default Study

  11. B-Piece Buyers B-Piece Buyers • The B-Piece buyer in a CMBS transaction will normally buy all bonds from unrated up through to BB+ • B-Piece deal negotiated right at the start of the transaction – the B-Piece buyer will take up to 7-8 weeks to complete due diligence • All other bonds normally sold in a 1-2 week time-frame after the B-Piece buyer has agreed the pool and the agencies have finalized rating levels • The “universe” of potential B-Piece buyers is normally 5 to 7 institutions, of which perhaps only 2 or 3 may bid on any given deal • Most B-Piece bidders are specialist investors/funds that look solely at CMBS B-Pieces, some are public companies • B-Piece buyers often also act as special servicer on deals so that they can control the liquidation of non-performing assets. Even if they are not the special servicer they always exercise control rights in terms of who is special servicer • B-Piece bids will contain bids as to yields on bonds, and will usually also contain “stips” as to minimum levels of subordination for certain classes, irrespective of the subordination levels the rating agencies provide • The B-Piece buyer underwrites all loans (this can be in excess of 130/140 loans in a standard CMBS conduit deal), and will exercise their right at the end of their underwriting to “kick out” loans that they do not like

  12. Rating Agency Overview Overview Of Rating Process • Preliminary Credit Support levels • Engagement • Due Diligence • Site visits • Evaluation of property manager/borrower • Evaluation of cash flows/derivation of asset value • Review of third party reports • Review of mortgage loan documents • Review of securitization documents and legal opinions • Final Rating Committee • Asset and loan review • Determination of final credit support levels • Presale report/investor inquiries • Surveillance

  13. Rating Agency Overview Determination Of Final Credit Support Levels • Pool Transactions • Property level underwriting results input into rating agency default model • Model calculates credit support at each category based on default thresholds and loss severity estimates at each rating level. • Subordination= foreclosure frequency X loss severity • Foreclosure frequency=% of loans defaulting (failing to meet threshold) • Loss severity= Amount that would be recovered upon liquidation vs. amount owed on loan • Adjustments made for non-economic factors such as environmental issues, seismic risk, non-compliant loan terms, bad borrowers etc.

  14. Credit Performance of Commercial Mortgages

  15. Rating Conduit CMBS • Expected Losses - Default Probability x Loss Rate • 18% default rate X 60% loss rate = 10.8% expected loss • Underwriting - LTV, DSCR, Cap rate • Diversity - Geographic and property type • Administration • Servicer / Trustee review • Legal infrastructure • Ongoing review • Triple AAAs can withstand upwards of 35% default rate @70% loss rate

  16. How CMBS Trade in the Market

  17. Bond Structuring Bond Structuring AAAs and AAs normally public – most of the actual $ amount; public bonds = more secondary liquidity I/O normally private – allows buyers to get more information Bonds bought by the B-Piece buyer Highest bond % rate will = lowest loan interest rate, so some bonds sold at an initial discount to par to give investors required yield

  18. Selling The Bonds Selling The Bonds Term Sheets and “The Red” used to sell the bonds. Term sheet is 25/30 page description of the pool. The red, or prospectus/prospectus supplement is 150/200 pages Lead Manager/Bookrunner runs the process of selling the bonds Co-managers normally responsible for selling a set $ amount of certain bonds – often only a small % of the AAAs

  19. Selling The Bonds Selling The Bonds Deutsche and BofA are both loan sellers and underwriters 30% + Multi/Manufactured Housing For Freddie Mac eligibility

  20. Fixed Rate CMBS Spreads Spread over 10Yr. UST (bps) Standard Deviation = 13.79 Source: Salomon Smith Barney Weekly CMBS Market Color Selling The Bonds Selling The Bonds Source; Bear Stearns CMBS Illustrated, Oct 22, 2002

  21. Selling The Bonds IO Structures • I/O Had traditionally been one class taking all of the excess spread • Recent innovation has been introduction of PAC and support IO • PAC is a protected “core” strip of excess spread that retracts over time • Support is a wider based strip taken off more classes than the PAC • Combination of protected PAC and wider support gives better blended pricing than single IO class

  22. Who Buys CMBS • Money Managers (Fidelity, PIMCO etc) • Insurance CO's (AIG, Traveler’s, etc) • Banks • Hedge Funds • CBO Issuers (Resecuritize) • Sell side firms (Goldman, Merrill) make a mkt.

  23. Examples of CMBS Property Specific Deals • Rockefeller Center $1.2 B (Single) • Mall of America $300 M (Single) • 4 Times Square $430 M (Single) • Citigroup Center $342 M (Large) • Buckland Mall $ 96 M (Large) • Chrysler Building $180 M (Portion)

  24. Property Specific CMBS • Typical loan will be to a borrower for say $150 Million • Rating Agencies (S&P, Fitch, Moody’s) rate $130 Million as Investment Grade(i.e. down to BBB-) • Issue CMBS for $130 Million • $20 million Mezzanine Loan

  25. Mezzanine Financing • In a typical large loan securitization, issuer will securitze down to BBB- • Basically investment grade • This is generally not enough $ for average borrower • One solution: mezzanine loan

  26. Large Loan CMBS • Assume $150 million loan • $130 million Investment Grade • Overall quote to borrower is 6.97% • Average Coupon on the IG is 6.60% (86.7% of loan) • Coupon on Mezz loan is 9.35% (13.3%) • real estate equity type of return

  27. What the mezzanine holder receives • A very attractive yield • Control if things go bad • If the borrower was to default the mezzanine holder becomes the owner of the property • They assume the financing that is already in place on the property

  28. Reason for Growth of CMBS • Conduit Loans • Broad Base of Investors • silk purse from sow’s ear idea • Off balance sheet • Capital Regulations • Large Loans • Size of many of the larger assets are too big for the original lenders(insurance companies, Banks etc) • Capital markets are an efficient way to raise capital and allocate risk

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