Commercial Mortgage Backed Securities Real Estate

Key risk to property cash flow

2.) Supply is greater than demand, leading to rising market vacancy, resulting in lower rents

Cap Rate

Cap rate varies by location, property type, and condition of the building. There is no one cap rate you can use across the board; however, CBRE has an average cap rate based on real estate to established market value.

Appraised Value

Direct cap rate is applied to net operating income = appraised value

Discounted present value

Discounted present value is based on sensitivity analysis of projected cash flows and terminal value at end of projection

Proposed loan amount

net income> greater than debt service, so there is a margin of safety for a decline in revenue

Proposed loan amount is based on % of appraised value, lender debt coverage on loan constant payment, loan as % of discounted present value

Financing formula: Constant Payment

Constant payment= pmt( int rate, loan amortization, loan amount)

Interest rate: that was negotiated

loan amortization: the number of years the loan is set to be repaid to the amount of zero, (steady repayment of principal, essentially paying back what you owe)

loan amount: the amount of the loan that has been underwritten

Financing formulas: Loan to Value (LTV)

Loan to Value (LTV)= loan/ asset value

the loan amount being negotiated divided by how the lender determines asset value

Financing formulas: Debt Coverage

Debt Coverage net operating income/ constant payment

net operating income project by the next 12 months divided by the constant payment of interest and principal on the mortgage

Financing Formulas: Debt yield

Debt Yield: net operating income/ loan amount

Lenders use debt yield to assess loan risk. It indicates how much income a property generates relative to the loan amount. A higher debt yield implies a lower risk, as the property generates more income per dollar loaned.

Declining percentage (step down)

• How it Works: The penalty is a predetermined percentage of the outstanding loan balance at the time of prepayment. This percentage decreases according to a set schedule as the loan matures

• Typical Structure: A common example for a five-year loan might be a "5-4-3-2-1" schedule, where the penalty is 5% in year one, 4% in year two, 3% in year three, 2% in year four, 1% in year five, and 0% thereafter.

• Pros/Cons: It offers predictability for the borrower and the penalty becomes less costly over time. It provides less protection for the lender against falling interest rates compared to other methods, so it is often found in bank loans. 

Yield Maintenance

Ensure that the lender makes the exact same amount of profit (the yield) regardless of whether you pay the loan off on time or early.

In the world of commercial real estate, Yield Maintenance is a prepayment penalty designed to make the lender "indifferent" to you paying off your loan early. It ensures the lender receives the exact amount of profit (the yield) they originally expected when they signed the contract.

If you pay off a 5.0% loan today, the lender has to take that cash and lend it to someone else. If the current market rate has dropped to 3.5%, the lender is now losing 1.5% every year. Yield Maintenance forces you to pay that 1.5% difference upfront in one lump sum

When interest rates drop, the penalty becomes extremely expensive, because the lender’s loss is bigger

When interest rates rise, the penalty is minimal, because the lenders loss if smaller

Loan Defeasance

Defeasance is not an actual prepayment but a substitution of collateral (the property) with a portfolio of government bonds that mimic the loans’ remaining payments. That allows the borrower to effectively get out of the loan while the lender's expected cash flows remain intact.

• The Purchase: You use money (usually from your property sale) to buy a "bucket" of government bonds.

• The Matching: You buy specific bonds that mature at the exact times your mortgage payments are due. If your mortgage is $10,000 a month, the bonds are set up to pay out $10,000 a month.

• The Swap: You give the lender the bonds. Because the U.S. government is "safer" than your building, the lender is happy.

• The Release: The lender releases the lien on your building. The "leash" is now attached to the bonds instead of the bricks and mortar.

Tranches between (“AAA”, “AA”,”BBB'“,”B”)

Each tranche is a different bond, which is the point of pooling the mortgages and securitizing them to make various tranches available to investors. Presumably, they could get put together in a portfolio to match the overall credit profile of the mortgages.

• AAA Tranche LTV 35% : Can buy & sell through market makers

• AA Tranche LTV 50%: Multiple sources of collateral

• BBB Tranche LTV 60%: Multiple interest rates, relatively liquid, and can pick and choose risk tolerance w/yield

• B Tranche LTV 70%: diverse financial asset

Conventional Mortgage

No diverse financial asset, single rate, not very liquid, single source of collateral, single asset

• typical holders: insurance company’s, pension, debt funds sponsered by private equity

What does LTV stand for

LTV stands for loan to value and is a primary indicator of credit risk

Origin of CMBS

CMBS origination is the process where conduit lenders fund commercial real estate loans, bundle them into pools, and sell them as bonds (securities) to investors, a market pioneered by Ethan Penner in the early 1990s following the savings & loan crisis to provide needed capital, differing from traditional banks by not holding loans long-term but rather securitizing them for broader market distribution

Creation of Bonds: Rating agency (Standard & Poor’s, Moody’s, fitch)

• Analyzes and rates the loan tranches

• Monitors and updates ratings

Creation of Bods: Primary servicer

• Loan administration & borrower communication

• Loan assumption approval and processing

Creation of Loan: Master Servicer/Trustee

• Fiduciary role/legal liability

• Handles payments to bondholders

Creation of Loan: Special Servicer

• Resolves troubled loans

• Loan modification & foreclosure following defaults

• “B” piece investor in the bond

CMBS

CMBS (Commercial Mortgage-Backed Securities) are fixed-income bonds backed by a pool of commercial real estate mortgages. Instead of a single lender holding a loan on their balance sheet, the loans are bundled into a trust that issues bonds to investors. These bonds are divided into tranches (layers) with different risk levels, ranging from AAA (safest) to the "B-Piece" (riskiest/first-loss)

Investment firms: Responsible for creating CMBS bonds (origination & underwriting), securitization, structuring, and distribution.

Who distributes payments to bond owners

Master Servicer is responsible for ensuring each bond owner receives its interest coupon.

CMBS bond waterfall

The CMBS bond waterfall sequences risk and return: investors can pick and choose their investment tranche based on their risk tolerance.

CMBS utilize a "waterfall" structure where payments and losses are handled in opposite directions. While principal and interest payments generally flow from the top down (starting with AAA), any losses resulting from loan defaults or foreclosures flow from the bottom up.Losses are allocated in reverse sequential order. This means the most junior (lowest-rated) tranches act as a protective "cushion" for the senior tranches.

B,BB,BBB,A,AA,AAA in the direction of losses (its the lowest grade first)

Advantages/Disadvantage of CMBS: Bond Investor

Advantage: diversified collateral, Ability to select risk tolerance by tranche, potential for higher returns with higher risk profiles, requires less capital to gain CRE exposure, No loan administration

Disadvantage: Cannot reject individual loans, limited information underwrite, and prepayment risk

Advantage of CMBS: Property Owner

Advantage: Competitive lending environment, Faster execution, Potential for higher loan proceeds, Non-resource loans

Disadvantage: inflexible loan terms, no relationship manager, liquidity can be quick to evaporate

Advantage of CMBS: Investment bank

Advantage: Origination fees, No balance sheet burden, Broadens client relationships, Converts traditionally illiquid assets into an asset

Disadvantage: Loan warehousing risk, potential conflicts of interest, interest rate risk

CMBS Underwriting Risk

Risk default in monthly payment

• Tenet credit & collection loss

• Lease expirations and vacancy loss

• Re-leasing costs and non-recurring capital costs

Key protections in CMBS underwriting

Prepayment is a major risk in CMBS underwriting and originators generally use the 3 methods of yield maintenance, defeasance, and fixed penalty of protecting against it

Bonds credit rating (an objective and expert assessment of the approximate magnitude of default risk

• AAA/AA (highest quality investment grade)

• A/BB (high quality investment grade)

• BB/B (medium quality (speculative grade)

• CCC&lower (poor quality, some issues in default, speculative junk grades), unrated (too little information or too risk to rate generally)

Sharpe Ratio formula in comparative risk adjusted returns

financial metric that measures an investment's risk-adjusted return, showing the excess return (above a risk-free rate) earned per unit of total risk (volatility) taken.

a higher Sharpe Ratio indicates better risk-adjusted performance, making it ideal for comparing different investment options like mutual funds or stocks to see which provides more return for the risk

Sharpe Ratio: (return-risk free rate)/standard deviation of return (return per unit of risk)