1. CMBSCommercial Mortgage Backed Securities

2. CMBS Part ITypical Characteristics Brief HistoryIndustry Participants 3. (CMBS) What are Commercial Mortgage-Backed Securities?CMBS consist of many single mortgages pooled together andtransferred to a trust. The trust issues a series of bondsthat vary in yield, duration and payment priority.As several commercial bonds and mortgages are broughttogether, investors get dividends funded by the pooledmortgages. Borrowers Guide to CMBS 4. CMBS are an increasingly popular investment option thatinvestors can consider during their asset allocation processCMBS are similar to Mortgage-Backed Securities (MBS): Asset-backed securities secured by a mortgage or collection of mortgages Bonds backed by mortgage paymentsCMBS and MBS differ: MBS - loans related to residential property CMBS - loans related to commercial property 5. Typical Characteristics of CMBS Term Period terms are typically three, five or ten yearslong Repayment of Investment principal and interest of themortgages is used to pay the principal and interest of theCMBS Rates of Return influenced by fluctuations in the overallposition of the real estate market RRSP Eligible CMBS are eligible through The RegisteredRetired Savings Plan 6. Typical Characteristics of CMBS continued Ratings credit ratings are assigned by nationally recognizedrating agencies: (AAA/AAA through BBB-/Baa3) (BB+/Ba1 through B-/B3) Unrated Class Risk Structured Payment directly correlated with rating class REMIC (real estate mortgage investment conduit) structuredas a pass-through securitized certificates, while individualinvestors pay taxes on income they receive from REMICs, thesecurities themselves are exempt from business income tax 7. Brief History of CMBS 1968 - Ginnie Mae (GNMA), first mortgage backed pass through security - to provide aliquid secondary market for existing loans; provided lenders the ability to originatemore primary loans 1971 - Freddie Mac (FHLMC) issued first mortgage pass through mostly of privatemortgages 1981 - Fannie Mae (FNMA) issued its first mortgage backed security 1983 - first CMBS transaction was priced - Fidelity Mutual Life Insurance, issued $60million of commercial mortgagebacked securities to three life insurance companies 1985 - total annual issuance of CMBS reached $3.7 billion and the market establisheditself as an effective financing mechanism for commercial real estate 1980s and 1990s - tax and regulatory reforms made these investments more appealingand suitable for a wider range of investors 8. CMBS Industry ParticipantsPrimary or Sub-ServicerMaster Servicer Special ServicerDirecting Certificate Holder / Controlling Class / B-Piece BuyerTrusteeRating Agencies 9. CMBS Industry Participants equitydefeasance.com 10. CMBS Part IIAdvantages & Disadvantages Borrower IssuerInvestor 11. Borrower Advantages Creates additional sources of funding for the development of projectsby introducing diversified levels of risk Level of Protection Through DefeasanceAs a substitution for collateral (real estate property) for theremainder of the term on a mortgage note, a borrower can elect topay the note before its maturity date (defeasance) through thesubstitutive purchase, exactly matching the cash flow of allscheduled mortgage payments, of US Treasury bonds 12. Issuer Advantages "CMBS helps in converting immovable real estate into liquid andtradable capital market instruments. CMBS acts as an additional source of funding for thebank/developer. The rating on CMBS defined can be separated from the rating ofthe bank/developer for a desired rating on the CMBS instrument. CMBS is more beneficial than bank loans as it reduces the overallcost of funds and optimizes the funds raised, due to offeringdifferent categories of options to suit different investor classes. CMBS helps lenders manage risk, by securitizing selectedcommercial mortgages and buying or selling suitable CMBSpapers." - www.ilikeinvesting.com 13. Investor Advantages "Investors are able to participate in real estate lending inamounts that are small. Investors can meet their objectives by choosing optionsthat suit their credit and maturity preferences. Investors can gain access to segments of the sector at lowtransaction and information costs. Internationally, defaults experienced on CMBS are muchlower than on other types of securities." - www.ilikeinvesting.com 14. Disadvantages Borrowers Borrowers may be locked out of prepayments, leading to financial lossesin an environment of lower interest rates. Borrowers are expected to make a balloon payment at the end of theloan term and becomes dependent on a source of funding to eitherretire the debt, or refinance. Higher rates may lead to financial losses.Inability to obtain funding may result in default loss, referred to asextension risk. 15. DisadvantagesLenders There is a much higher rate of default in CMBS issuances due to thereliance on cash flows and income from commercial tenants andfinancial risk due to macro and local economic conditions anddemographic trends. The loans are generally made without recourse, leaving the lenderdependent on the sale of the property to recoup costs and losses. Lenders ability to recoup their investment is determined by thetranche position of their investment. Senior tranches are paid first,followed by subordinated and residual class investors. Liquiditycrunches and financial loss can cause an investor to lose their entireinvestment if sale proceeds do not exceed the debt. 16. CMBS Part IIIValuation of CMBS &Difficulties in Valuation 17. VALUATION OF CMBSCMBS collateral property valuations requirethe analysis of details and inherent complexitiesattributed to the uniqueness of each commercial property 18. Commercial properties are each distinct owing to theircompetitive positioning within their markets and themakeup of their physical structure, tenancy/occupancy,and management. Parking Lots Office Properties Hotels Industrial Properties Malls Multi-Family Properties Restaurants Retail Shops Hospitals Self-Storage Facilities 19. A Few Examples of Risk Considerations Location/Visibility In place vs. MarketRate Leases Demographic Trends Environmental Risks Rent Roll Employment Growth Availability of Nearby Government SubsidiesUndeveloped Land Supply and DemandDynamics Management/Franchise SecurityAgreements Occupancy/Tenancy/Co- ConsolidationsTenancy/Shadow Competition/CompetitivAnchors e Strength Expenses Subleasing/Subleasing Structure/Design/Physic Shareholder ProfilesRates alAttraction/Layout/Parking 20. Property Cash Flow AnalysisA collateral propertys net cash flow is the principal indicator asto whether a proposed loans periodic debt service will be paid.Cash flow analysis requires the underwriter to obtain informationon Net Operating Income (total recurring revenue less totalexpenses) generated by the income producing property from itsusual operations. 21. Property Cash Flow Analysis continued Revenues - income from tenancy or occupancy, andreimbursement of operating expensesHowever, recurring revenue related to a propertys operationscould come from a variety of sources.Example, in addition to rent, income from a retail tenant basedon the percentage of sales by the retail store can be an additionalsource of revenue for the property. 22. Property Cash Flow Analysis continued Expenses - costs of operating and maintaining property: management fees facility supplies franchise fees costs of goods sold utilities insurance leased equipment service agreements like maintenance landscaping or marketing employee salaries 23. An underwriters document requirements from the borrower are specificto the uniqueness of each property and at minimum include thefollowing: Operating statements current plus three prior calendar years Operating budget current and following years operating budget Current Rent Roll includes tenant names, cotenancy provisions,leased square foot area, lease commencement dates, lease expirationdates, current rents (contractual rent increases during lease terms),renewal options, termination options, and current or futureconcessions 24. Market AnalysisBy tracking and projecting market trends, an underwriter canreasonably predict the commercial viability of a particularproperty over the term of the loan and beyond the anticipatedrefinance period to provide the basis for the probableperformance of the collateral. 25. Market Analysis continuedMacro and Local Economic and DemographicTr e n d s I n f l u e n c e t h e D e m a n d f o r S p a c e Supply and Demand Conditions Nominal GDP (as indicative of Local Population Growthincreasing prices) Major Local Employers Employment Growth Rate Local Job Patterns Disposable Income Household Formation Changing Demographics inMarkets Median and Disposable Income MarketSpecific Economic 26. Risk AnalysisTo properly value CMBS, an underwriter must consider allthe risk factors specific to the uniqueness of each property.Additionally, underwriters must also consider a borrowersability to make timely payments and eventual repayment onthe loan at the maturity date.This calls for lenders to customize their underwriting toreflect the risk within each proposed loan in relation to thecriteria and conditions of each property. 27. Monetary Risks Term Default -Term Risk is the probability of default from loanorigination through loan maturity: Underwriters Considerations: probabilities in fluctuations in cash flows due to lease turnover andchanges in expensesRequire higher debt service coverage ratio and credit enhancementssuch as; reserve funds based on the uniqueness of each property 28. Monetary Risks Maturity Default Maturity Risk is the probability of default atthe date a loan is due:Reflects ability of a borrower to: attain refinance proceeds to fully repay the matured loan or sell the property and utilize sales proceeds to repay the loanDebt constants, debt-yields and loantovalue ratios are used to assess Maturity Risk 29. Non-Monetary Risks Technical Default determining the probability of a technicaldefault, an underwriter evaluates:borrowers motivation andcapacity to abide with constraints of loan agreementsbeyond payment termsTechnical defaults can have severe repercussions if not cured by borrowerwithin a reasonable period of timeExample: borrower neglects to sufficiently insure a property, the property andloan may suffer adverse consequences and risk of loss 30. Rating Issueshttp://youtu.be/36q1fLiH3lwhttp://www.theratingsdebate.com/ 31. Conclusion http://youtu.be/KGrQv1fZ0jU 32. CMBS - PowerPoint Presentation 2011 ByNatalie CohenNeville OCallaghan Mark UngewitterPublic Domain Photo Credits Photo By Denise Gould Photo By Jim PeacoPhoto By David Hafley Photo By Natalie Cohen 33. Sources CMBS.Com, http://www.cmbs.com/Mission.aspx, accessed December 2011 Invetopedia, http://www.investopedia.com/terms/c/cmbs.asp#axzz1ZaNvpHhi, accessed December 2011 Ilikeinvesting, http://www.ilikeinvesting.com/general-investment-articles/commercial-mortgage-securities.php,accessed December 2011 CMBS Borrowers Guide,accessed December 2011 http://equitydefeasance.com/assumptions_process.html , accessed December 2011 Urbanland, http://urbanland.uli.org/Articles/2011/Mar/SepciCMBS , accessed December 2011 CREFC.orghttp://www.crefc.org/uploadedFiles/CMSA_Site_Home/Industry_Standards/CREFC_Underwriting_Principles_121510.pdf, accessed December 2011 Defeasnce, Wikipedia http://en.wikipedia.org/wiki/Defeasance accessed December 2011 The Ratings Debate, YouTube http://youtu.be/36q1fLiH3lw, accessed December 2011 Buffet on Derivatives, YouTube - http://youtu.be/KGrQv1fZ0jU, accessed December 2011