1. July 2001Brent W. Ambrose, University of Kentucky1 Commercial Mortgage-Backed Securities National University of Singapore July 27, 2001 Notes from lecture given by Brent Ambrose at National University of Singapore – July 2001

2. July 2001Brent W. Ambrose, University of Kentucky2 COMMERICAL MORTGAGE- BACKED SECURITIES What is a CMBS? A commercial mortgage-backed security (CMBS) is a financial asset. –created when an issuer places a commercial mortgage (or collection of mortgages) into a trust –the trust issues classes of bonds backed by the underlying principal and interest payments.

3. July 2001Brent W. Ambrose, University of Kentucky3 Objectives for this Session This session will cover the following topics: –Differences between CMBS and MBS. –The anatomy of a CMBS deal. –Prepayment penalties on commercial mortgages. –CMBS risks (prepayment & default) –CMBS underwriting and the role of rating agencies. –The role of CMBS servicers. –Empirical studies of CMBS default and loss severity. –How CMBS deals are rated.

4. July 2001Brent W. Ambrose, University of Kentucky4 CMBS vs. MBS Basic difference between residential MBS and commercial MBS: –PREPAYMENT Commercial mortgages have prepayment lockouts and penalties. This changes the termination options. Default is now paramount.

5. July 2001Brent W. Ambrose, University of Kentucky5 U.S. CMBS Legalities Real Estate Mortgage Investment Conduits (REMIC) –U.S. tax code provision that allows the pooling and securitization of mortgages. Once pool is formed, not allowed to substitute mortgages.

6. July 2001Brent W. Ambrose, University of Kentucky6 U.S. CMBS Legalities Financial Asset Securitization Investment Trust (FASIT) –created in 1997 –allows issuers to substitute and add collateral after securitization now issuer can add mortgages to pool as they are originated

7. July 2001Brent W. Ambrose, University of Kentucky7 U.S. CMBS Legalities FASIT – Allow securitization of a broader class of assets including: 1.construction loans 2.commercial property bridge loans 3.automobile loans 4.credit card receivables 5.home equity loans

8. July 2001Brent W. Ambrose, University of Kentucky8 CMBS Anatomy Cash Flows Subordination Prepayment Penalties CMBS Risks Call Protection Property Diversification Credit Enhancements Underwriting Role of Servicers

9. July 2001Brent W. Ambrose, University of Kentucky9

10. July 2001Brent W. Ambrose, University of Kentucky10 Actual CMBS Examples GMAC Mortgage Pass-through Certificates NationsLink Commercial Mortgage Pass- through Certificates Series 1998-1

11. July 2001Brent W. Ambrose, University of Kentucky11 GMAC Mortgage Pass-through Certificates, Series 1997- C1 DMG was the Lead Manager of a $1.7 Billion conduit securitization - the largest of its kind at the time of issuance Co-Lead Managers:Deutsche Morgan Grenfell Inc. Lehman Brothers Inc. Servicer:GMAC Commercial Mortgage Corporation Sellers:ContiTrade L.L.C. German American Mortgage Corporation GMAC Commercial Mortgage Corporation Issuance Date:September 25, 1997 The other remaining mortgaged properties are located throughout 37 other states, Puerto Rico and the District of Columbia Collateral: Source: Anthony Sanders

12. July 2001Brent W. Ambrose, University of Kentucky12 Bonds: GMAC Mortgage Pass-Through Certificates, Series 1997-C1 Source: Anthony Sanders

13. July 2001Brent W. Ambrose, University of Kentucky13 NationsLink Pass-through Certificates Series 1998-1

14. July 2001Brent W. Ambrose, University of Kentucky14 CMBS Anatomy Cash flow prioritization: –1) Principal repayments (both scheduled amortization and unscheduled prepayments) go to retire senior class debt first. CF go to senior classes AAA through BBB Intermediate class Junior class Unrated Equity holder –2) Coupon interest paid to all classes

15. July 2001Brent W. Ambrose, University of Kentucky15 CMBS Anatomy Loss prioritization: –Principal and interest due the most junior class bondholder must be completely exhausted before any loss is assigned to the class above it.

16. July 2001Brent W. Ambrose, University of Kentucky16 The Anatomy of a CMBS

17. July 2001Brent W. Ambrose, University of Kentucky17 The Anatomy of a CMBS

18. July 2001Brent W. Ambrose, University of Kentucky18 The Anatomy of a CMBS

19. July 2001Brent W. Ambrose, University of Kentucky19 The Anatomy of a CMBS

20. July 2001Brent W. Ambrose, University of Kentucky20 CMBS Anatomy Expected Cash Flows – Review –Principal repayment Scheduled amortization Unscheduled prepayment –Interest –Penalties Hyperamortization Prepayment Penalty Balloon Default

21. July 2001Brent W. Ambrose, University of Kentucky21 CMBS Anatomy (Penalties) A. Hyperamortization (cash trap): all cash flows in excess of operating expenses go to retire debt. Triggered by i.Delinquency ii.failure to maintain required DSCR iii.failure to maintain debt rating iv.failure to maintain adequate reserves

22. July 2001Brent W. Ambrose, University of Kentucky22 CMBS Anatomy (Penalties) B. Prepayment penalty: »penalty assessed the borrower for early repayment of debt. »Penalty may be computed in various ways.

23. July 2001Brent W. Ambrose, University of Kentucky23 CMBS Anatomy (Penalties) C. Balloon default: penalty assessed the borrower for failing to refinance at the end of the loan term.

24. July 2001Brent W. Ambrose, University of Kentucky24 CMBS Anatomy (Penalties) Prepayment Penalties 1.A (declining) percent of the outstanding balance (e.g. 5-4-3-2-1) paid when the loan is prepaid 2.Yield maintenance: the prepayment penalty is computed as the difference between the book value of the loan and the PV of the remaining contractual payments discounted at some required interest rate. The required interest rate is expressed as some spread over the rate prevailing on comparable maturity Treasuries. A. 300bp over Treasuries B.zero spread: Treasuries flat

25. July 2001Brent W. Ambrose, University of Kentucky25 CMBS Anatomy (Penalties) Prepayment Penalties: 3. Lockout – complete prohibition of prepayment of principal. Usually only in effect during the first few years of the mortgage.

26. July 2001Brent W. Ambrose, University of Kentucky26 Simple Prepayment Example Mortgage Assumptions: –Two year, $10 million interest only mortgage 10% interest rate on the loan at date of issuance Loan is repaid after 1 year when interest rates fall to 8%.

27. July 2001Brent W. Ambrose, University of Kentucky27 Simple Prepayment Example Prepayment Penalties –Yield Maintenance penalty provision Penalty = ($1,000,000 - $800,000) / (1+0.08) = $185,185 –Percent of Prepaid Amount penalty provision Assume 1% penalty in this example Penalty = 1% * $10 million = $100,000

28. July 2001Brent W. Ambrose, University of Kentucky28 Allocation of Prepayment Penalties Allocation is based on the language in the CMBS prospectus –Ultimately determined by investment bankers and lawyers during the creation of CMBS –Underwriters have a great deal of latitude –No standard approach exists

29. July 2001Brent W. Ambrose, University of Kentucky29 Yield Maintenance Calculations One bullet loan tranched into two classes: –Assumptions: 1.Underlying loan is a ten year bullet loan priced at par and pays a 9% coupon 2.Multi-class structure: Senior class is $90 million and pays an 8% coupon (priced at par). Subordinate class is a $10 million classs that pay an 18% coupon (priced at par). 3.Borrower prepays in full at at year 3. Current interest rates are 100bps lower than in year 0.

30. July 2001Brent W. Ambrose, University of Kentucky30

31. July 2001Brent W. Ambrose, University of Kentucky31 Allocation of Penalty:

32. July 2001Brent W. Ambrose, University of Kentucky32

33. July 2001Brent W. Ambrose, University of Kentucky33

34. July 2001Brent W. Ambrose, University of Kentucky34 CMBS Anatomy – Risk Source: Anthony Sanders

35. July 2001Brent W. Ambrose, University of Kentucky35 CMBS Anatomy CMBS Risk impacted by: –property quality –geographic location –tenant creditworthiness

36. July 2001Brent W. Ambrose, University of Kentucky36 CMBS Risks Default risk: –Income property loans are typically nonrecourse. Borrower has the financial incentive to default when the market value of the property falls below the outstanding balance of the loan (negative equity). Also referred to as “optimal”, “strategic”, or “financial” default.

37. July 2001Brent W. Ambrose, University of Kentucky37 CMBS Risks Balloon risk: –income property mortgages typically have terms that are less than the loan amortization period, thus the borrower must refinance to continue making mortgage payments. –Circumstances in the property and capital markets may have changed in ways that make refinancing difficult or even impossible. Also referred to as “refinancing risk”

38. July 2001Brent W. Ambrose, University of Kentucky38 CMBS Risks Prepayment risk: –Many income property mortgages provide some call protection. lock-out provisions prepayment penalties Treasury defeasance –Some income property mortgages do not have any of these features.

39. July 2001Brent W. Ambrose, University of Kentucky39 CMBS Call Protection Lock-out provisions: – prohibit loan prepayment over given period Prepayment penalties: –paid in a lump sum at the time of prepayment; –Cash flows are proportionally allocated to remaining certificate classes. See previous examples of a (declining) percent of the outstanding loan balance or yield maintenance agreements

40. July 2001Brent W. Ambrose, University of Kentucky40 CMBS Call Protection Treasury defeasance: –the borrower must purchase a series of Treasuries that provide the same future cash flows assuming the loan not prepaid. Property release provision: –prohibits asset substitution; –prevents the issuer/lender from removing the stronger properties from the pool.

41. July 2001Brent W. Ambrose, University of Kentucky41 Property Diversification Diversification across: –Loan size: usually no single loan exceeds 5% of the aggregate issue amount. An exception to this is a fusion deal, where a single large loan is packaged with several smaller loans. –Property type –Property location State metropolitan area

42. July 2001Brent W. Ambrose, University of Kentucky42 Sherwood Lakes Schererville, Indiana Apartment $20,162,442 14 Laurel Portfolio Various Apartment $17,950,331 15 Sweet Paper Various Warehouse $17,420,000 16 Sheraton Portsmouth Portsmouth, New Hampshire Hotel $15,949,087 17 Trinity Commons Fort Worth, Texas Retail $15,242,981 18 Village Square Indianapolis, Indiana Apartment $14,993,950 19 Golden Books Fayetteville, North Carolina Warehouse $14,493,350 20 Air Touch Dublin, Ohio Office $13,992,523 Source: Charter Research. Loan Diversification

43. July 2001Brent W. Ambrose, University of Kentucky43 Geographic Diversification

44. July 2001Brent W. Ambrose, University of Kentucky44 Property Type Diversification

45. July 2001Brent W. Ambrose, University of Kentucky45 Credit Enhancements Subordination Cross collateralization: –properties that collateralize individual loans are pledged against all loans in the pool Cross default: –allows the lender to call ALL LOANS in the event a single loan is in default.

46. July 2001Brent W. Ambrose, University of Kentucky46 Credit Enhancements Lock box: –Gives the trustee control of the property gross revenues. The trustee assigns priority in the following order: (1) taxes and insurance; (2) operating expenses; (3) debt service; (4) management fees; (5) reserves for replacements; (6) equity investor

47. July 2001Brent W. Ambrose, University of Kentucky47 Credit Enhancements Overcollateralization: –When the book value of the loans exceed the par value of the bonds issued. –Most common in residential MBS Especially common in CMO structure

48. July 2001Brent W. Ambrose, University of Kentucky48 Reserve Funds Established at loan closing to: –Provide liquidity: to pay interest for investment grade bonds –Service the asset: to pay –property taxes –property insurance –legal fees –Maintenance

49. July 2001Brent W. Ambrose, University of Kentucky49 Standardized CMBS Underwriting Key Underwriting Characteristics –Debt Service Coverage Ratio (DSCR) –Loan to Value Ratio (LTV) –Average loan size –Max loan not to exceed certain percentage (e.g. 5%) –Diversification across Property types Geographic locations –Prepayment terms –Loan maturities

50. July 2001Brent W. Ambrose, University of Kentucky50 Role of rating agencies Establish different rating criteria for various property types. Negotiate subordination levels with issuers. Track property performance/delinquencies Servicer and trustee report ongoing loan level performance –Monthly/quarterly DSCRs –occupancy levels –updated bond information

51. July 2001Brent W. Ambrose, University of Kentucky51 Role of Servicers Master Servicer: –Oversees the deal and servicing agreements –Facilitates timely payment of principal and interest –May provide (servicer) advances for delinquent/defaulted loans Sub-Servicer: –loan originator in a conduit deal who retains servicing

52. July 2001Brent W. Ambrose, University of Kentucky52 Role of Servicers Special Servicer: –Becomes engaged when loan more than 60 days delinquent. –Has the authority to Extend the loan Modify/restructure the loan (based on an appraisal) Foreclose

53. July 2001Brent W. Ambrose, University of Kentucky53 Pricing CMBS Unlike residential MBS, the underlying mortgages have little prepayment risk. However, default risk is now relevant due to these risks: –Lease termination risk –Lease rollover risk Imperative to monitor developments in the overall real estate market. –For example, low vacancy rates may lead to additional construction. This additional supply can result in reduced real lease rates in future years. Has implications on the ability of the property to service the debt in future years.

54. July 2001Brent W. Ambrose, University of Kentucky54 Pricing CMBS Rating agencies play a critical role in the CMBS pricing process. –S&P, Moodys, and Duff & Phelps maintain internal models of collateral risk in order to rate default risk associated with CMBS deals. In addition to having to price deals in accordance with rating agency opinions, it is wise to understand the underlying real estate markets in order to anticipate payments delays or defaults. –Example. Lease rates and vacancy rates may look great at the moment, but will these indicators prompt developers/banks into another frenzy of construction?

55. July 2001Brent W. Ambrose, University of Kentucky55 Pricing CMBS Remember – CMBS product is part of the fixed-income universe. –Capital markets are linked such that shocks in one market impact others. For example – Russian debt crises in 1998 –See following charts.

56. July 2001Brent W. Ambrose, University of Kentucky56

57. July 2001Brent W. Ambrose, University of Kentucky57

58. July 2001Brent W. Ambrose, University of Kentucky58

59. July 2001Brent W. Ambrose, University of Kentucky59

60. July 2001Brent W. Ambrose, University of Kentucky60

61. July 2001Brent W. Ambrose, University of Kentucky61

62. July 2001Brent W. Ambrose, University of Kentucky62 Bond Spreads

63. July 2001Brent W. Ambrose, University of Kentucky63 Income Property Debt: Default and Loss Severity What do we know about income property default and loss severity? –1. Fitch ICBA, Inc. (1998) –2. Corcoran and Kao (1998) –3. Vandell, Barnes, Hartzell, Kraft, and Wendt (1993) –4. Snyderman (1994) * *-these notes are based on lecture material provided by Thomas Thibodeau at Southern Methodist University.

64. July 2001Brent W. Ambrose, University of Kentucky64 Income Property Debt: Default and Loss Severity

65. July 2001Brent W. Ambrose, University of Kentucky65 Income Property Debt: Default and Loss Severity

66. July 2001Brent W. Ambrose, University of Kentucky66 Income Property Debt: Default and Loss Severity

67. July 2001Brent W. Ambrose, University of Kentucky67 Income Property Debt: Default and Loss Severity

68. July 2001Brent W. Ambrose, University of Kentucky68 Income Property Debt: Default and Loss Severity

69. July 2001Brent W. Ambrose, University of Kentucky69 Income Property Debt: Default and Loss Severity

70. July 2001Brent W. Ambrose, University of Kentucky70 Income Property Debt: Default and Loss Severity

71. July 2001Brent W. Ambrose, University of Kentucky71 Income Property Debt: Default and Loss Severity

72. July 2001Brent W. Ambrose, University of Kentucky72 Income Property Debt: Default and Loss Severity

73. July 2001Brent W. Ambrose, University of Kentucky73 Income Property Debt: Default and Loss Severity

74. July 2001Brent W. Ambrose, University of Kentucky74 Income Property Debt: Default and Loss Severity

75. July 2001Brent W. Ambrose, University of Kentucky75 Income Property Debt: Default and Loss Severity

76. July 2001Brent W. Ambrose, University of Kentucky76 Income Property Debt: Default and Loss Severity

77. July 2001Brent W. Ambrose, University of Kentucky77 Income Property Debt: Default and Loss Severity

78. July 2001Brent W. Ambrose, University of Kentucky78 Income Property Debt: Default and Loss Severity

79. July 2001Brent W. Ambrose, University of Kentucky79 Income Property Debt: Default and Loss Severity

80. July 2001Brent W. Ambrose, University of Kentucky80

81. July 2001Brent W. Ambrose, University of Kentucky81 Default and Loss Severity To summarize, the studies show that: –Commercial mortgage default estimates are highly dependent upon the data source. –Most CMBS deals were originated during period of unprecedented economic growth and expansion. Loans have not been tested through full economic cycle.

82. July 2001Brent W. Ambrose, University of Kentucky82 Rating CMBSs Property Cash Flow Adjustments Capitalization Rate Adjustments Pool analysis Ideal Pool for Small Income Property Loans

83. July 2001Brent W. Ambrose, University of Kentucky83 Rating CMBSs

84. July 2001Brent W. Ambrose, University of Kentucky84 Rating CMBSs

85. July 2001Brent W. Ambrose, University of Kentucky85 Rating CMBSs

86. July 2001Brent W. Ambrose, University of Kentucky86 Rating CMBSs

87. July 2001Brent W. Ambrose, University of Kentucky87 Rating CMBSs

88. July 2001Brent W. Ambrose, University of Kentucky88 Rating CMBSs

89. July 2001Brent W. Ambrose, University of Kentucky89 Rating CMBSs

90. July 2001Brent W. Ambrose, University of Kentucky90 CMBS in Singapore MAS declared that real estate securitization is a strategic goal. Current debt securitization programs: –Mortgage-Backed bonds Similar to single mortgage securitization. Typical deal will have additional credit enhancements from mortgage borrower. Does not have credit rating or credit enhancements from 3 rd parties. –Asset-Backed Securitization One step further than mortgage-backed bonds in that property securing the debt is transferred to a “special-purchase vehicle”.