Investments & Securities Chapter 14 Commercial Mortgage Loans And Commercial Mortgagedbacked Securities Summary The Mortgage

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CHAPTER 14

COMMERCIAL MORTGAGE LOANS AND

COMMERCIAL MORTGAGED-BACKED SECURITIES

CHAPTER SUMMARY

The mortgage market consists of residential mortgages and commercial mortgages. Residential

mortgage loans are for properties with one to four single-family units. Residential mortgage–backed

COMMERCIAL MORTGAGE LOANS

Commercial mortgage loans are for income-producing properties. These properties include

multifamily properties, office buildings, industrial properties (including warehouses), shopping

Indicators of Potential Performance

If there is a default on a commercial mortgage loan, the lender looks to the proceeds from the sale

of the property for repayment and has no recourse to the borrower for any unpaid balance. Two

measures have been found to be key indicators of the potential credit performance: debt-to-service

coverage ratio and the loan–to–value ratio.

For residential mortgage loans, only prepayment penalty mortgages supply protection against

prepayments. For commercial mortgage loans, call protection includes prepayment lockout,

defeasance, prepayment penalty points, and yield maintenance charges.

A prepayment lockout is a contractual agreement that excludes any prepayments during the

the prevailing Treasury rate.

Balloon Maturity Provisions

Commercial mortgage loans are typically balloon loans requiring sizeable principal payment at

the end of the balloon term. If the borrower fails to make the balloon payment, the borrower is in

default. During the work-out period for the loan, the borrower is charged a higher interest rate,

As with residential mortgage-backed securities (RMBS), CMBS can be issued by Ginnie Mae,

Fannie Mae, Freddie Mac, and private entities. All of the securities issued by Ginnie Mae,

Fannie Mae, and Freddie Mac are consistent with their mission of providing funding for

residential housing.

While securities backed by Ginnie Mae and issued by the two government-sponsored enterprises

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The structure of a CMBS transaction is the same as in a nonagency RMBS in that most structures

have multiple bond classes (tranches) with different ratings, and there are rules for the

distribution of interest and principal to the bond classes. However, there are three major

differences due to the features of the underlying loans.

The first difference in structuring involves the fact that the prepayment terms for commercial

be dealt with in structuring an RMBS.

The third difference in structuring between CMBS and RMBS has to do with the role of the

buyers when the structure is being created so as to remove certain loans from the pool. More

specifically, typically potential buyers of the junior bond classes are first sought by the issuer

before the deal is structured. The potential buyers first review the proposed pool of mortgage

The credit enhancements for nonagency RMBS can be used in CMBS structures. Typically, the

primary form of credit support is the senior-subordinated structure.

Prepayment Protection and Distributions of Prepayment Premiums

In a CMBS structure, there are two levels of prepayment protection. The first is at the loan level.

maintenance charges are referred to as prepayment premiums.

Balloon Risk in CMBS Deals

CMBS with senior subordinated structures face the risk that all loans must be refinanced to pay

off the most senior bondholders. The balloon risk of the most senior tranche may be equivalent

to that of the most junior bond class in the deal.

limited to when the balance of mortgage loans in the mortgage pool represents 1% to 3% of the

deal’s original balance of the trust. Usually the price at which the remaining loans can be

repurchased is the outstanding balance of the mortgage loans plus accrued interest.

TYPE OF DEALS

The two major classifications for CMBS deals are single borrower/multi-property deals and

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multi-property conduit deals.

Single Borrower/Multiproperty Deals

In a single borrower/multi-property deal there is one borrower and multiple properties. Three key

structural features in such deals are the cross-collateralization feature, cross-default feature, and

property release provisions.

The cross-collateralization feature is a mechanism whereby the properties that collateralize the

individual loans in the mortgage pool are pledged against each loan. The cross-default feature

permits the lender to call each loan within the mortgage pool when any one property defaults. By

including these two features, the principal and interest payments of all the properties are

available to meet the obligations of all the loans.

Because there is a single borrower, there is concern that the borrower can benefit by removing

the best properties from the mortgage pool by prepaying the balance and selling those properties.

This action would result in a deterioration of the structural protection afforded the bondholders.

The objective of property release provisions is to protect the investor against borrower

than $50 million and then smaller loans, it is referred to as a fusion conduit deal.

Servicers

As with a nonagency RMBS, a servicer is required and plays an important role. The

responsibilities of the servicer include collecting monthly loan payments, keeping records

relating to payments, maintaining property escrow for taxes and insurance, monitoring the

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Typically, the special servicer has the authority to extend the loan, make loan modifications,

restructure the loan, or foreclose on the loan and sell the property.

Analysis of the Collateral

The unique economic characteristics of each income-producing property in a pool backing

a CMBS deal require that credit analysis be performed on a loan-by-loan basis not only at the

economic downturns that may be unique to that geographical region.

Stress Testing Structures

An analysis of the credit quality of the tranches in a CMBS involves looking at the commercial

loans on a loan-by-loan basis. Rating agencies and analysts will then stress test the structure with

respect to a combination of default and prepayment assumptions.

interest and, if there is a default, the lender looks to the proceeds from the sale of the property

for repayment.

• Two measures that have been found to be important measures of potential credit performance

for a commercial mortgage loan are the debt-to-service coverage ratio and the loan-to-value

nonagencies.

• The structure of a transaction is the same as in a nonagency residential mortgage-backed

security, with the typical structure having multiple bond classes with different ratings.

• There are rules for the distribution of interest and principal to the bond classes and the

distribution of losses. However, there are differences in structuring transactions due to

• There are two major classifications for CMBS deals. One type is the single borrower/multiproperty

deal. Three key structural features in these deals are the cross-collateralization feature, cross-default

feature, and property release provisions.

• The second type of CMBS deal is the multi-borrower deal, also called a conduit deal. A

conduit is a commercial-lending entity that is established for the sole purpose of generating

• An analysis of the credit quality of a CMBS structure will also look at the dispersion of the

DSC ratios and LTV ratios for the underlying loans, the types of income-producing

properties, and the geographical dispersion of the properties.

• Rating agencies and analysts will then stress test the structure with respect to a combination of

default and prepayment assumptions.

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ANSWERS TO QUESTIONS FOR CHAPTER 14

(Questions are in bold print followed by answers.)

1. “The net operating income (NOI) of a commercial property is determined solely by

taking the rental income of the property”. Do you agree with the above statement?

2. Why might an investor be skeptical about the loan–to-value ratio for a commercial mortgage

loan?

3. Explain the underlying principle for a yield maintenance charge.

The underlying principle for a yield maintenance charge is to prevent lenders from refinancing

4. What types of prepayment protection provisions result in a prepayment premium being

paid if a borrower prepays?

For residential mortgage loans, only prepayment penalty mortgages provide protection against

prepayments. For commercial mortgage loans, call protection can take the following forms:

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5. The following statement was made in a special report, “Commercial Mortgage Special

Report” (September 19, 2005, p. 2), by FitchRatings: “Defeasance of a loan in a CMBS

transaction is a positive credit event.” Explain why.

The defeasance of a loan in a CMBS transaction is a positive credit event because it can make

credit risk of a CMBS disappear. More details are given below.

6. In an article by Matt Hudgines “More CMBS Borrowers Pay off Balloon Mortgages on

Time,” posted on August 18, 2010, the following appeared

38.7% the previous month and is the highest level since the end of 2008.”

been 32.2%.”

(See: http://nreionline.com/finance/news/cmbs_borrowers_pay_balloon_mortgages_0818/#)

Explain the relevance of this information to investors in CMBS.

The increasing percentage of balloon payments made over recent year implies a number of

7. Answer the below questions.

a. Explain whether you agree or disagree with the following statement: “The largest sector

of the CMBS market is securities issued by agency and government-sponsored securities.”

One would not agree with the statement. While securities backed by Ginnie Mae and issued by

the two government-sponsored enterprises constitute the largest sector of the RMBS market, it is

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commercial real estate investors and ready access to capital for commercial lenders.

A commercial mortgage loan is originated either to finance a newly originated commercial

purchase or to refinance a prior commercial mortgage obligation. Regardless, the lender needs to

look at the cash flow from the property backing payment of the interest and principle.

c. Explain whether you agree or disagree with the following statement: “A fusion CMBS

deal has only one single large borrower.”

Conduits are commercial-lending entities that are established for the sole purpose of generating

collateral to securitize, and the CMBS transactions that result are called conduit deals. The

rating agencies refer to conduit transactions as multi-borrower deals indicating more than one

8. Why do CMBS trade in the market more like corporate bonds than RMBS?

9. What are the major differences in structuring CMBS and RMBS transactions?

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10. In a commercial mortgage-backed security, what is the concern that the bondholders

have when there is a prepayment premium paid by a borrower?

Prepayment penalties and yield maintenance charges are referred to as prepayment premiums.

When there are prepayment penalty points, there are rules for distributing the penalty among the

CMBS bondholders. In the case of loans with a yield maintenance provision, several methods are

11. The following appears on the web site of Chatham Financial, an advisory service:

“Kennett Square, Pa., June 21, 2010 — Chatham Financial announced today that it advised

Primus Capital in the defeasance of $76.9 million in debt secured by twelve properties held in

Explain what is meant by a defeasance of loans?

Defeasance of a securitized commercial mortgage-backed security (CMBS) is a process by

which a borrower substitutes other income-producing collateral for real property to facilitate the

elimination of an existing lien without paying-off an existing note. Typically, a basket of U.S

treasury obligations is the only collateral suitable for this type of substitution. The original note

12. Explain why commercial mortgage-backed securities do not trade like residential

mortgage-backed securities in the market.

It is because of the substantial prepayment protection at the loan and structure level that a

commercial mortgage-backed security (CMBS) is not viewed in the market in the same way as

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valuation: the value of an asset is the present value of the expected cash flow. This makes trading

for commercial mortgage loans more risky because it is difficult to estimate future cash flows

and discount rates that are needed to arrive at the value of a commercial mortgage loan.

13. Answer the below questions.

a. What are the two types of structural provisions that can be present in CMBS

transactions to mitigate balloon risk?

The two types of structural provisions are internal tail and external tail. The internal tail calls

for the borrower to document efforts to refinance the loan within one year of the balloon maturity

b. With respect to the mitigation of balloon risk, what is meant by an external tail?

The external tail is the second of two types of structural provisions that can be present in CMBS

transactions to mitigate balloon risk. With an external tail, the maturity date for the CMBS issue

14. Answer the below questions.

a. Explain the cross-collateralization feature and its significance in a single borrower /

multiproperty CMBS transaction.

In a single borrower/multi-property deal there is one borrower and multiple properties. Three key

structural features in such deals are the cross collateralization feature, cross-default feature, and

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15. Answer the below questions.

a. How does a single borrower/multiproperty deal differ from a conduit deal?

In a single borrower/multi-property deal there is one borrower and multiple properties. On the

other hand, conduits loans are multi-borrower deals involving commercial mortgage loans that

are “originated” in accordance with guidelines that permit them to be rated by credit rating

b. What is meant by a fusion conduit deal?

16. “The duties of a special servicer could arise when a loan has 60 days past due, and the

duty is just to extend the loan.” Explain why you agree or disagree with this statement.

One would disagree about the statement. Firstly, the duties of a special servicer arise only when a

17. How does the analysis of a commercial mortgage-backed security differ from that of a

residential mortgage-backed security?

A commercial mortgage loan is originated either to finance a commercial purchase or to

refinance a prior mortgage obligation. Unlike residential mortgage loans where the lender relies

Thus, the unique economic characteristics of each income-producing property in a pool backing

a CMBS deal require that a credit analysis be performed on a loan-by-loan basis. This analysis

should not only be performed at the time of issuance, but also monitored on an on-going basis.

The second difference in structuring is due to the significant difference between commercial and

residential mortgages with respect to the role of the servicer when there is a default. In

commercial mortgages, the loan can be transferred by the servicer to the special servicer when

the borrower is in default, imminent default, or in violation of covenants. The key here is that it

is transferred when there is an imminent default. The special servicer has the responsibility of

modifying the loan terms in the case of an imminent default to reduce the likelihood of default.

The third difference in structuring between CMBS and RMBS has to do with the role of the

buyers when the structure is being fashioned. More specifically, typically potential buyers of the

junior bond classes are first sought after by the issuer before the deal is structured. The potential

18. “It is claimed that for all properties backing a CMBS deal, a weighted-average debt-to–

service coverage ratio for the pool of commercial mortgage loans is required to be

computed. Thus, the weighted-average DSC ratio would be adequate in assessing the

potential performance of a CMBS transaction”. Indicate whether you agree or disagree

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19. Why is it important to look at the dispersion of property types and geographical location

of properties in analyzing a CMBS transaction?

In general, investors prefer deals that are not concentrated in one property type. Diversifying in

a variety of property types reduces risk through avoiding exposure to only one property type.

Investors are also interested in the geographical dispersion of the properties. The concern is that

20. What is the implication that the debt-to-service coverage (DSC) ratio is greater than

one?

The debt-to-service coverage (DSC) ratio is the ratio of a property’s net operating income (NOI)

divided by the debt service. The NOI is defined as the rental income reduced by cash operating