Commercial mortgage-backed securities (CMBSs) are backed by a pool of commercial mortgage loans on income-producing property—multi- family properties (i.e., apartment buildings), office buildings, industrial
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properties (including warehouses), shopping centers, hotels, and health care facilities (i.e., senior housing care facilities). There are three types of CMBS deal structures that have been of interest to bond investors: (1) liquidating trusts; (2) multiproperty single borrower; and (3) multiprop- erty conduit. The liquidating or nonperforming trusts are a small seg- ment of the CMBS market. This segment, as the name implies, represents CMBS deals backed by nonperforming mortgage loans. The fastest growing segment of the CMBS is conduit-originated transactions. Con- duits are commercial-lending entities that are established for the sole purpose of generating collateral to securitize.
Credit Risk
Unlike residential mortgage loans where the lender relies on the ability of the borrower to repay and has recourse to the borrower if the pay- ment terms are not satisfied, commercial mortgage loans are nonre- course loans. This means that the lender can only look to the income- producing property backing the loan for interest and principal repay- ment. If there is a default, 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. Basically, this means that the lender must view each property as a standalone business and evaluate each property using measures that have been found useful in assessing credit risk.
While fundamental principles of assessing credit risk apply to all property types, traditional approaches to assessing the credit risk of the collateral differs for CMBS than for nonagency MBS and real estate- backed ABS discussed earlier. For MBS and ABS backed by residential property, typically the loans are lumped into buckets based on certain loan characteristics and then assumptions regarding default rates are made regarding each bucket. In contrast, for commercial mortgage loans, the unique economic characteristics of each income-producing property in a pool backing a CMBS requires that credit analysis be per- formed on a loan-by-loan basis not only at the time of issuance, but monitored on an ongoing basis.
Regardless of the property type, the two measures that have been found to be key indicators of the potential credit performance is the debt-to-service coverage ratio and the loan-to-value ratio.
The debt-to-service coverage (DSC) ratio is the ratio of the prop- erty’s net operating income (NOI) divided by the debt service. The NOI is defined as the rental income reduced by cash operating expenses (adjusted for a replacement reserve). A ratio greater than 1 means that the cash flow from the property is sufficient to cover debt servicing. The
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look at the dispersion of the DSC ratios for the underlying loans. For example, one might look at the percentage of a deal with a DSC ratio below a certain value.
Studies of residential mortgage loans have found that the key deter- minant of default is the LTV. The figure used for “value” in this ratio is either market value or appraised value. In valuing commercial property, there can be considerable variation in the estimates of the property’s market value. Thus, analysts tend to be skeptical about estimates of market value and the resulting LTVs reported for properties. But, the lower the LTV, the greater the protection afforded the lender.
Another characteristic of the underlying loans that is used in gauging the quality of a CMBS deal is the prepayment protection provisions. We discuss these provisions later. Finally, there are characteristics of the prop- erty that affect quality. Specifically, analysts and rating agencies look at the concentration of loans by property type and by geographical location.
Basic CMBS Structure
As with any structured finance transaction, sizing will determine the necessary level of credit enhancement to achieve a desired rating level.
For example, if certain DSC and LTV ratios are needed, and these ratios cannot be met at the loan level, then subordination is used to achieve these levels.
The rating agencies will require that the CMBS transaction be retired sequentially, with the highest-rated bonds paying off first. There- fore, any return of principal caused by amortization, prepayment, or default will be used to repay the highest-rated tranche.
Interest on principal outstanding will be paid to all tranches. In the event of a delinquency resulting in insufficient cash to make all sched- uled payments, the transaction’s servicer will advance both principal and interest. Advancing will continue from the servicer for as long as these amounts are deemed recoverable.
Losses arising from loan defaults will be charged against the princi- pal balance of the lowest-rated CMBS tranche outstanding. The total loss charged will include the amount previously advanced as well as the actual loss incurred in the sale of the loan’s underlying property.
The investor must be sure to understand the cash flow priority of any prepayment penalties and/or yield maintenance provisions because this can impact a particular bond’s average life and overall performance.
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Structural Call Protection
The degree of call protection available to a CMBS investor is a function of the following two characteristics: call protection available at the loan level and call protection afforded by the actual CMBS structure. At the commercial loan level, call protection can take the following forms: pre- payment lockout, defeasance, prepayment penalty points, and yield maintenance charges.
A prepayment lockout is a contractual agreement that prohibits any prepayments during a specified period of time, called the lockout period. The lockout period at issuance can be from two to five years.
After the lockout period, call protection comes in the form of either prepayment penalty points or yield maintenance charges. With defea- sance, rather than prepaying a loan, the borrower provides sufficient funds for the servicer to invest in a portfolio of Treasury securities that replicates the cash flows that would exist in the absence of prepayments.
Prepayment penalty points are predetermined penalties that must be paid by the borrower if the borrower wishes to refinance. Yield mainte- nance charge, in its simplest terms, is designed to make the lender indif- ferent as to the timing of prepayments. The yield maintenance charge, called the “make-whole charge” in the corporate area, makes it uneco- nomical to refinance solely to get a lower mortgage rate.
The other type of call protection available in CMBS transactions is structural. That is, because the CMBS bond structures are sequential- pay (by rating), the AA-rated tranche cannot pay down until the AAA is completely retired, and the AA-rated bonds must be paid off before the A-rated bonds, and so on. However, principal losses due to defaults are impacted from the bottom of the structure upward.
Call provisions at both the loan and structure level make contrac- tion risk less likely. Therefore unlike some of the mortgage assets described earlier, they are not likely to exhibit negative convexity.
Balloon Maturity Provisions
Many commercial loans backing CMBS transactions are balloon loans that require substantial principal payment at the end of the term of the loan. If the borrower fails to make the balloon payment, the borrower is in default. The lender may extend the loan, and in so doing may modify the original loan terms. During the workout period for the loan, a higher interest rate will be charged, the default interest rate.
The risk that a borrower will not be able to make the balloon pay- ment because either the borrower cannot arrange for refinancing at the balloon payment date or cannot sell the property to generate sufficient funds to pay off the balloon balance is called balloon risk. Because the
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