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Introduction to Commercial Mortgages. Source: Inside Mortgage Markets & Fannie Mae. Commercial Mortgages. My focus today will be on the Differences between residential and commercial mortgages Loan terms Underwriting Performance Standardization. Commercial Mortgages.
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Commercial Mortgages My focus today will be on the Differencesbetween residential and commercial mortgages Loan terms Underwriting Performance Standardization
Commercial Mortgages • A commercial mortgage is a mortgage (note+mortgage) where the collateral that is pledged is an income-producing commercial property • Major types • Multifamily • Office • Retail • Hotel • Industrial/Warehouse
280 Trumbull Hartford 57 Dodge New Haven
Commercial Properties • Each type of commercial property represents a unique business with its own unique risks and returns • We will focus on the common attribute that for each type of property, the fee simple owner of the property generates income by leasing the real estate to a user in return for periodic lease payments.
Income Statements • The income statement for a commercial property has the following general format: Potential Gross Income (PGI) -Vacancy Effective Gross Income (EGI) -Operating Expenses Net Operating Income (NOI)
NOI • Income +$228,026 • Expenses - $65,690 • NOI $162,336
The Net Operating Income(NOI) from a commercial property is a measure of the property’s income generating capability and hence the owner’s capacity to service debt. • There are many different strategies for getting to NOI, but the bottom line is measured by NOI • NOI is often used to get a rough estimate of the value of a commercial property • Cap rates:
Size of Commercial Mortgage Market Commercial Mortgages Outstanding ($,Billion) Roughly 20%-25% of All Mortgage Debt
Holders of Commercial Mortgages Source: Flow of Funds, Federal Reserve Board of Governors
Commercial Mortgage Originations • Good Origination Data for Commercial Mortgages is Hard to Get • MBA Surveys Members • Coverage is approximately 50% • Total Origination Volume: Approximately $250-$350 Billion/year • Best Evidence is that List of Largest Commercial Lenders Mirrors Previous Breakdown by Holder • Conduits (27%) • Banks (24%) • Life Co. (22%) • Conduits exceeded banks in MBA survey in 2004 but MBA survey misses many smaller bank originations
Commercial Mortgage Originations: Pricing • Commercial Mortgages Priced off the Ten Year Treasury • Basically BBB credit • Spreads: • Typical Range from 75-250 over 10 year Treasury • Long Run Average about 150 bp for “best” loans • Current averages 200-275bp • Still about 150bp for “best” loans
Underwriting Commercial Loans • “Three C’s” still generally apply • Capacity measured by DSCR • ratio of NOI to required debt service • Higher numbers (>1)indicate greater cushion • Collateral measured by LTV ratio • Appraised value generally based on income approach to valuation • Present value of future income • Credit measured by track record of owner/manager/developer • Current and past operating results
Personal Research Data • Conduit loans originated in 1997 and 1998 • Tracked and observed until 2003 • property type Freq. Percent Cum. • ------------+----------------------------------- • office | 1786 13.48 13.48 • hotel | 1122 8.47 21.96 • multifamily | 4824 36.42 58.38 • retail | 3951 29.83 88.21 • industrial | 1562 11.79 100.00 • ------------+----------------------------------- • Total | 13245 100.00
LTV by Property Type Summary of Cut-off date LTV ratio Property type Mean Std. Dev. Freq. ------------+------------------------------------ office | .68 .09 1786 hotel | .66 .10 1122 multifamily| .72 .09 4824 retail | .71 .10 3951 industrial | .68 .11 1562 ------------ +------------------------------------ Total | .70 .10 13245
DSCR by Property Type Property type | Summary of Cut-off date DSCR | Mean Std. Dev. Freq. ------------+------------------------------------ office | 1.46 .29 1786 hotel | 1.61 .30 1122 multifamily| 1.44 .25 4824 retail | 1.40 .27 3951 industrial | 1.51 .37 1562 ------------+------------------------------------ Total | 1.45 .29 13245
Performance • Commercial Loans are generally viewed as having more credit risk and less prepayment risk than residential mortgages • More “ruthless” exercise of the option to default • Generally no effective recourse to other assets of borrower • Frequently the borrower is a special purpose corporation
Overall Average for Commercial Mortgages: 12%-15% Overall Average for Residential Mortgages: 1% -3% Source: ACLI data
Default Experience through 2003 for Loans Originated in 1997-1998 Property type | % Defaulted Mean # of Defaults Total ------------+------------------------------------ office | .026 46 1786 hotel | .156 175 1122 multifamily| .021 101 4824 retail | .043 169 3951 industrial | .020 31 1562 ------------+------------------------------------ Total | .039 522 13245
Prepay Experience through 2003 property type| % Prepaid | Mean # Prepaid Total ------------+------------------------------------ office | .025 45 1786 hotel | .012 13 1122 multifamily| .043 207 4824 retail | .015 59 3951 industrial | .025 39 1562 ------------+------------------------------------ Total | .027 363 13245
LTV & Default Risk Residential Loans • Source: Avery Bostic Canner & Calem (Federal Reserve Bulletin) Table 1 • Default Rates for Residential Loans by LTV Category
Debt Service Coverage Exhibits Little Systematic Relationship with Default
Commercial Loan Characteristics • Balloon loans • Commercial mortgages are generally “balloon” loans. • Maturity of 7, 10 or 15 years • Amortization schedule of 25-30 years • Prepayment Provisions • Most commercial loans cannot be prepaid by the borrower at will • Lockout periods • Yield maintenance provisions • Defeasance provisions have become very common in CMBS issues in last few years
Common Loan Types in Current CMBS Type of Loan | Freq. Percent --------------------------+--------------------------- Anticipated Repayment Date | 1938 14.98 Balloon | 9827 75.97 Fully Amort. | 1121 8.67 Step Loan | 13 0.10 Interest Only | 1 0.01 Int. Only/Balloon | 19 0.15 Int. Only/Hyper Amort | 9 0.07 Int. Only/Amort | 8 0.06 --------------------------+---------------------------- Total | 12936 100.00
Standardization • Residential loans are very homogeneous • Underwriting standards/mortgage documents/ provisions in the notes are dictated by the major secondary market agencies (FNMA /FHLMC) • Commercial loans are less homogeneous • They can be tailored to specific borrower or property needs
Commercial Loans • Participation Loans • A property may need several years of work to reach its potential NOI • Lenders often believe they bear much of the downside risk of a project but the traditional loan does not let them share in the upside potential
Participation Loans • A mortgage loan with a lower then market rate of interest but that provides that the lender shares or participates in some way in the cash flows of the property • Lender can participate in • Gross income • NOI • Cash flow after regular debt service • proceeds from sale of the property
An Example • Consider Textbook Example (pp 334-351) • Lender offers two loans • 10% standard 15 year mortgage • An 8% loan plus • 50% of all NOI> $100,000 • 45% share of gain from sale of property
Interest-Only Loans • Commercial loans can be interest-only • Borrower payment is equal to the interest rate times the principal balance • Loan does not amortize over the maturity • Interest Only Period Can Vary • Full loan amount is due and payable at maturity • 7-10 years • Risk to lender • Without amortization, the lender has less protection against declines in property value • Benefit to Borrower • Reduces cash flow requirements • All debt service is tax-deductible