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Introduction to Commercial Mortgages

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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Introduction to Commercial Mortgages

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  1. Introduction to Commercial Mortgages

  2. Source: Inside Mortgage Markets & Fannie Mae

  3. Commercial Mortgages My focus today will be on the Differencesbetween residential and commercial mortgages Loan terms Underwriting Performance Standardization

  4. 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

  5. 280 Trumbull Hartford 57 Dodge New Haven

  6. 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.

  7. 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)

  8. NOI • Income +$228,026 • Expenses - $65,690 • NOI $162,336

  9. 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:

  10. Size of Commercial Mortgage Market Commercial Mortgages Outstanding ($,Billion) Roughly 20%-25% of All Mortgage Debt

  11. Holders of Commercial Mortgages Source: Flow of Funds, Federal Reserve Board of Governors

  12. 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

  13. Commercial Mortgage Originations by Property Type

  14. 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

  15. 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

  16. DSCR Ratios by Type and Time

  17. LTV Ratios by Type & Time

  18. 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

  19. 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

  20. 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

  21. 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

  22. Overall Average for Commercial Mortgages: 12%-15% Overall Average for Residential Mortgages: 1% -3% Source: ACLI data

  23. 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

  24. 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

  25. Loss Rates by Property Type

  26. LTV & Default Risk Residential Loans • Source: Avery Bostic Canner & Calem (Federal Reserve Bulletin) Table 1 • Default Rates for Residential Loans by LTV Category

  27. Commercial Loans Do Not Exhibit the Same Pattern

  28. Debt Service Coverage Exhibits Little Systematic Relationship with Default

  29. Loan Pricing Exhibits a Very Strong Relationship

  30. 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

  31. 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

  32. 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

  33. 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

  34. 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

  35. 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

  36. 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

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