This article examines the process involved in pooling conduit loans and turning them into commercial mortgage backed securities (CMBS), with a focus on the role of the rating agency. You will learn about the risks and rewards of CMBS and be in a better position to analyze these financing options for your property. You will also discover the creation of CMBS only begins with the funding of a conduit loan.
Getting Into the Pool
The process of creating a CMBS transaction occurs after the origination of the loan(s) and is seamless to the borrower. Unlike local or regional banks that generally originate individual loans, conduit lenders originate loans for the express purpose of packaging them with other commercial loans of various sizes, property types and locations. Their goal is to ultimately sell the pool of loans as bonds.
To minimize the interest-rate risk associated with having loans on their balance sheet, a CMBS issuer will hold the newly originated conduit loans in its “warehouse” for only a few months, and will frequently work with other issuers to rapidly achieve the amount of loan collateral necessary to form a pool. On achieving the necessary critical mass, the issuer will transfer ownership of these loans to a legal trust through the use of a unique tax entity known as the Real Estate Mortgage Investment Conduit (REMIC).
As defined by the Tax Reform Act of 1986, REMICs can hold loans secured by real property without specific regulatory, accounting and economic obstacles. Without being taxed at the entity level, REMICs can distribute the cash flow from these loans to bondholders through the issuance of securities. This passive structure is designed to collect principal and interest payments of the pooled mortgages and redistribute proceeds to bondholders.
In the REMIC procedure, the sum of the mortgage pool’s principal and interest payments (the income stream) are sold as securities. By selling these securities—which have been heavily scrutinized and purposefully structured into specific risk classes—a market is created to efficiently distribute, price and quantify the risk associated with commercial real estate loans.
CMBS bonds are sold to institutional investors such as pension funds, insurance companies and even banks that originate these types of mortgages themselves. Once the loans are pooled and transformed into risk-adjusted classes of securities, investors view the financial instruments and their expected yield more like bonds than real estate loans.
The end result of this process is a very efficient cost of capital and liquid distribution mechanism for the loan originators. These efficiencies are ultimately returned to the borrower in the form of cheaper capital with better terms than whole loans, albeit with certain restrictions. This is why a property owner should conceptually understand CMBS before diving in.
What are Rating Agencies and What do They do?
Before CMBS transactions are created, there are several steps that must be taken for the newly created securities to be marketed to the investment community. SEC requirements mandate that all public securities must be rated by designated groups that have obtained status as Nationally Recognized Statistical Rating Organizations (NRSRO), better known as the rating agencies.
There are currently four companies in the United States with approved NRSRO designation: Dominion Bond Rating Service, Fitch Ratings, Moody’s Investor Service, and Standard & Poor’s. The rating agencies are a major part of the process of creating new issuance CMBS, and they have a significant influence on CMBS structure and pricing.
Rating agencies examine the aggregate pool of collateral contained in a proposed CMBS issuance and assign risk ratings and subordination levels to the bonds. They rate the bonds from highest to lowest, and according to their loss priority. The ratings assigned to the pool determine its composition and pricing structure, which is then used by the marketing agents to sell the bonds to institutional investors.
Once the rating agencies have assigned ratings to the CMBS issuance, the investors who buy these bonds select their purchases based on the level of credit risk and the yield they desire—the higher the risk, the higher the return. So what are the risks associated with buying CMBS, and how are they quantified by the rating agencies? A more thorough understanding of the ratings process and the structure of a CMBS transaction will help answer that question.
Loan-Level Analysis: Quantitative and Qualitative
Typically, rating agencies will not examine the entire pool of assets, but rather a representative sample, usually 60 percent to 70 percent of the mortgage pool. The sample is purposely chosen to provide the agency with a representative subset of loans by property type, location and balance for each contributor to the transaction.
In conducting quantitative analysis, the agencies re-underwrite the sample to determine an independent estimate of net cash flow for each loan. To accomplish this, each applies its own internal underwriting benchmarks to ensure appropriate credit standards are being met based on its criteria as well as other industry standards.
First, an agency scrutinizes the originator’s cash-flow projection to ensure underwritten revenue is based on market rents and is not overly aggressive when compared to historical property operations. It also ensures projected expenses and expense ratios are in line with market, historical and actual expenses. The agency then compares net cash flow for a given loan to the originator’s number to determine if a significant level of variance exists. It will compare the level of variance on the sampled assets by property type and may later “haircut” the originator’s cash flow on nonsampled loans within the pool.
Besides cash flow, agencies look at other quantitative loan factors and key indicators, such as loan-to-value ratios, debt-service coverage ratios (DSCR) and borrowers’ financial strength. In addition, they review all third-party reports used by the originator in making the loan to ensure no exception items are contained. These reports include, but are not limited to, the commercial appraisal, the environmental site assessment and property-condition reports. Additionally, the agencies apply a stabilized market capitalization rate to the adjusted net cash flow to make an independent determination of value.
It is also likely each agency will use its adjusted net cash flow and employ the use of a “standardized” loan constant (rather than the actual loan constant) to size the loan and determine “stressed” DSCRs, both at loan origination and the end of the term. A loan constant represents the percentage ratio between the annual debt service and the loan principal (annual debt service divided by the beginning loan balance equals the loan constant). The rationale for this analysis is to size the loan based on normalized interest rates, since interest rates fluctuate greatly over time.
For example, given the same net cash flow, a loan made on an 8 percent interest rate will have a substantially lower DSCR than the same loan made on a 5.5 percent rate. The use of a standardized stress constant allows the analyst and investment community to compare the loan on a relative basis to similar loans made over time. This benchmark analysis ensures debt will be able to refinance in a higher interest-rate environment.
Qualitative factors reviewed by agencies include items such as property location, market, property competition, borrower experience, property age and many others. The rating agencies also conduct physical site inspections of the sampled assets, focusing on the quality and competitiveness of the property in its market, as well as vacant land and new construction that may have a long-term impact on the subject property’s operation.
Structure and Ratings
The CMBS transaction’s monetary distribution generally follows a sequential payment structure commonly referred to as a “waterfall.” Each month, the entire sum of all principal and interest received by the trust is collected and redistributed to the bondholders, according to the predefined payment priority. specifically, those investors holding the highest rated bonds (typically AAA) are repaid first and receive principal and interest payments at a priority over lower-rated bonds.
In a typical sequential payment structure, all AAA-rated securities must be repaid in full before any lower-rated bond receives a principal payment. Once all of the accrued interest and principal on the highest-rated bonds have been repaid, principal payments start flowing to the next highest bond holders. This continues in sequence until all of the tranches are repaid, hence the waterfall analogy.
In the event of a default and an associated loss in the underlying mortgage(s), it is likely that there will be a shortfall of principal returned to the structure. In this case, the lowest- rated (or unrated) bond will suffer a loss. If the pool has many losses, the investments of the lowest-rated bondholders will continue to erode. If the losses are significant enough, the entire class of securities may eventually be eliminated, in which case the losses would start to erode the next lowest-rated class. In other words, investment returns are awarded from the top down, and losses are assigned from the bottom up.
After completing the loan-level analysis on the pool of assets, the rating agencies conduct a pool-wide analysis to assign subordination levels and determine the ratings allocation for the CMBS issuance. Assigning subordination levels is a complicated process in which the pool of loans is modeled and structured into specific classes of securities, and the risk of credit loss is disproportionately distributed among those classes. The end result is a credit-enhanced, senior-subordinated structure whereby the different classes of bonds carry different risk ratings and repayment terms. To reiterate, the return of principal is typically distributed top down, and losses are allocated bottom up.
The “subordination” (credit support) for a given class of bonds largely depends on how well protected a particular security is against the anticipated default loss. In general, the lower the credit qualities of the underlying mortgages that comprise the pool, the higher the required levels of credit support at equivalent credit-rating levels. Each of the four major agencies has a different procedure for determining subordination levels, but their end goals are similar as they attempt to model and estimate the credit loss that will potentially occur in the pool over the life of the bonds.
Final Product—Ratings and Presale Report
Once all of the analysis is complete and the rating agencies have assigned their respective subordination levels to the pool, they prepare and distribute a document to the investment community known as a presale report. This is a comprehensive document that presents the results of the agencies’ analysis. Among other things, it will:
- Present the pool’s composition by property type and geographical dispersion of the collateral.
- Offer a thorough analysis and write up of the pool’s largest assets by loan balance.
- Disclose any areas of concern or other factors discovered by the agency in conducting its pool analysis.
- Disclose the subordination levels and risk rating assigned to the CMBS, which will be used in the sale of the bonds.
Self-Storage Gets a Lane and Competes Well
CMBS pools contain all types of commercial real estate assets, including industrial, retail, multifamily, office, hotels, manufactured housing, healthcare and self-storage properties. Traditionally, the debt-service coverage stress levels, standardized loan constants and standardized cap rates used for self-storage loans have been more stringent than those applied to other property types.
Self-storage loans tend to have smaller balances compared to other assets, which may mean they are not as well researched and understood by lenders and the investment community. Since a lender does not know which loans are going to be scrutinized by the rating agencies, they underwrite and price self-storage loans in a range they believe will pass the agencies’ “stress” levels and internal guidelines and still allow him to make money on execution of the loan sale.
Self-storage loans generally comprise less than 3 percent of the total pool being securitized. According to Citigroup Global Markets, of the total universe of securitized loans, which currently totals around $302.9 billion, self-storage comprises a meager 1.6 percent, or $4.84 billion. Even more astounding is the fact securitized self-storage loans have historically had the lowest overall default rate of all property types: 0.57 percent compared to the average CMBS default rate of 2.4 percent (Rohit Srivastava, MIT Center for Real Estate). Some think this is attributable to the fact self-storage properties have been held to harsher standards than other property types. Proponents believe self-storage properties have historically been over-stressed due to the lack of empirical data available to support the industry.
Regardless, because of its excellent track record, conduit originators have taken note, and self-storage is becoming one of the more favorably priced property types. More than ever, lenders are pushing the stress levels on self-storage loans to new limits with cautious optimism and the hope they will not be negatively affected when the loans are scrutinized. Rating agencies and investors have also demonstrated willingness to listen to the selfstorage story and better understand the nuances of the industry.
CMBS Borrowers Awash in benefits
Over the past decade, CMBS have accounted for an estimated $60 billion annually, and consistently account for a significant component of the commercial real estate debt market. Securitized mortgages constitute the fastest growing category of commercial loans, increasing $15.6 billion in 2003 from the previous year.
The proliferation of the CMBS industry and conduit financing has taken commercial real estate financing to a new level. It has positively affected the capital markets by bringing increased liquidity to lenders and decreasing risk to investors of real estate mortgage debt. They are no longer forced to invest in whole loans, which carry concentrated risk.
CMBS subordination levels have also decreased dramatically in the past 10 years, leading to market entry and fierce competition among originators for conduit-loancollateral. In 1996, average subordination levels for investment-grade bonds BBB or higher was greater than 15 percent. This means a CMBS pool of $100 million dollars was tranched into roughly $85 million of investment-grade bonds and $15 million of below-investment-grade bonds. Today, deals are coming to market at investment-grade subordination levels of 5 percent or less, meaning that of that same $100 million dollar pool, $95 million is investment-grade collateral.
Keep in mind the inverse relationship between risk level and return: the higher-rated (low-risk) classes have lower coupons, and the lower-rated (high-risk) classes have higher coupons. As subordination levels have decreased over time, so too has loan pricing, which is a major benefit for self-storage owners who borrow conduit money. The reasons for these decreases are many, but the main driver is the positive historical CMBS performance.
The CMBS industry is evolving into a major source of financing for commercial real estate property owners, including those in selfstorage. The process of securitizing mortgages into bonds is self-policing and has inherent efficiencies that have been proven as the industry has evolved.
Conduit mortgages are a more practical and viable alternative than even before. As we head toward a potentially rising interest-rate environment, these loans may very well provide the ideal financing terms for self-storage borrowers who wish to finance properties at low rates for an extended period of time. Given these market conditions, expect more owners to jump into the conduit-financing pool and enjoy its benefits in the near future.
Neal Gussis is a principal and Shawn Hill is a vice president at Beacon Realty Capital Inc., a mortgage-banking firm that arranges financing for all types of commercial real estate and specializes in self-storage nationwide. For more information, call 310. 207.0060; visit www.beaconrealtycapital.com.