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A promising outlook: the quiet progress now evident on the commercial mortgage securitization front mirrors the early growth stages of the residential mortgage securities market.

A Promising Outlook

Compelling signs are emerging that the market for commercial mortgage securities may well be on the brink of significant growth. This market was virtually nonexistent five years ago. But in 1989, $3 billion of commercial mortgage securities were issued - a 25 percent increase over the $2.5 billion issued in 1988. By 1990, the annual volume of commercial mortgage securities is expected to reach $4 billion.

Although only a slice of the nearly $725 billion commercial mortgage market, the relative magnitude of growth in securitization could ultimately be as dramatic as that experienced in the residential mortgage market. In fact, the early periods of securitization in the two markets appear to be similar. Both resemble a classic life cycle pattern exhibited by many new products. This pattern reflects the three-stage evolution of inception, growth and maturity that is experienced by most new technologies.

In the inception stage, modest growth is achieved as vigorous efforts are made to refine and improve the technology so that it is more attractive in the marketplace. This was the case in the residential mortgage market in the early 1970s, and is likewise true for the commercial mortgage market today. Currently, 97 percent of the commercial market is financed conventionally and retained in lender investment portfolios.

In the second phase, as marketplace acceptance of the product increases, growth accelerates rapidly. In 1989, more than 35 percent of the net increase in residential mortgages were securitized. In little over a decade, securitized residential mortgages have become among the largest sources of capital in the world. As it now stands, 36 percent or approximately $861 billion of residential mortgage outstandings are securitized.

The marketplace acceptance of securitization is extending to non-mortgage assets as well. In the past two or three years, very active markets have developed for securities backed by credit card receivables, and automobile, equipment and consumer loans.

Clearly, securitization is one of the most exciting developments in the financial markets today. This article reviews the current status of the market for securitized commercial mortgages. It details how the increasing use of innovative capital market techniques by real estate developers and owners, as well as mortgage holders is making securitized transactions attractive alternatives to traditional mortgages.

Traditional vs. securitized

Commercial mortgages are typically negotiated one-on-one between the lender and the borrower. This often laborious process produces terms that are tailored to a particular transaction. A small number of lenders have long dominated the commercial mortgage market. Commercial banks were the traditional source for construction loans, while life insurance companies and thrifts provide funding for permanent loans. As of July 1989, banks held 46 percent of outstanding commercial mortgages, while life insurance companies and thrifts held 26 percent and 18 percent respectively for a total of 90 percent of the commercial mortgages outstanding.

The market for these mortgages has grown rapidly. During 1989, approximately $155 billion of commercial mortgages were originated - more than four times the number in 1982. Today, the commercial mortgage market, with some $742 billion of commercial mortgages outstanding, is rivaled in size by few others.

When a single commercial mortgage (also called a whole loan) or pool of commercial mortgages is securitized, it is packaged, underwritten and sold in what are commonly known as asset-backed securities. These asset-backed securities can be issued and traded in public or private capital markets. The principal intermediaries for these transactions are major investment banking firms.

Unlike traditional mortgages, securitized mortgage transactions can be creatively and flexibly structured to appeal to a wide range of investors. For example, in a recent $200 million securitized financing for the new Marsh & McLennan Companies headquartered in New York City, the securities were offered to 112 eligible institutions. Thirteen of these made individual purchases in amounts ranging from $2 million to $70 million.

Investors in these financings are insurance companies, commercial banks and thrifts as well as pension funds and corporate purchasers. Institutional investors in Europe and Japan are increasingly active in the U.S. securitized commercial mortgage market.

Benefits of securitization

Securitized transactions enable property owners and developers to raise funds at lower cost, gain improved access to capital and raise larger sums of capital. Existing mortgagees are using securitization as a means to realize the present market value of their mortgage and mortgage-related assets without selling those assets and experiencing certain unwanted tax and accounting obligations. Through securitization, existing mortgage holders may also meet capital requirements and attain a better match of their assets and liabilities. Both groups of issuers are able to diversify their funding sources through securitization.

For the real estate developer and owner, yields demanded on whole commercial mortgages traditionally have been higher than for other types of corporate loans of comparable creditworthiness. The relatively high cost of commercial mortgages is attributable to a variety of factors. Most notably, the expensive underwriting process, the perceived riskiness of real estate loans, the limited liquidity of the commercial mortgage secondary markets and the narrow universe of lenders willing and able to accommodate large loan amounts all have a bearing on financing costs. Other contributing factors are the non-recourse nature of most commercial mortgages, the limited ability to apply capital markets technology to the traditional commercial mortgage structure and prepayment risk.

The typical measure of a loan premium is the spread between 10-year conventional mortgage rates and 10-year U.S. Treasury securities. From 1983 through the first quarter of 1989, this spread fluctuated between approximately 277 and 100 basis points on a semi-annual basis. Even though commercial mortgage spreads have declined significantly, they have been relatively wider than for equivalent-risk corporate bonds for at least the past 10 years. In recent months, the spread on commercial mortgages has been about 50 basis points wider than spreads for a single. A-rated corporate security placed in the private debt market. The credit quality of the latter security is comparable to a very high-quality commercial mortgage.

Because mortgage interest is generally the largest expense facing owners of commercial properties, obtaining lower-cost financing is particularly important in today's slower development and construction climate. During a 10-year period, a savings of 50 basis points on a $100 million securitized mortgage results in total savings of approximately $5 million.

Even with the same rate of interest, the all-in fixed cost of a securitized transaction can be substantially less than for a traditional commercial mortgage.

Moreover, the premium paid by issuers for a mortgage-backed security should continue to decline in comparison to a traditional loan as the investor market expands and becomes more liquid. This can occur even though the underwriting costs for a specific transaction increase with the size of the offering.

Improved access to capital

Sometimes, real estate developers and owners have difficulty finding commercial mortgage lenders offering an acceptable interest rate because of the perceived riskiness of commercial real estate loans. Relatively few lenders have the experience and skill needed to assess the real risks of the underlying property. Given the substantial capital commitment required in many commercial mortgages and the fact that most are non-recourse, there is a considerable need for such evaluation and understanding.

An additional complication that must be considered is the uniqueness of each commercial property. The lender must analyze a host of complex variables, including cash flow from the property, the market in which the property is operated, the location, historic and current occupancy rates, rent levels, leases, experience of the management, seasoning of the project and environmental hazards.

The perceived risk of commercial mortgages is compounded by the relative lack of liquidity in the commercial mortgage market. Secondary markets for commercial whole loans, while developing are not yet fully efficient.

By allowing issuers to creatively structure offerings that appeal to diverse groups of investors, securitization can open other doors to capital. A securitized mortgage can be sold in units as small as $1 million, making the investment more suitable for investors desiring a diversified investment portfolio than a traditional mortgage. Smaller investment units and the globalization of capital markets has greatly widened the potential investor base for securitized commercial mortgages.

Although the securitized market is in the formative stage, investor interest in commercial mortgage securities is enhanced by the liquidity available in an increasingly active secondary market. As the market expands, it will undoubtedly parallel other major corporate securities markets, becoming more liquid for investors and less costly for issuers.

Access to capital can be further facilitated in securitized transactions through the use of such standard capital markets tools as bond rating and credit enhancement. Both of these tools, which are discussed elsewhere in this article, effectively reduce the perceived risks of investment in commercial mortgages and lower the cost of funds.

Accommodating larger issuers

The same factors limiting access to capital for real estate developers and owners in the traditional commercial mortgage market restrict the amount of capital that can be raised in that market. Few lenders have the ability or willingness to finance the large loans that many real estate developers and owners require.

A securitized transaction, by appealing to multiple investors, makes more feasible even very large issues. A compelling demonstration of this was a transaction structured for Rockefeller Group, Inc. In this case, three distinct securities were used that appealed to the most efficient market for each type of investor - those in the U.S., Europe and Japan. The aggregate amount of $1.3 billion raised through these issues represented the largest real estate financing ever done. Indeed, it was larger than all but a few corporate debt issues at the time. It is inconceivable that a lender offering a traditional, whole loan mortgage could have funded this dollar amount.

Benefits for pool holders

The flexibility and creativity that can be built into securitized transactions can equally benefit institutions holding pools of existing, whole, commercial mortgages. Depending on how the transaction is structured, securitization can help accomplish the following objectives: * Portfolios can be restructured to accomplish

the following: reduce the

average life of a commercial mortgage

portfolio; eliminate

concentrations in a commercial

mortgage portfolio; increase revenues

by taking advantage of the

yield curve; better match assets

with liabilities; create tax losses

or realize profits; and increase the

issuer's net worth ratio to assets. * Tax and accounting objectives can

be met by selling commercial mortgage

pools as securities that can

qualify for "sale of assets treatment"

for both tax and accounting purposes,

or for tax purposes only. * Proceeds can be maximized for

high-quality mortgages to provide

nearly 100 percent financing of

mortgage assets. * Cash flow can be reallocated to create

securities with different


Growing receptivity among investors

A broad base of investors are becoming more and more receptive to securities backed by commercial mortgages. This in turn, has been a key factor prompting real estate developers, owners and mortgage holders to undertake securitized transactions. Utilizing various capital market techniques, issuers can structure securities that are appealing for a number of reasons. * The securities can provide higher

yields than similar corporate securities

of similar risk. As mentioned

earlier, in the current market environment,

investors in AAA-rated

mortgages can earn spreads that

are as much as 50 basis points

higher than are available from similarly

rated corporate securities. * The investment quality that is required

by pension plan sponsors and

other fiduciaries to meet investment

criteria can be achieved through ratings

and credit enhancements. * The securities are secured by a

first mortgage lien on the real estate

and an assignment of the

property's leases and rents. By

comparison, a typical corporate

bond is generally an unsecured

obligation of the issuer. * The issuer and investor are remote

from bankruptcy problems. Even if

a property owner defaults, the investor

can expect to receive the

appropriate payment, because the

securities are secured by a first

mortgage lien on the real estate

and an assignment of the property's

leases and rents. * There is safety from event risk. The

securitized commercial mortgage

market is relatively immune to the

risk that the high credit quality of

an issuer's outstanding debt could

suffer if the issuer became the target

of a leveraged takeover

attempt. This is because a takeover

cannot disturb the first priority of

the mortgage lien. * The flexibility to meet asset/liability

preferences allows the matching of

duration and other kinds of portfolio

characteristics. * There is often prepayment

protection, which provides more

certainty in regard to cash flow timing.

This is accomplished through

prepayment lock-out clauses or

penalties at the mortgage level. * Portfolio diversification by property

type, geography and quality can be

accomplished by buying and selling

mortgage securities in the secondary

market. * Improved information flow, an accompanying

development of rated

real estate transactions, makes it

easier to analyze mortgages and facilitates

secondary market trading.

Forces driving securitization

The momentum that is building in the market for securitized commercial mortgages stems, in large measure, from four key developments: ratings, credit enhancement techniques, interest rate swaps and the availability of alternative structures for securitizing pools of commercial mortgages.

In the securitized commercial mortgage market, as in the conventional corporate bond market, ratings are an essential means of reducing financing costs. Ratings also allow investors to evaluate the risks and rewards of investment alternatives. Standard and Poor's Corporation (S&P) introduced the first rating system for commercial mortgage securities in late 1984, followed by Moody's Investors Service and Duff & Phelps. Among them, these rating agencies cover a range of commercial properties. Their ratings are based on the probability that investors will be paid in full and on time. To rate a particular security, they evaluate and analyze properties, leases, market condition, loan documents and so forth.

The first single-property securitized, mortgage financing to receive a AAA-rating from all three rating agencies was for The Village at Corte Madera, a retail property in Marin County, California. This 1988 transaction involved the private placement of $40 million in mortgage bonds secured by retail property. The bonds were distributed by both traditional mortgage lenders and by investors in traditional corporate securities.

The transaction enabled the owners, The Hahn Company and JMB Realty Corporation, to raise non-recourse debt at a lower cost than was available in the traditional mortgage market. They achieved other objectives as well, such as broadening their financing sources, keeping substantial operating control of the property and obtaining superior prepayment and transfer provisions. The success of this transaction provides more concrete evidence of the potential benefits of commercial securitization.

Letters of credit and other credit


Credit enhancement is a requirement of the rating process for securitized mortgages when there is uncertainty that the mortgaged property can produce enough cash flow to meet the payments on the securities under all economic conditions. The most common enhancements in securitized transactions are letters of credit (LOCs) and surety bonds, the senior/subordinated structure and tenant (i.e., lease-related) credit support. For mortgages secured by pools of properties, cross-collateralization of the underlying properties is another enhancement device.

The number of rated financial institutions willing to provide LOCs on a fee basis for commercial mortgage securities has increased significantly in recent years. These include U.S. as well as Japanese and other international banks. In fact, many rated transactions have included blanket third-party guarantees covering all payments to investors. These guarantees expedite the rating process and minimize enhancement costs.

In a LOC structure, investors look solely to the third-party credit enhancer for their payments with no direct recourse to the issuer of the security; eliminating the property owner's risk. A separate agreement is made between the guarantor and the issuer to protect the guarantor's interests. (It should be noted that in some transactions, LOCs are used to provide partial rather than 100 percent credit support.) Surety bonds provided by creditworthy insurance companies have the same effect as LOCs by upgrading and clarifying the credit quality of one or more commercial mortgages.

The first U.S. public offering of LOC-backed notes for real estate was executed by International Business Machines Corporation (IBM) and White-Southbury Associates Limited Partnership in 1987. The financing raised $278 million of non-recourse construction and permanent financing for the IBM corporate office complex in Southbury, Connecticut. The notes, secured by a LOC issued by the Mitsubishi Trust and Banking Corporation, received a Aaa rating and provided a more cost-effective means of raising capital than traditional mortgage financing alternatives available at the time.

The senior/subordinated structure is commonly used when the credit rating of a mortgage issuer is such that other forms of credit support can only be obtained at a prohibitively high cost or not at all. For instance, a LOC may not be obtainable because the mortgages may include adjustable rates or negative amortization. Those features make it difficult for the LOC issuer to assess the potential credit risk over an extended period of time.

The senior/subordinated structure incorporates two classes of securities: the senior class which is credit enhanced, and the subordinated class which constitutes all or part of the credit enhancement for the senior class. The senior class has a priority in the distribution of cash to pay interest and principal, and benefits from an over-collateralized position. For example, in a 90/10 structure, each dollar of senior notes is backed by $1.11 of collateral.

Credit support for the senior securities can also be provided by a reserve fund set up by the issuer and may occasionally include a supplemental insurance policy or guaranty as well. As in other senior/subordinated corporate issues, the amount of interest paid reflects the amount of risk the investor is willing to take. Therefore, the senior class pays a lower interest rate than the subordinated class.

The senior/subordinated structure was used in 1987 by Philadelphia-based Meritor Mortgage Securities Corporation in the first publicly registered and rated issue of commercial mortgage pass-through securities. This transaction is discussed in the subsequent section.

A property owner using tenant credit support enhances the credit rating of a mortgage security by contracting with a creditworthy tenant whose lease represents a significant part of the cash flow of the property underlying the security.

In one example, The Kroger Company recently used a senior/subordinate structure to refinance $612.5 million of bank debt. The total proceeds represented 90 percent of the appraised value of the underlying real estate. The senior debt was issued through a special purpose corporation, guaranteed by a financial guarantor and rated AAA. The financing allowed Kroger to lower its cost of debt by 200 basis points, lengthen maturities from five to fifteen years, retain control of its stores and maximize the mortgage proceeds.

This technique was also used for the Marsh & McLennan corporate headquarters financing. The $200 million in non-recourse debt was raised at a cost that compared very favorably with the direct financing alternatives available to Marsh & McLennan at the time. The notes, secured by a net lease and the property, received AAA ratings.

Security for investors may also be obtained through a cross-collateralization agreement with the issuer. Such an agreement stipulates that if one property is in default, the shortfall in payments to the investor is made up for by other properties owned by the issuer.

Commercial mortgage pools

Holders of pools of whole commercial mortgage loans can benefit in various ways from securitizing their assets. They may structure different types of securities that are secured by a pool of commercial mortgages and are rated using the full gamut of credit enhancement techniques. The most common structures are commercial mortgages pass-through certificates, commercial mortgage-backed bonds and collateralized mortgage obligations (CMOs).

Depending on which structure is used, the securities can represent ownership interests in the underlying commercial mortgages or obligations of the issuer. When the securities represent ownership interests, the issuer typically "pays through" to investors the interest and principal payments made on the underlying pool of mortgages. When the securities represent obligations of the issuer, investors typically receive a fixed-rate of interest on the mortgage bonds. This structural diversity gives holders of commercial mortgage pools considerable flexibility in developing issues that meet their specific financial requirements.

In the Meritor financing already noted, $213 million was raised by issuing commercial mortgage pass-through securities. This transaction also enabled Meritor to diversify and rebalance its portfolio. A senior/subordinated structure was used to issue three classes of senior certificates that are AAA-rated. Meritor obtained better pricing than it could have by selling whole loans.

Growth outlook

There are good reasons to anticipate that securitized transactions will account for an ever greater portion of the commercial mortgage market. One reason is the advanced state of securitization in the residential mortgage market. The market for securitized commercial mortgages has benefitted a great deal from the residential security market. It has applied much of the capital markets technology that catapulted the securitization of residential mortgages to the commercial side. All signs point toward similar patterns of growth.

In fact, the innovative application of ratings, credit enhancements and structuring techniques has solved many of the obstacles to commercial mortgage securitization. The one major challenge remaining is the diversity of commercial real estate and the effort required to establish the value of the properties underlying the securities. As the rating agencies gain experience in these transactions and refine their evaluation systems, this should become less of an area of concern. Further, investment banks and other intermediaries that advise in these transactions should be able to provide in-depth research and transactional experience that can aid significantly in the rating, credit enhancement and structuring processes.

The advantages already demonstrated for issuers and investors of securitized transactions as compared with traditional mortgages will undoubtedly add to the momentum that is building in the market. The ability to lower financing costs, broaden funding sources, raise larger amounts of capital and restructure portfolios, among many other benefits, are powerful inducements for real estate developers and owners and mortgage holders. Increasing liquidity, comparatively higher yields, investment quality and other attractive features are expanding the investor base to include pension funds and other large institutional investors that have until now not been active in this market.

Growth of the securitized mortgage market will also be spurred by external catalysts. With financial institutions placing increased emphasis on obtaining optimal value for their stock, they are focusing greater attention on boosting return on equity. The securitization of corporate real estate assets can be an effective means of achieving this objective. For commercial banks, thrifts and other mortgage holders, stricter capital adequacy guidelines are providing an incentive to securitize mortgage portfolios to rebalance assets and liabilities. Many banks are reducing commercial mortgage holdings in order to free up precious regulatory capital.

Indeed, one single bank, Chase Manhattan, stated that "[in 1989, Chase] placed more mortgage money than any other bank in the United States - approximately $2 billion." In the final analysis, securitization is a new financial technology that is still relatively in its infancy.

Thomas J. Healey is a general partner at Goldman, Sachs & Co. He is responsible for all commercial mortgage activities in the firm's real estate department. He was formerly assistant secretary of the Treasury for domestic finance. The author wishes to thank William B. Brueggeman, Richard Baxter, T. Sheldon Chang and Darcy Troy for their contributions to this article.
COPYRIGHT 1990 Mortgage Bankers Association of America
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Author:Healey, Thomas J.
Publication:Mortgage Banking
Date:Jul 1, 1990
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