Commercial mortgage loans

and fund sources

Real Estate Principles: A

Value Approach
StevenGlazeKansasCity
Outline
Legal foundations
Mortgage products
Application and underwriting
Equity capital
Mortgage loan
In a mortgage loan, the borrower always
conveys two documents to the lender: (1) a
note, and (2) a mortgage.
The note details the financial rights and
obligations between borrower and lender,
e.g., whether a loan can be paid off early and
at what cost, what fees can be charged for
late payments, etc.
The mortgage pledges the property as
security for the debt.
The note
As in residential mortgage financing, the
note is the document used to create a legal
debt.
The note often deals with (1) amounts and
timing of periodic payments, (2) penalties for
late payments, (3) record keeping, (4)
hazard insurance requirements, (5) property
maintenance, and (6) default.
The mortgage
Again, the mortgage comes with the
note.
The commercial mortgage ensures that
lenders can have the property sold to
satisfy the debt if borrowers default.
Overall, commercial mortgages and
notes are not as standardized as home
loans.
Balloon
A commercial mortgage loan is usually a partially
amortized fixed-rate balloon mortgage.
25 to 30 year amortization of principle.
5 to 10 year maturity.
Balance of loan at maturity must be refinanced or
paid off with a balloon payment.
Balloon loans reduces the lenders interest rate risk
because of the short loan term of 5-10 years.
Balloon example, I
A 30-year amortization schedule and a 5-year,
$5 million mortgage, at 5.56%
(5.56%/12=0.4633%) stated rate.
The monthly payment is: -5,000,000 PV; 360 N;
0.4633 I/Y; CPT PMT = $28,577. This relative
low payment makes the loan affordable.
The final, balloon payment at the end of the 5-
year contract is: 300 N; 0.4633 I/Y, 28577 PMT;
CPT PV = -4,626,716.
Balloon example, II
Suppose that the market interest rate jumps from 5.56%
to 6%(6%/12=0.5%) immediately after origination of the
loan (interest rate shock).
The PV of the 5-year loan goes from $5 million to: 60 N;
28577 PMT; 4626716 FV; 0.5 I/Y; CPT PV = -4,908,280*.
If this were a typical 30-year fully amortized (FV = 0)
contract (not a 5-year balloon one), the PV of the loan
goes from $5 million to: 360 N; 28577 PMT; 0 FV; 0.5 I/Y;
CPT PV = -4,766,404**.
* is closer to $5 million than **. So, the balloon loan is
less sensitive to interest rate shocks.
Restrictions on prepayments
Most fixed-rate commercial mortgages
do not allow for prepayment. 2
mechanisms: (1) lock-out, and (2)
penalty.
Lock-out: prohibition against
prepayment for up to 5 years.
Prepayment penalties, e.g., 2-4% of
loan balance.
Alternative financing
Floating-rate loans (or I/O loans)
Just like ARMs in residential mortgages.
Based on prime rate or LIBOR (London
Interbank Offer Rate).
Joint venture
Sale-leasebacks
Mezzanine financing
Joint venture
Usually between a developer (with local
knowledge) of a large project and a:
Pension fund.
Life insurance company.
REIT.
The funding institution provides (1)
construction financing, (2) long-term
mortgage, (3) equity capital, or (4) a
combination of them.
BTC redevelopment
Devonwood Investors, LLC bought BTC for $25
million in 2013.
Redevelopment permit was obtained in March
2017.
Joint venture with Rouse Properties, a REIT, in April
2017.
Redevelopment costs: $225 million. So, total cost
is about $250 million.
About 60% financed by debt: about $150 million
debt, $100 million equity.
Sale-leaseback, I
Property user (initial owner) sells property to a long-term
investor, e.g., a pension fund, REIT, or life insurance
company.
User leases property back from the investor and occupies it
under long-term net lease.
Triple net lease (nnn): a lease in which tenants are
responsible for all 3 major categories of ongoing expenses:
property tax, insurance premium, and maintenance.
Net lease (single, double, triple): one or more of the 3
major categories of ongoing expenses is the responsibility
of the tenant.
Sale-leaseback
User benefits:
Lease payment is deductible for income taxes.
Equity capital is freed up to invest in core
business of company.
Restructure capital structure.
Investor benefits:
Can be safe investment (depending on credit
worthiness of tenant and contract length).
Inflation hedged (especially if lease payments
increase with inflation).
Mezzanine financing
Mezzanine debts are supplements
underlying first mortgage debt.
Mezzanine debt is often a non-
mortgage loan secured by a pledge of
ownership shares.
If borrower defaults, lender takes over
the borrowers ownership position.
Loan application package
1. Loan request application: the amount
request, borrowers financial statement,
credit report, etc.
2. Property description: map, photo, etc.
3. Legal aspects: precise, legal description
of the property, deed restrictions, etc.
4. Cash flow estimates: pro forma, DCF
analysis, etc.
5. Appraisal report.
Commercial underwriting
Lenders focus more on the income-
generating ability of the property. Recall that
in residential underwriting, lenders focus
more on applicants characteristics, e.g.,
creditworthiness and ability to pay).
Lenders must perform a due diligence to
determine, essentially, that potential
borrowers have not misrepresented the
properties in any way.
Loan commitment: if ok, 45 to 90 days after
receipt of package.
Other debts
Land acquisition financing: finance the
purchase of raw land.
Land development loan: finance the
installation of improvements to the
land (sewers, utilities, etc.).
Construction loan: finance the
construction of building.
Duration of debt
In general, short-term debt is cheaper
than long-term debt.
Thus, firms have incentives to use
short-term debt to finance long-term
properties and assets.
This dangerous practice is
characterized by maturity mismatching.
Broadway Partners faces the
music on short-term debt
Broadway, a closely held New York-based office
investor, bought several billion dollars of property
with short-term debt near the top of the market in
2006 and 2007. When real estate markets sized up
last summer, Broadway was suddenly put on
defense and is now trying to shore up its finances.
New York tycoon Harry Macklowe, unable to
refinance $7 billion in short-term debt, has agreed
to five his lenders the keys to 7 Manhattan towers.
Source: WSJ, Apr. 23, 2008.
Sources of commercial RE debt

Commercial banks
Thrift institutions
Life insurance companies
Mortgage bankers
Commercial MBSs (CMBSs)
A commercial banks
commercial mortgage menu
Wells Fargo Commercial Mortgage offers a full line of commercial
mortgage lending and servicing solutions to middle-market investors
and developers across the nation. With a full suite of products and
services, we can serve virtually any commercial real estate need.
Permanent Debt Finance Non-recourse (secured), fixed- and
variable-rate financing on income-producing properties.
Construction & Project Finance Construction, interim, and mini-
perm financing; construction loan advisory services; and Freddie Mac
multifamily financing to middle-market investors, developers, and
commercial banking customers.
Commercial Mortgage Servicing A full range of commercial
mortgage backed securities (CMBS) loan servicing for third-party
institutional investors, government-sponsored agencies such as
Freddie Mac and Fannie Mae, investment banks, life insurance
companies, and other financial institutions.
https://www.wellsfargo.com/com/realestate_fin/cmo/
Equity financing
Investors can hold equity shares in
commercial RE through either (1)
direct private investment, or (2) RE
securities.
RE securities can be issued in either
(1) private markets or (2) public
markets, e.g., NYSE.
Direct private investment
Individuals (families) can surely invest in commercial
real estate, say owning an office building in
Manhattan.
Pension funds, public funds (e.g., Alaska Permanent
Fund), life insurance companies, and other
institutional investors participate in direct private
investments as well.
However, most of direct private investments are
owned by syndicates.
A syndicate is a group of persons or legal entities who
come together to carry out a direct RE investment.
Syndicate
RE syndicates are usually organized as
limited partnerships (LP) or limited liability
companies (LLC).
Limited partnership:
Taxed at individual level (so no double taxation).
Limited liability for some of the partners.
Limited liability company:
Limited liability for owners.
No double taxation.
Syndicator
Syndicator organizes the investors and
manages the activities of the enterprise.
Usually a well-known RE businessperson in
a local RE community.
Syndicator is general partner (GP) in LP or
managing member in LLC.
Develop concept; raise money; acquire RE;
professional management; disposition.
Syndication regulation
Under Federal Securities Acts of 1933 and
1934, all RE syndications are securities.
All securities are subject to federal and state
securities laws.
SEC has responsibility for administering
federal securities laws:
All offerings are registered with SEC, unless exempted.
Every state also has securities laws.
RE securities: REITs
RE securities have became
increasingly important over time.
Among RE securities, real estate
investment trusts (REITs) are the
dominant form of equity financing.
The growth: REIT $ offerings
Listing status
Public, listed REITs
Public, non-listed REITs
Private (non-listed) REITs
REIT status
REITs are pass-through public
corporations.
REITs are not taxed at the corporate level if:
At least 100 shareholders.
At least 75% of assets in RE, cash, or
government securities.
At least 75% of gross income comes from RE
assets.
90% of REIT taxable income must be paid out in
dividends each year.
Benefits being REITs
REITs are kind of like closed-end
mutual funds for investing in real
estate.
Diversification benefits.
Liquidity, thus higher RE values, if listed.
REIT types
Equity REITs
Office
Retail
Industrial
Hotel
Health care
Apartment
Self-storage
Non-traditional
Mortgage REITs
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