With Jimmy Stepanian

Legal foundations Mortgage products Application and underwriting Equity capital

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.

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.

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.

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 lender’s interest rate

risk because of the short loan term of 5-10 years.

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.

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.

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.

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

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.

“General Growth Properties Inc., the second largest mall owner, is shopping its portfolio to potential joint-venture partners as it scrounges for capital to pay off $18.7 billion of debt coming due over the next 4 years.”

“At the height of its buying binge in 2004, General Growth financed nearly all of its $12 billion purchase with debt.”

General Growth’s debt binge has left it with a debt-to-capitalization ratio of 66%, well above those if its peers (38-48%).

“The company is approaching pension funds and life-insurance companies to first determine if they are interested in a deal before hashing out which properties would be involved.”

Source: WSJ, Apr. 16, 2008.

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.

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).◦ Inflation hedged (especially if lease payments

increase with inflation).

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 borrower’s ownership position.

1. Loan request application: the amount request, borrower’s 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.

Lenders focus more on the income-generating ability of the property. Recall that in residential underwriting, lenders focus more on applicant’s 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.”

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.

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, 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.

Commercial banks Thrift institutions Life insurance companies Mortgage bankers Commercial MBSs (CMBSs)

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/

In 2007, Blackstone Group completed a huge deal: the $26 billion leveraged buyout of Hilton Hotels Group.

The equity was $6 billion and the debt was $20 billion.

“The Hilton deal already has proved painful for the 7 banks that provided the financing…as they still are struggling to sell pieces of the debt.”

“Some analysts believe much, if not all, of that equity has been wiped out, at least on paper.”

Source: WSJ, Nov. 05, 2008.

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.

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.

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 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.

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 have became increasingly important over time.

Among RE securities, real estate investment trusts (REITs) are the dominant form of equity financing.

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Public, listed REITs Public, non-listed REITs Private (non-listed) REITs

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.

REITs are closed-end mutual funds for investing in real estate.◦ Diversification benefits.◦ Liquidity, thus higher RE values, if listed.

Equity REITs◦ Office◦ Retail◦ Industrial◦ Hotel◦ Health care◦ Apartment◦ Self-storage◦ Non-traditional

Mortgage REITs