Chapter 17 Sources of Funds for Commercial Real Estate Properties © OnCourse Learning

Chapter 17

Sources of Funds for Commercial Real Estate

Properties

© OnCourse Learning

Chapter 17 Learning Objectives Understand the sources of funds that support the development and purchase of

real estate

Understand the difference between debt and equity sources of funds

Understand how different institutions specialize in either debt or equity financing, or in financing different types of real estate

Understand how government regulations affect real estate investment decisions of financial institutions

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Debt Financing of Residential Real Estate

Depository institutions – largest private institutional holders of residential mortgage debt (26% of all debt)

GSEs (Fannie Mae and Freddie Mac)

Agency and GSE Pools

Credit Unions

Flow of Debt Funds

Institutions invest in real estate by either lending directly or by purchasing debt obligations from another originator

The holder of the securities is the ultimate source of funds

Mortgage brokers originate mortgages solely for sale to other investors

For a particular institution the following relationship holds:

Originations + Purchases = Gross Acquisitions – Sales

= Net Acquisitions – Repayments

= Net change in holdings


Important Features of Flow of Funds (2007 – 2012) Decline in holdings of mortgage debt in single family

properties Drop in GSEs holdings due to government mandates to

reduce their role in the secondary mortgage market Decline in the value of the existing mortgages due to

defaults, foreclosures and REOs

This trend should reverse post 2012 as the housing market continues to recover


Sources of Commercial Debt

Life Insurance Companies

Commercial Banks

Savings Institutions

Commercial Mortgage-Backed Securities


Commercial Mortgage Backed Securities (CMBSs) Backed by commercial mortgages

May be backed by a single, large property or by a mix of mortgages on different property types in different geographical locations

Provide liquidity through a secondary market mechanism


Risk of CMBSs Riskier than residential MBSs

Lack of the mortgage insurance that residential mortgages have (FHA and VA insurance)

Difficulty in evaluating risk of underlying properties, due to a mix of mortgages on various properties

Financial ratings by Moody’s and S&P. Assign first quality ratings (QR) of A, B, C, D or E based on financial factors (LTV, DSCR, etc.),

qualitative factors and type of the property

Assign final rating based on economic strength of state and city where the property is located


CMBSs with Tranches Tranches with different maturity and credit risk Risk of default may go first to the residual class, then to the last

security, then to the next-to-last security, etc. The least risky class of security is rated highest by the rating

agencies and carries the lowest interest rate Pool insurance to cover losses from default “Profit” by the conduit if the weighted average of rates paid on

the securities (including premium for pool insurance) is less than the interest received on the underlying mortgages of the CMBS and there is not a significant amount of default accruing to the residual class


Commercial Loan Securitization

Key to acceleration is standardization of the underlying assets: Standardized loan documents

Extended amortization beyond the “bullet” loans of 5 to 7 years

Establish minimum debt service and LTV ratios

Establish a prohibition of prepayment for some standard initial period


CMBS – The Securitization Process


Example of Security Creation - CMBS


Trends in CMBS Financing

2007 peak year of CMBS issues

Significant increase in the default rate on CMBS during the downturn

Reluctance of investment bankers to issue and investors to purchase new CMBSs.

CMBS holders represented 22% of the total commercial loans in 2010.

As the real estate market continues to recover the role of CMBSs in financing commercial real estate will continue to increase.


Equity Financing in Commercial Real Estate Equity positions through direct investment or indirect investment

Indirect investment: Real estate limited partnerships (RELPs) or real estate investment trusts (REITs)

Tax Act of 1986 makes partnerships less attractive


Institutional Investors in Equity Real Estate Life insurance companies

Primary role is providing debt financing

Pension Funds

Defined-contribution vs. defined-benefit plans

Commingled funds include investments by several firms or groups


Pension Funds Defined-contribution and defined-benefit plans Defined-benefit plans

The largest of the pension funds in terms of amount and number

Reluctant to invest in real estate –due to low liquidity of real estate


Pension Fund Restrictions

Employee Retirement Income Security Act (ERISA, 1974) designed to protect the integrity of pension funds Funds must invest as “a prudent man”

Funds must diversify their portfolios

Does not restrict types of real estate

Pension funds exempt from paying federal taxes, but prohibited from engaging in business not related to their primary purpose Unrelated business income tax (UBIT)

Must comply with the fractions rule in leveraged real estate through a partnership where at least one of the partners is not a QQ


Trends in Pension Fund Investment in Real Estate Increased pension fund investment in real estate FASB-87 limits the range in the discount rate that the

companies can use to determine their pension liability and requires the unfunded portion of the liability to be recorded on the company’s B/S Encourages pension funds to invest in real estate


Public/Private Partnerships

Local governments provides land, money, grants, subsidies, or other resources to private developers

May be low interest loans from tax-free bonds

Designed to serve community needs

Some restrictions by federal tax regulations


Documents

Chapter 17 Sources of Funds for Commercial Real Estate Properties © OnCourse Learning