The Role of Commercial Mortgage Backed Securities, Coursework Example
A 300,000 SF office building in a CBD that can be purchased at an unlevered 6% capitalization rate. You’re not sure if it’s a bit pricey, and you will have to finance it within six months and lever the return to meet your goals. You may assume that the due diligence has been done and you are satisfied that the property is appropriate for the fund. The property is “in transition” with one-third of the leases expiring within two years and another third in five years.
Investing in this property is essentially a capital markets investment. The capitalization rate represents the receivable cash flow yield the investor acquires when a building is purchased without a mortgage. Cash flow from levered assets first go to the mortgage with the investor receiving what’s leftover, but since the property will have to be financed
The fact that the property is a CBD, means it’s located in a central business district and this could make the property much more valuable as an investment if any portion of the building is utilized for different services such as retail, while another part serves as an office for a reputable business. As the company is well versed in the benefits of diversification, it makes sense that owning a building in a central city location downtown, with multiple uses might be appealing. I think this is a risky but promising investment. The reason this is a risky investment is that the case states that I am satisfied the property is “appropriate for the fund,” but the case can in no way guarantee that the property will continue to be appropriate as this is not a standard property.
The building is financed under a bridge loan, which is a type of hard money loan where approval guidelines are delegated based more on the property value as opposed to the applicant’s credit. This is why the case states that the property is in transition, because bridge loans represents a transition between mortgage types. This means the one third lease expiring within two years and the other third lease which expires in five years suggests the appraised value of the property can fluctuate and change significantly depending on its final real value when the property is completed or improved upon during the transition or it can suffer substantially due to a potential financial crisis or unexpected environmental hazard such as a hurricane or earthquake. One major con to this particular investment is that as a capital market investment it’s vulnerable to fluctuations in the capital markets, both global and domestic. This means such a short term loan can harbor more volatility and chance of loss of the initial investment but it can also pose a greater return. Due to the fact that the money being investment is essentially all disposable income that will pose no great impact to the portfolio as a whole and it satisfies the initial objective of the case to balance the portfolio through a real-estate investment, I recommend investing in this property as opposed to investing in the other opportunities.
Some of the main reasons why I believe investing in this the purchase of this CBD is sound investment has to do with the vast potential it poses in regards to bringing in returns. CBDs tend to have multiple uses with office buildings located on the higher floors, while retails stores or service outlets are located on the main floor. This factor combined with the prime downtown location of the facility puts it in the position to be in high demand for businesses that might want to rent out the space.
A portfolio of CMBS bonds issued in 2007- the A4 tranche’s yield is currently 3.5%, with the bonds maturing on or before 2017 and rated AAA. The properties backing the bonds are located all over the country and include office, multifamily and retail.
CMBS stands for commercial mortgage backed security. CMBS as are created through the process of lumping a group of multiple family loans or single commercial loans together into a trust. Once this is done, a series of bonds are issued by the trust with varying yields based on select tranches. Credit tranching sets up multiple classes of securities, referred to as “tranches,” with seniority levels that are relative to one another based on priority. Senior classes are protected from junior classes, which have more exposure to credit risk. Rating agencies measure the credit strength of a transaction’s different tranches and assign ratings accordingly as a standard aspect of a CMBS deal. The fact that this investment has a AAA rating is not necessarily a unique aspect either considering that around 85% to 88% of the issued securities can attain Moody’s and S&P ratings at the triple-A level (Nomura, 3). Whether this is a sound investment really depends on the return and protection offered by the tranche. A4 is the last cash flow tranche and it relies most heavily on the endurance of the market to yield long-term results. As Nomura notes, generally, the A1 tranches are based on the principle payments occurring every three years, while A2 tranches are sized primarily based on the principle payments which are reflected in three and five year distributions. The A3 tranches represent the five to seven year payments, with the A4 tranches representing payments in eight or more years (Nomura, 3).
The problem with this type of investment is that risk verses the reward. Unlike traditional residential mortgage backed securities, most CMBS aren’t guaranteed by the U.S. government or any form of government sponsored entities (GSEs), which add to their lack of security. This is why standard CMBSs use credit tranching in an attempt to enhance the stability of the security and mitigate risk in case of a default and loss on the underlying loan. It can be seen however that the expected return is only 3.5% compared to the 6% capitalization of the previous case. In the defense of this scenario, a substantial portion of the capitalization from the previous case would have to be reinvested in covering leverage. This would not be an issue here, but the principle would still be at risk like any normal investment with a completely alternative and more diversified form of exposure to the real-estate market that is not necessarily provided by a standard direct investment into real-estate. However, despite the fact that this A4 tranche is rated AAA, it can easily fluctuate after the debt is issued and the fact that it’s not secured leaves the investment vulnerable to potentially even more risk over the 8-10 year waiting period. For this reason, I would have to not recommend this form of investment.
A $50 million allocation for a secondary stock offering for a large retail REIT (rated Baa1) with a diversified portfolio by geography and tenant throughout the USA, with some properties in Canada. The issuer plans to raise $500 million of new equity, even though it will dilute existing shareholders. The REIT’s dividend is 4.5% (to be paid in cash, not stock per 2009 IRS guidelines). Total market capitalization is approximately $10 billion. (Remember- market cap, which is merely stock price x shares outstanding differs from total market cap, which is equity and debt outstanding.) The REIT’s portfolio is levered at 44% before joint ventures (debt + preferred/gross assets), secured debt/gross assets is 11% (before joint ventures), and fixed charge coverage is 2.6x. The prospectus includes the typical statement that the money will be used for operations, to pay down debt and to make future opportunistic acquisitions.
As the total value of the portfolio is not disclosed, and it’s only revealed that 10% of the stock market investment allocation accounts for $50,000 million dollars, it can only be assumed that the rest of the portfolio significantly larger than this making the 50 million dollars investment account for anywhere from 5%-1% of the total portfolio value, maybe even less. I base this assumption on the fact that the instructions stated the portfolio is heavily diversified, which basically implied the final balance would not be heavily impacted by the loss of these funds. The problem that arises is it’s not clear as to the intended motives of this new investment allocation. At first glance it appears like the basis for making the investment is to diversify and balance the portfolio, but then the scenario states that “you are otherwise sufficiently diversified such that a $50 million acquisition of any of the following will not adversely impact the fund’s balance”. This makes it seem as though investing in something that stakes on more substantial risk is the goal since this investment has been classified as disposable, but if risk is the goal why not just leave it in the stock market investment allocation? I can only assume a combination of more risk and further diversification of the portfolio is the real goal, which brings up the question, how much risk is too much and is desertification the main objective? This is the main question that needs to be address in respect to the REIT investment.
The REIT investment has a Moody’s Long-term Corporate Obligation Rating of Baa1. This means the company is classified in the 8th highest rating classification exposing the $50 million dollar investment to moderate risks but still debatably much more risk than the other two investments. It should also be noted that this is a stock, which poses some redundant investment motives in the sense that the $50 million dollars will essentially be removed from one stock in the stock market allocation portion of the portfolio to be reinvested back into the stock market allocation section of the portfolio in another stock. This undermines the key objective of further diversification or balancing the portfolio, especially since no information is provided as to the caliber of stocks or stocks from which funds were liquidated in the first place. To reiterate, the objective presented by the case was, “Your real estate allocation has fallen below the fund’s target portion of the overall portfolio because your stock market investment allocation gained 10% in value last year”. This implies that real-estate investment directly in the real-estate market was essentially the goal.
While REIT is a real-estate investment trust, this option provided here is not to invest in real-estate but to purchase shares from a company that invests in real-estate, so this should not be confused with a real-estate investment. This is a stock. If it’s assumed, that the stocks, from which the 10% stock market allocation profit, accounting for $50,000 in available funds were freed from, are of a different caliber and lack a distinct speculative characteristic of the other stocks, this could still be a worthwhile investment. REIT does have some positive characteristics. Let’s take a look at them.
One of the main benefits of investing in REIT is that it has a diversified portfolio geographically with a wide range of tenants throughout the US, as well as some Canadian properties. If the company were ranked A3 or higher, it could be argued that REIT has no plans of doing a reverse split, reverse merger, or any form of another issuance of shares leading to dilution. These are all common risks that come with investing in stocks especially the lower they rank on Moody’s. The fact that the company does issue a dividend of 4.5% adds some good faith to their statement about their goals for growth and reason behind refinancing for new equity. If this is true, then it may shape REIT up to be a sound and promising investment for the future. Another good sign is that the company does demonstrate the ability to satisfy fixed financing expenses, like interest and leases with a fixed charge coverage of 2.6x. It can be assumed with this fixed charge coverage the investment would not have problems sustaining profitability and yielding returns, granted no significant changes are made after second share issuance and their isn’t a thirds share issuance which would result in dilution. For the reason that this investment does not fit the main objective of the case to diversify through real-estate investing, I would have to not recommend this investment, but it does pose some characteristics that may make it a fitting alternative to the first option and a more promising choice in regards to faster returns when compared to the second option.
Commercial Mortgage Securities Association CMSA. “The Role of Commercial Mortgage Backed Securities (CMBS) and Commercial Real Estate Collateralized Debt Obligations (CRE CDOs) in the U.S. Real Estate Finance Market”. CMSA. 2007
Nomura. “Synthetic CMBS Primer” Nomura Fixed Income Research” Nomura Fixed Income Research. 2006, 1-23 http://www.markadelson.com/pubs/Synthetic_CMBS_Primer.pdf
Pryor, Don. “Peeling The Onion on Capitalization Rates” Odessa Realty Investments, LLC. Web. 2010, 1-5. <Retrieved from> http://www.odessainvest.com/pdf/Peeling%20the%20Onion%20on%20Capitalization%20Rates.pdf
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