Post on 22-Dec-2015
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
© OnCourse Learning 2
3© OnCourse Learning
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
© OnCourse Learning 4
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
5© OnCourse Learning
Sources of Commercial Debt
Life Insurance Companies
Commercial Banks
Savings Institutions
Commercial Mortgage-Backed Securities
© OnCourse Learning 6
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
© OnCourse Learning 7
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
© OnCourse Learning 8
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
9© OnCourse Learning
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
© OnCourse Learning 10
CMBS – The Securitization Process
11© OnCourse Learning
Example of Security Creation - CMBS
12© OnCourse Learning
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.
© OnCourse Learning 13
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
© OnCourse Learning 14
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
© OnCourse Learning 15
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
16© OnCourse Learning
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
© OnCourse Learning 17
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
18© OnCourse Learning
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
© OnCourse Learning 19