cmbs definition

							                 Chapter 7
       Capital Markets and Real Estate

I. Relationship between Space and Capital
Markets – although real estate space markets are
local, real estate financial markets compete in
capital markets, contributing over 40% of stock
of public and private wealth.

A. Conceptual Foundations: Property valuation
capitalizes space income by a market determined
rate (V=NOI/R). Effectively, real estate
investment competes with other capital
investments (stock, bonds, etc.). Risk/return
tradeoff, where cap rates were at record lows (5-
10 range) in 2006. Why?

B. Market Overview – value of institutional
investment in commercial real estate $4.26
trillion in 2006, with 75% invested in public and
private real estate debt (majority in CB and LIC,
with <$1 trillion in securitized (CMBS) debt).
Space markets tied to GDP, where decrease in
real growth rate (historically 3%) will result in
lower demand for space. Effect on cap rates?

                        1
Recognize that space markets vary by location
and type (office, retail, multifamily, industrial,
hospitality).

C. Space Markets – includes strength of market
and strength of property within the market.
Must look at demographics relating to growth to
determine strength of market, and look at site-
specific and lease attributes (rent rate,
concessions, term, etc.) to determine relative
strengths. If economy and markets are growing
(declining), rents will increase (decrease), with
corresponding effect on NOI and cap rates.
How does this translate to effect on value? Does
type of property matter (i.e. what demographics
impact industrial, office, multifamily, retail,
etc.)?

D. Capital Markets – include private debt and
equity, and public debt and equity:

1. Real Estate debt markets would include both
private and public sources.



                         2
a. Private Debt - bank loans, mortgages,
   REITs and venture debt, both
   construction and mini perm loans.
   Although historically this was the
   primary source of funds, since 1990s
   more capital for real estate comes from
   public sources. Departure of private
   debt sources in early 1990s led to largest
   commercial real estate downturn since
   Great Depression.

b. Public Debt – Commercial Mortgage-
   Backed Securities (CMBS) has
   exploded since early 1990s to become
   primary form of commercial real estate
   lending. CMBS are bonds collateralized
   by commercial property loans, typically
   permanent loans. Created by CBs, Mtg
   Bankers and Brokers, Wall Street firms.
   CMBS can be structured with third-
   party debt ratings and then broken into
   tranches, with return based on risk of
   getting money in various tranches. Can
   exist on commercial and residential
   properties (FNMA and FHLMC largest

                    3
       of residential originators). Recent
       downturn in CMBS markets – why?

   c. Private Equity – large source of
      financing up until early 1990s, now less
      of a factor. Would include private
      investors, private equity funds
      (Blackstone), pension funds, foreign
      investors.

   d. Public Equity – primarily REITs.
      Mortgage and Hybrid only 10% of
      REITs, with 90% making equity
      investments. UPREITs thrived in mid
      1990s, with traditional REITs now
      doing most of equity investment.

II. Real Estate Finance Cycle – many forms of
finance used in real estate development, from
predevelopment finance through permanent
financing. As go through process, investment
risk decreases, therefore interest rates and
required returns decrease (what happens to cap
rates?). Lenders concerns – loss of principal,
non-payment of debt service, mismatching

                       4
maturities. Equity investor concerns – cash
flow, appreciation and tax benefits. Debt
Investors are risk averse, thus stay away from
most land acquisition and construction loans,
and instead finance completed projects with
credit tenants. Equity Investors have higher risk
tolerance, but higher return requirements.

A. Predevelopment Sources of Funds – riskiest,
   since no cash flow and uncertainty over
   completion. Often requires equity investor
   or cross-collateralization. At this stage,
   need zoning, permits, preleasing, various
   feasibility studies, etc. Joint Venture typical
   between developer and equity investor (or
   debt lender).

B. Land Acquisition – typically from
   Commercial Bank with cross
   collateralization and assurance of
   construction and/or permanent loan. High
   risk, therefore high interest with recourse.
   Likely source is seller financing (purchase
   money mortgage (aka land contract)) with
   subordination agreement. Alternatives:

                        5
1. Purchase Option – developer pays
   landowner option fee for right to purchase
   land at agreed upon price and terms.
   Exercisable at option of developer, giving
   developer time to do studies and get permits
   without committing substantial resources.
   Option fee can be applied to purchase price.
   Various types, as outlined in text.
2. Ground Lease – developer signs long term
   (25-99 years) lease for use of land, thus
   saving initial capital. Lease payments often
   tied to value of land, normally on triple net
   basis where lessee is responsible for all
   expenses. Downside is that improvements
   revert to landowner at end of lease, although
   can structure payment for the improvements.

C. Construction Financing – available from
   Pension Funds, REITs, Commercial Issuers,
   LICs, although primarily CBs:

1. Commercial Banks – typically structure with
   adjustable rate (prime + or LIBOR +) with
   interest only and origination fees.

                       6
2. Savings & Loans – despite almost going out
   of existence, now second largest issuer of
   multifamily debt, although very limited by
   FIREEA.
3. Credit and Finance Companies – now about
   3% of market. Ex. GE Capital, raises funds
   in capital markets and lends on real estate,
   earning spread and sometimes equity
   participation.

D. Permanent Financing – historically Life
   Insurance Companies, although now
   primarily CMBS. Before permanent „take-
   out‟ commitment issued, require:
1. Certificate of Occupancy
2. Stabilized income at agreed upon occupancy
   rate.
3. Minimum Debt Coverage Ratio (1.2-1.6)
4. Maximum Loan to Value Ratio (70-85%)
5. Lien Waivers from construction
   subcontractors
6. Timely takedown of loan.

III. Primer on Legal Elements of Real Estate
Finance.

                       7
A. Classification of Estates - Estate refers to a
possessory or potentially possessory interest,
where holder can occupy or use property during
period of possession. Can have an interest in
real estate that is not an estate, ex. an easement.
Also, security interest lender receives upon
making loan is not an estate, since it is not
possessory:

1. Possession versus non-possession - differ by
possessory interest, where non-possession
typically is a future interest.

  a.    Possession:

  1)    Freehold - lasts for indefinite period of
        time:

        a) Fee Simple Absolute - most complete
        interest, where owner can do anything
        they want with the property, subject to
        public and private limitations of
        ownership.


                         8
     b) Life Estate - freehold estate that
     lasts only as long as the life of the
     owner or life of some other person.
     Upon death, interest reverts back to
     original grantor (or heirs or designee).
     Ex. Reserved life estate or Legal Life
     Estate (will, where typically not of
     inheritance).

2)   Leasehold (less than Freehold): Creates
     Leasehold and Leased Fee estates.

     a) Estate for Years - beginning and
     ending period, w/ max of 99 years.

     b) Periodic Tenancy - continues for
     successive periods until either party
     gives notice, ex. month to month lease.

     c) Tenancy at Will - indefinite
     duration, but with permission of
     landlord, ex. created when tenant holds
     over with permission upon lease exp..



                     9
        d) Tenancy at Sufferance - created
        when tenant holds over without
        permission. No legal rights other than
        the landlord must take legal action to
        evict.

  b.    Non-Possessory (future estates) - do not
        convey right to use until the future:

        1) Reversion - exists when holder of an
        estate conveys to another person a
        present estate with less ownership rights
        than the original, with right to take back
        all rights in the future. Can have value,
        and thus can be sold or mortgaged.

        2) Remainder - similar to reversion
        interest, where future interest for a third
        person that receives the reversionary
        interest.

B. Quality of Title - when acquiring title, must
be concerned with how good that title is, since
that will effectively determine value associated
with title.

                        10
1. Meaning of Title - title refers to the quantity of
rights that a real estate interest possesses. To
determine the extent of title, do an abstract of
title, which is a historical summary of the
publicly recorded documents that affect title.
Title can be impacted by freehold and leasehold
interests (since a leasehold can effectively
restrict an owners right to use and possess).

2. Deeds - title is typically conveyed by the deed,
where must be in writing to be a valid
conveyance of the ownership interest in real
property. While title can be encumbered, as an
example subject to easements, liens or leases, it
can still be conveyed (i.e. it is marketable),
although the deed should note the
encumberances. Type of deed is determined by
extent of warranties:

    a. General Warranty Deed - most common,
       where grantor warrants that title is good
       against all claims from the beginning of
       time. If problem, grantor must stand


                         11
         behind - typically done by providing a
         title policy, thereby transferring the risk.

    b. Special Warranty Deed - same as
       general, but grantor only warrants
       quality of title since they have owned.
       Ex. - HUD.

    c. Quitclaim - only transfers the personal
       rights that a grantor has, which may be
       none! No warranties are made.
       Typically used to clear clouds on title.

    d.   Special Purpose Deeds (no warranties):

         1)   Executor‟s Deed
         2)   Sheriff‟s Deed
         3)   Trustee‟s Deed
         4)   Correction Deed

3. Abstract and Opinion Methods - start with
Abstract of Title, which involves locating and
examining all instruments in the public record,
then have examined by Attorney. Attorney
offers opinion about how marketable title is, and

                          12
what, if any, cures need to effected to make title
good. This method, termed Opinion of Title, is
used in some states and addresses the legal
element, but offers little recourse if problems
surface in future. Main problem is not
attorney‟s incompetency but fact that attorney
can only be held accountable for items that are a
matter of public record. As a result, Title
Insurance industry has come about.

4. Title Insurance - unusual in that insures events
that have already occurred. Start with abstract
and attorney‟s opinion, then issue policy to
cover any unforeseen hazards. Required for any
mortgage that could be traded in the secondary
market (which is most!). Typically have two
policies, the owner‟s policy (insures interest of
property owner) and the lender‟s policy (insures
interests of the mortgagee). Both are paid for
with a one-time premium.

5. Recording Acts - every state has statutes
known as recording acts which provide for the
establishing of claims or interests in real estate.
By recording an interest, constructive notice is

                         13
deemed to have been given to the world. Texas
uses a chronological index (as opposed to a tract
index) with a “race type” system. Importance of
recording is establishment of priority of claim,
and therefore ownership interest. In Texas,
record deeds, mechanic‟s liens, easements,
leases, land contracts, options, etc. If default on
any instrument, holder can foreclose to recover
collateral (i.e. force the sale of the property).

C. Mortgage Instrument - similar for residential
and income property, although more
standardized for residential.

1. Definition - mortgage is technically a pledging
of collateral on a loan, although typically used to
include both the mortgage and the promissory
note (pledge to repay).

   a.   Title vs. Lien Theory - deals with how
        security is viewed by the courts to be
        held by the lender. Lien theory is most
        dominant, including that used in Texas.



                         14
    b. Mortgage vs. Deed of Trust - some
       states, like Texas, use a three party
       agreement in place of a mortgage.
       Advantage of this system is that if there
       is a default, no need for a foreclosure
       suit. Therefore, saves time and money.

2. Requirements - to be valid, Statute of Frauds
requires that it must be in writing. While no
specific form, most have similar wording that
expresses the intent of the parties to create a
security interest and any other items required by
state law. ( FNMA and FHLMC have created a
standardized document that must be used for
mortgages traded in the secondary market.
Since that encompases the majority of loans,
effectively there is now a “standard” document.)
Most states require the following at a minimum:

    a. Identification of mortgagor (borrower)
       and mortgagee (lender).

    b. Legal description of property.



                        15
    c. Covenants of seisin and warranty (i.e.
       type of deed).

    d. Reference to promissory note.

    e. Any specific provisions agreed upon by
       both parties.

3. Typical Mortgage Clauses (not “all inclusive):

    a. Payment of Principal and Interest
       (amount, when, where, etc.), plus
       allowance for prepayment and late
       charges.

    b. “Budget” Mortgage (escrow of funds for
       taxes and insurance).

    c. Requirement of Hazard Insurance -
       typically borrower and lender are the
       beneficiaries.

    d. Preservation and Maintenance of
       Property.


                        16
   e. Right of Inspection.

   f.   Condemnation - how any awards are to
        be apportioned between mortgagor and
        mortgagee.

   g. Joint and Several Liability - and binding
      of successors and assigns of mortgagor
      and mortgagee.

   h. Due on Sale Clause - allows
      acceleration of debt when property is
      sold (also can be used to escalate
      interest on an assumption, plus approval
      of person assuming).

   i.   Acceleration and Remedies in event of
        default.

   j.   Assignment of Mortgage (assumption)
        with an Estoppel Certificate.

4. Non-typical Mortgage Clauses:



                      17
    a. Future Advances - if mortgage covers
       anything other than the initial loan
       amount, ex. it is for a home-equity loan
       or a construction loan, then the extent,
       timing, and costs of the future advances
       should be clearly specified.

    b. Subordination clause - typically requires
       first lien holder (ex. seller that carries
       back paper) to subordinate their lien
       position to another lender (ex.
       construction or permanent lender on
       improvements).

5. Assumptions - Lenders often enforce “due-on-
sale” clauses, but may also use them in
conjunction with an assumption clause. This
allows the assumption, but requires the approval
of the new buyer by the lender. Further, the
lender may get the right to “escalate” the interest
with the assumption. Two ways to assume:

    a. Assumption - buyer agrees to assume
       and becomes personally liable for the
       original debt. If this is intent of parties,

                         18
        seller should get a release from the
        lender.

    b. “Subject to” Assumption - buyer agrees
       to assume debt, but does not become
       personally liable, i.e. original mortgagor
       remains liable. Reality is that lender
       will typically look to all parties in event
       of default, unless they have provided a
       release.

6. Recording mortgages - priority of lien
typically determined by when the document was
recorded.

D. Other Financing Instruments - variety of
specific purpose instruments used in real estate:

1. Purchase Money Mortgage - two definitions:

    a. Any financing used by purchaser to
       complete transaction.

    b. Seller financing (most common of the
       two definitions) - often used to help a

                        19
       purchaser that may not qualify for other
       financing; assist seller in installment
       reporting; earn greater return on money
       than otherwise available.

2. Packgage Mortgage - used to secure personal
and real property.

3. Land Contracts - used to denote a number of
possible contracts, such as installment sales
contract, contract for deed, etc. Most have the
feature that title is not conveyed until all
payments under contract have been made. As
such, it is a form of installment financing
contract. Risk in that seller still has title after
sale, but can overcome problems by having title
insurance at time of purchase, and buyer should
record their contract.




                         20