This Return of the Loan: Commercial Mortgage Investing after the 2008 Financial Crisis case study allows students to calculate expected yield in commercial mortgages. It discusses the differences between Commercial Mortgage-Backed Securities and individual mortgage loans.
Craig Furfine
Harvard Business Review (KEL757-PDF-ENG)
June 19, 2013
Case questions answered:
- Calculate the expected yield (IRR) on directly lending the $5.8 million in commercial mortgages using the information contained in Exhibit 6. Please show your work.
- Use the template provided to construct amortization tables for each of the underlying loans.
- Construct the promised cash flows from an investment in each of the five principal “receiving bonds” (CMBS tranches). Disregard the X bond (this is a partial IO strip — as we’ve discussed in class — designed to increase the duration of all the bonds from which the coupon is partially stripped).
- Qualitatively discuss the benefits and costs of making direct mortgage investments rather than an investment in the D-bond of this particular CMBS deal. As part of this discussion, you should consider the relative expected rates of return of the two investment strategies.
- Do a deep-dive review of the underwriting of your assigned “presentation” loan and TWO additional loans of your choosing in the CMBS deal. Summarize the positives and negatives of your three loans and properties/property portfolios. Based on your review of the loan documentation, which of the three loans you’ve analyzed in the CMBS deal give you the most concern about future potential losses? Why?
- Based on your analysis in Question 4, identify an (ideally plausible) adverse economic scenario that you believe is most likely to cause at least one of the underlying CMBS loans to default. In your write-up, the scenario should outline the economic reason/event that would lead a borrower to be unable to satisfy its debt service requirements. **For simplicity, assume that the recoveries of (impaired) loan balances don’t occur until the end of the 5th year, even if the adverse economic condition you’ve envisioned occurs much earlier than that. (There may be a period of zero payments prior to the end of the term.)**.
- In April of 2010, Moodys was reporting a 6.18% yield on Baa-rated bonds, taking into account some average loss rate on Baa bonds. Discount the expected cash flows of the D-bond you calculated in question 6 (in the “Total Weighted Average” tab) at 6.18% to find the market value of the entire D-bond. How does this compare to the par value of the pool of $29,434,000? What par value of D-bonds does this imply UPL ought to be able to purchase with their $5.8M? (Everyone’s answer will differ here because each group chooses different loans to become impaired and different probabilities/loss rates).
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Return of the Loan: Commercial Mortgage Investing after the 2008 Financial Crisis Case Answers
This case solution includes an Excel file with calculations.
(Answers to questions 1, 2, and 3 of this “Return of the Loan: Commercial Mortgage Investing after the 2008 Financial Crisis” case study are shown in the Excel spreadsheet.)
4. D-bond of particular Commercial Mortgage-Backed Securities deal
Benefits:
The bonds in the commercial mortgage-backed securities offering allowed UPL to target a particular level of risk. All of the bonds were investment grade, meaning it has a lower risk associated with them.
- Loss rates over the five-year investment period would be less than those in a direct mortgage portfolio.
- If purchasing a bond in a CMBS, you do not need to originate or service a loan, reducing the amount of consistent work necessary to benefit.
- United Principal Life’s investment policy statement describes a desire to create “a Fixed Income Investment Program to … reduce the risk of the overall investment portfolio”. This lines up much more with what a CMBS tranche provides.
- The D Tranche is rated BBB- by RealPoint and Baa3 by Moody’s, equivalent to the highest possible rating of a single mortgage.
Costs:
- It was impossible to know what return would be realized from a bond investment because the prices of the bonds were unknown. Although it was true that Aaa-rated bonds typically sold at par, the lower-rated tranches would certainly be sold at a discount, and we would need to know how much of a discount to know if investing is a good deal.
Direct Mortgage Investment:
Benefits:
- Making individual mortgage loans generated a set of promised cash flows in exchange for fixed investment. In that way, they might be expected to have yields comparable to that of bonds. Direct Loans have the potential to generate high coupon-based cash flows and higher expected returns.
- United Principal Life’s investment policy statement describes them already having a primary policy “to make loan originations that are underwritten using the standard loan due diligence process, so risks are identified, evaluated, and priced accordingly.”
- Direct Mortgage investing is already in their business model and plans, so it should not be hard to get them to commit to investing and taking on the increased risk.
Costs:
- Only has the potential for higher return because of higher risk.
- Have to originate and service all loans, which requires constant work.
- May have to foreclose on a house or deal with the bankruptcy of the potential borrower.
- The typical commercial mortgage was often no better than a Ba-rated investment.
5. Cole I:
There are many positives associated with this loan. Firstly, as of 04/01/2010, the property was 100% occupied by tenants. We see that no lease expires for the first few years of the loan (2010-2012), which allows for the negotiation of a lease renewal for the 10 leases that will expire before 2015.
Compared to the whole loan balance, we see a loan-to-value (LTV) ratio of 49%, a debt yield of 18.2%, and a 2009 NOI/SCR of 3.09, which are excellent metrics for this loan.
Additionally, there is a fee simple, which implies that the land underneath the building is…
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MBA student, Boston
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