Investing in CMBS

November 4, 2004

Regulation passed by the NCUA in mid-2003 opened up a new avenue of investments for credit unions. RegFlex eligible institutions can purchase Commercial Mortgage Backed Securities (CMBS) in an aggregate amount of up to 50% of their net worth as long as:

• Security is rated AA- or better
• Underlying pool has more than 50 loans (no individual loan > 10% of the pool)

CMBS Pool Fundamentals

Security – The underlying collateral for a CMBS bond is a pool of mortgage loans secured by commercial real estate such as office buildings, shopping centers, apartments and warehouses (see Table 1).

Rate, Term and Amortization -- The majority of the underlying mortgages have a fixed interest rate, a 7 to 10 year balloon/maturity date and a 25-30 year amortization schedule.

Prepayment – Strong call/prepayment protection and average life stability are key reasons investors buy CMBS. Most of the underlying commercial mortgages have several forms of prepayment protection. During an initial 2-5 year period, most borrowers are either subject to defeasance or prohibited from prepaying altogether, after which there is a yield-maintenance period that typically runs until 3-6 months prior to maturity. Some older vintage loans use prepayment penalty points (such as 5-4-3-2-1% during the last 5 years of the loan term), which may not provide adequate protection. It’s important to know the type of prepayment formulas as well as the allocation of prepayment premiums to the various CMBS tranches before investing.

Location – In addition to analyzing geographic diversification by region, state, and city, it’s important to consider what percentage of the pool is located in economically weak cities or in tertiary markets. History has shown that property vacancy rates, mortgage delinquency rates and loss severities vary greatly by metro area and state.

Vintage – Older vintage deals (pre-1999) benefit from the availability of a track record and the fact that they were underwritten before the peak of the real estate cycle. In addition, due to the immaturity of the CMBS market at that time, higher credit enhancement levels were assigned. Deals originated in 1999-2001, on the other hand, were underwritten at the peak of the real estate cycle and may have more downside risk. While newer deals (2002-2004) are thought to reflect more stringent underwriting resulting from the weaker economy and real estate fundamentals, heated competition for loans and lower credit enhancement levels cause some to question how the more recent vintages will fair.

Underwriting – The two most important indicators of credit quality for a pool of commercial mortgages are the debt service coverage ratio (DSCR) and the loan to value ratio (LTV). The DSCR determines the borrower’s ability to make his/her monthly mortgage payment with a lower DSCR indicating a higher probability of a default. The LTV is an indicator of default risk and loss severity. It’s important to analyze not only the CMBS pool’s average DSCR and LTV but also the dispersion of the individual loan DSCRs and LTVs. Pools with a higher percentage of loans with an LTV > 85% and DSCR < 1.20 are of particular concern.

Waterfall – Most CMBS use a sequential-pay structure where principal payments are applied to the highest-rated classes first, while any losses are allocated to the bottom, lower-rated classes up. Thus, the lower-rated classes provide credit enhancement to the senior classes.

Comparative Advantages of CMBS

Large, liquid, high quality asset class -- As of July 1, 2004 the CMBS market has a total market value of $276 billion according to Lehman Brothers’ CMBS index. It is of high quality with 79.1% rated AAA, 5.0% rated AA, 15.9% rated below AA. Domestic CMBS issuance has grown to almost $70 billion per year (Table 2). The upgrade/downgrade ratio for CMBS has also outperformed corporates by a wide margin (Table 3).

Yield spreads – Currently, 5-year AAA CMBS yield approximately 80 bp over treasuries. The yield spread for 5-year AAA-rated CMBS has averaged about 101 bp over the 5-year U.S. Treasury for the past 5 ½ years.

Increased portfolio diversification – Due to the low, and in some cases even negative, correlations between investment grade CMBS and other asset classes, superior portfolio diversification can be accomplished with the addition of CMBS.

Strong prepayment protection – Strong call/prepayment protection and average life stability relative to residential MBS are key reasons investors buy CMBS.

A Word of Caution

Analytics – Due to the varying loan terms and complex deal structures, systems that allow you to model default probabilities, loss severities, extension risk and prepayments at the individual loan level are critical in the risk/return analysis. Geographic, property type and tenant exposure must also be analyzed at the portfolio level to ensure adequate diversification.

-- Due to the dynamic nature of the commercial real estate markets, it is important to continually monitor the pool performance via bondholder remittance reports and rating agency updates. As conditions change, model assumptions must be updated so that accurate yield projections and successful portfolio decisions can be made.

Credit Union Appeal

CMBS offer exposure to commercial mortgage lending risk (and the higher yields that come with it) without having to build a commercial mortgage lending operation. The resources spent to grow commercial mortgage lending expertise, implement the necessary infrastructure and compliance requirements are surely worth the effort. However, as any credit union that has begun commercial mortgage lending can attest to, it can take a lot of time and capital.

Julie Cook, Investment Officer – Structured Products, MEMBERS Capital Advisors (julie.cook@cunamutual.com ) with Jerry Boebel, Sr. Investment Advisory Consultant with CUNA Mutual Group (jerry.boebel@cunamutual.com, 800-356-2644 x7864).

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