1. Chapter 17 Sources of Funds for Commercial Real Estate Properties © OnCourse Learning

2. 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. 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 3 © OnCourse Learning

4. 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

5. 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

6. Sources of Commercial Debt  Life Insurance Companies  Commercial Banks  Savings Institutions  Commercial Mortgage-Backed Securities © OnCourse Learning 6

7. 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

8. 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

9. 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

10. 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

11. CMBS – The Securitization Process 11 © OnCourse Learning

12. Example of Security Creation - CMBS 12 © OnCourse Learning

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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