Introduction to CMBSThe Anatomy of a CMBS

$ 1 Billion of CMBS

Class Rating Principal Coupon Subordination Price

A-1 “AAA” $ 150mm 6.25% 101.00%

A-2 “AAA” $ 250mm 6.35% 101.00%A-3 “AAA” $ 300mm 6.40% 101.00% A “AAA” $ 700mm 30%B “AA” $ 50mm 6.50% 25% 101.00%C “A” $ 50mm 6.60% 20% 100.75%D “BBB” $ 80mm 6.75% 12% 100.50%E “BB” $ 60mm 7.00% 6% 85.00%F “B” $ 20mm 7.00% 2% 75.00%G unrated $ 40mm 7.00% 0% 45.00%IO “AAA” notional 0.90% na 4.75%

Introduction to CMBSThe Anatomy of a CMBS

Characteristics of a CMBS

Rating CMBSs Role of servicers Cash flow and cap rate adjustments

Expected Cash Flows Multi-class Sequential Pay Pass Through The Unrated Piece The IO Piece

Required Subordination Probability of Loss Loss Severity

CMBS Risks Default Balloon

Credit Enhancements

Introduction to CMBSRating CMBSs

Role of rating agencies

Establish different rating criteria for various property types Site inspect sample of properties in CMBS

o Re-evaluate revenue, vacancy, operating & capital expenses o Apply Net Cash Flow “haircut” to non-sampled properties

Negotiate subordination levels with issuers Track property performance/delinquencies Best predictors of loan default

Debt service coverage ratio Loan to value ratio

Introduction to CMBSRating CMBSs

Role of Servicers

Master Servicer: Oversees the deal and servicing agreements Administers performing loans

Receives mortgage payments Facilitates Trustee’s timely payment of principal and interest Makes tax, insurance and other escrow payments

May provide (servicer) advances for deliquent/defaulted loans Sub-Servicer: loan originator in a conduit deal who retains servicing Special Servicer:

Becomes engaged when loan more than 60 days delinquent Has the authority to

1. Extend the loan 2. modify/restructure the loan (based on an appraisal) 3. Foreclose

Introduction to CMBSRating CMBSs

Introduction

Property Cash Flow Adjustments

Capitalization Rate Adjustments

Financial Ratios

Pool analysis

Ideal Pool for Small Income Property Loans

Introduction to CMBSRating CMBSs

Property Cash Flow Adjustments

Rental income = min {contract rent, market rent} Non-rental income = frequently ignored Vacancy loss = max {actual, market, 10% (or some min.)} Operating expenses = max {historical, industry standards, appraisal} Management fees = max {historical, appraisal, 5% for MF} = max {historical, appraisal, 4% for commercial} Capital reserves = $250 - $450 per unit for MF = $0.15 - $0.30 per square foot for office = $0.15 - $0.25 psf for retail = 4-5% of Gross Revenues for hotel

Introduction to CMBSRating CMBSs

Property Cash Flow Adjustments Expected property cash flows also adjusted for: (1) Average lease term (by property type) (2) Tenant improvements (assuming 50-60% retention)

a. new tenant improvements b. renewal tenant improvements

(3) Leasing commissions

a. new leasing commissions (4-6%) b. renewal leasing commissions (varies by property type)

Introduction to CMBSDebt Service Adjustments

below market interest rates increased

loan term adjusted for remaining economic life of the property

Constant debt service: required debt service payments

if borrower must refinance in a ‘AA’ stress environment.

Introduction to CMBSRating CMBSs

Property Capitalization Rate Adjustments Cap rates can be adjusted down 50-75bp for net cash flow after adjusting

cash flows for capital items, tenant improvements and leasing commissions—cap rates based on Net Cash Flow, NOT NOI!

Cap rates adjusted up50-150bp for non-cured environmental impairments

and for lower quality properties. Cap rates adjusted up to reflect market conditions.

Fi nanc ia l Rat ios

Issuer Issuer NCF

DSCR = Actual Debt Service

Term = Fitch NCF DSCR Actual Debt Service Constant = Fitch NCF

DSCR Fitch Constant Debt Service

Fitch 50% Term DSCR + Stressed = 50% Constant DSCR DSCR

Fitch Value = Fitch NCF Fitch Cap Rate

Fitch LTV = Outstanding Loan Balance

Fitch Value

DSCR – Debt service coverage ratio. NCF – Net cash flow. LTV – Loan-to-value ratio.

Introduction to CMBSRating CMBSs

Pool Analysis

Probability of loss: the probability that any loan will default, beforeclosed on, and be liquidated.

Probability of loss = f(LTV, DSCR, property type, loan structure,fixed/floating rate, loan quality, seasoning,management, ownership structure, barriers toentry (loan to replacement cost, CF volatility,recourse)

Loan loss = f (cost to obtain the asset, time to sell, cost to sell)

Introduction to CMBSRating CMBSs

Ideal Pool for Small Income Property Loans

At least 500 loans

No one loan > 1% of loan balance

Geographically diversified

Taxes, insurance, and capital reserves escrowed

Full recourse

Introduction to CMBSExpected Cash Flows

1. Principal repayment

a. Scheduled amortization b. Unscheduled prepayment

2. Interest 3. Penalties a. Hyperamortization (cash trap): all cash flows in excess of operating expenses go to retire debt. Triggered by

i. delinquency ii. failure to maintain required DSCR iii. failure to maintain debt rating iv. failure to maintain adequate reserves

b. Prepayment penalty: penalty assessed the borrower for early repayment of debt. Penalty may be computed in various ways. c. Balloon default: penalty assessed the borrower for failing to refinance at the end of the loan term.

Introduction to CMBSExpected Cash Flows

Prepayment Penalties

1. A (declining) percent of the outstanding balance (e.g. 5-4-3-2-1) paid when the loan is prepaid 2. Yield maintenance: the prepayment penalty is computed as the difference between the book value of the loan and the PV of the remaining contractual payments discounted at some required interest rate. 3. Treasury Defeasance: replace the commercial loan cash

flows with cash flows from US Treasuries.

Introduction to CMBSExpected Cash Flows

Multi-class Sequential Pay Pass Through Cash flow prioritization: 1) Principal repayments (both scheduled amortization and unscheduled prepayments) go to retire senior class debt first.

CF go to senior classes AAA through BBB Intermediate/Junior classes Unrated Equity holder

2) Coupon interest paid to all classes

Loss priortization: Principal and interest due the most junior class bondholder must

be completely exhausted before any loss is assigned to the class above it.

Introduction to CMBSExpected Cash Flows

The Unrated Piece

The unrated piece is used to provide subordination for the lowestrated junior piece.

The size of the unrated bond reflects rating agency requirements forloans that are not cross-collateralized and cross-defaulted.

The unrated piece is sold privately and typically purchased by thespecial servicer.

Introduction to CMBSExpected Cash Flows

The IO Piece

The notional balance of the IO piece is initially the aggregate issue amount ($ 1 billion in the example)

The notional balance of the IO piece equals the sum of the

certificate balances for the sequential pay certificates. The IO piece typically pays a small coupon (e.g. 90bp) and sells at

a steep discount. The pass through rate applicable to each IO component is equal to

the weighted-average net mortgage rate minus the pass-through rate then applicable to the corresponding class of sequential pay certificates.

Introduction to CMBSRequired Subordination

The required level of subordination is computed as the expected loss in the event of a recession in the real property market. More specifically, required subordination = probability of loss (given a recession) x severity of loss (given a default) The probability of loss varies from small (say 10%) to large (say 50%), depending on the magnitude of the real property recession. The severity of loss is the amount of the loss conditional on a default. For example, a “Class B” real property recession will result in loan losses with a 10% probability. The severity of the loss is typically 20% of the loan balance. Therefore, the required subordination for a “Class B” real property recession is 10% x 20% = 2%.

Introduction to CMBSRequired Subordination

Required Subordination

Type of Probability x Severity = RequiredRecession of Loss of Loss Subordination

“AAA” 50% x 60% 30%“AA” 45% x 55% 25%“A” 40% x 50% 20%

“BBB” 30% x 40% 12%“BB” 20% x 30% 6%“B” 10% x 20% 2%

Introduction to CMBSRequired Subordination

Introduction to CMBSCMBS Risks

Default risk: income property loans are typically nonrecourse so the borrower has the financial incentive to default when the market value of the property falls below the outstanding balance of the loan (negative equity).

Balloon risk: income property mortgages typically have terms that

are less than the loan amortization period. When the term of the loan is also less than the maturity of the bond, the borrower must refinance to continue making mortgage payments. Circumstances in the property and capital markets may have changed in ways that make refinancing difficult or even impossible.

Prepayment risk: while many income property mortgages provide

some call protection (e.g. lock-out provisions, prepayment penalties, Treasury defeasance), some income property mortgages do not have any of these features

Introduction to CMBSDefault Risk

Probability (2006 Fitch US CMBS Default Study) o Annual o Cumulative o By Property Type

Loss Severity (Fitch ICBA, Inc. 1998) o Balance deficiency o Advanced interest o Property protection expenses o Legal

Introduction to CMBS2006 Fitch US CMBS Default Study: 1993-2005

Annual CMBS Loan Defaults

Year Default ($ Mil.) DefaultCount

2005 $1,855.0 3172004 $2,162.2 3242003 $2,864.1 4552002 $1,916.9 3162001 $1,349.8 2632000 $940.9 1321999 $350.0 541998 $199.9 421997 $51.0 91996 $30.0 81995 $4.7 2

Introduction to CMBS2006 Fitch US CMBS Default Study: 1993-2005

Cumulative CMBS Loan Defaults ($Mil.)

Default Cumulative Cumulative

YearDefault ($Mil.)

Issuance ($Mil.) default rate

2005 11,724.40 314,953 3.72%2004 9,869.50 238,170 4.14%2003 7,707.30 204,064 3.78%2002 4,843.20 175,474 2.76%2001 2,926.30 160,570 1.82%2000 1,576.50 133,613 1.18%1999 635.6 113,086 0.56%1998 285.6 83,427 0.34%1997 85.7 43,904 0.20%1996 34.7 18,728 0.19%1995 4.7 7,432 0.06%

Introduction to CMBS2006 Fitch US CMBS Default Study: 1993-2005

Cumulative CMBS Loan Defaults

Default Cumulative CumulativeYear Default Issuance rate

Count Count

2005 1,922 41,891 4.59%2004 1,605 36,043 4.45%2003 1,281 32,671 3.92%2002 826 29,237 2.83%2001 510 27,329 1.87%2000 247 23,551 1.05%1999 115 20,034 0.57%1998 61 14,205 0.43%1997 19 8,114 0.23%1996 10 3,903 0.26%1995 2 1,482 0.13%

Introduction to CMBS2006 Fitch US CMBS Default Study: 1993-2005

2005 CMBS Loan Defaults by Property Type

Source: Fitch

Commercial Property MortgagesLoss Severity

Fitch IBCA, Inc. (1998)

Loss = loan balance at securitization+ interest advanced+ property protection expenses- loan amortization- property income- net sales proceeds

Losses reported as a percent of loan balance at securitization for loansCOMPLETELY resolved (e.g. properties sold).

Commercial Property MortgagesLoss Severity

Fitch IBCA, Inc. (1998)

Source of losses:

Decrease in property value 35.8%+ advanced interest 10.5%+ advanced property protection expenses 7.7%- amortization- property income (combined) 14.9%

Average Loss Rate: 39.1%

Introduction to CMBSThe Anatomy of a CMBS

Credit Enhancements

Subordination

Cross collateralization: properties that collateralize individualloans are pledged against all loans in the pool

Cross default: allows the lender to call ALL LOANS in the eventa single loan is in default.

Lock box: gives the trustee control of the property gross revenues.The trustee assigns priority to: (1) taxes and insurance;(2) operating expenses; (3) debt service; (4) management fees;(5) reserves for replacements; (6) equity investor

Overcollateralization: when the book value of the loans exceedthe par value of the bonds issued.