REAL ESTATE FINANCE.

Student Research Project ( Posted on 30/10/2006)

Introduction

The Indian real estate market is growing rapidly driven by a buoyant economy, and a favourable regulatory environment. As a result of this growth, the funding requirement for commercial real estate is increasing substantially. Though the real estate exposure of banks has grown significantly, only five banks accounted for over half of the total banking exposure to the real estate sector as at March 31, 2005. This highlights the fact that funding sources for developers within the banking sector are highly concentrated.

In order to healthy growth of commercial real estate market, more diversified sources of funding is needed. Commercial mortgage backed security (CMBS) provides a good alternative funding tool for the developer. It also an effective way for banks to manage their risks in the real estate sector.

What is a commercial property?

Commercial property refers to property let out for economic benefit and not used for self-occupation. It includes retail centres, office premises, restaurants, hotels and warehouses. Globally, even multi-family dwelling units (in the form of apartments or condominiums) are classified as commercial properties.

What is a CMBS?

CMBS is a financial instrument secured by receivables from commercial real estate. CMBS is a popular fundraising source for developers and banks worldwide. A CMBS instrument is created by pooling together one or more commercial mortgages and securitising the pool.

How a CMBS transaction works

A diagrammatic representation of CMBS (where a bank is securitising its commercial mortgage) is shown below-steps in a typical CMBS transaction are:

1. A loan is given to the owner of the property, usually the developer, by a finance entity. This loan is secured by a mortgage on the specified property.

2. Repayment terms of the loan are structured as follows-

1. Net lease rentals (charges such as maintenance costs, TDS, service tax, property tax etc. are deducted from the gross rentals to arrive at the net rentals available to service debt) are paid into a designated account charged with the lender.

2. The debt servicing is met out of these net lease rentals on a periodic basis, and the balance is apportioned towards various expenses and reserves needed for maintenance of property. Any residual cashflows then flow back to the borrower.

3. The principal repayment on the loan is in the form of a balloon payment at the end of the tenure.

3. The finance entity sells this loan to an SPV. The SPV funds the purchase of the loan through issue of one or more CMBS instruments. The mortgage on the property now belongs to the SPV.

4. The developer normally acts as the servicer for the securitisation transaction.

5. The account into which the lease rentals flow is converted into trust ans retention account (TRA) charged with the trustee.

6. The trustee draws the debt servicing amount pertaining to the loan and uses it to meet the payment obligation on the CMBS.

7. The scheduled maturity of the CMBS instrument is the same as the maturity of the loan to the borrower.

8. Since the principal payment on the loan has to be made either through refinancing or through sale of the property, the developer must obtain a refinancing commitment by a specified time, in advance of the scheduled maturity date. This is to ensure that balloon payment can be made on the maturity date of the loan. Alternatively, the developer may choose to make the balloon payment from its own cashflows.

9. In case the developer is not able to obtain a refinancing commitment as stipulated, the documents empower the SPV to do the same on behalf of the borrower. The SPV may appoint an investment banker for this purpose.

10. If the loan is not redeemed by the maturity date, the SPV can enforce the security and sell the property. The proceeds from the sale are used to redeem the CMBS instrument. The access if any will normally flow back to the borrower. This process has to be completed by the legal final maturity date. Which is set at a date some time after the schedule maturity date. The gap between the legal final maturity and the schedule maturity date depends on the typical time it takes for taking legal possession, completing the sale and realising the proceeds. This time gap is different countries/regions.

Thus, to summarize, in a typical CMBS transaction

• Lease rentals from the property are used to pay the interest on the CMBS

• The principal is normally repaid at the end of the tenure.

• Lease rentals alone are normally not sufficient to repay principal

• Thus, all or almost all of the principal repayment is through refinance, or sale of property

Risk analysis for CMBS transactions

A: Risk of reduction in the lease rentals

As mentioned earlier, the interest on the CMBS are to be serviced out of the lease rentals from the underlying property. Thus any reduction in the lease rentals from the level assumed poses a risk factor. This reduction can arise due to any of the following factors.

1. Credit risk – if the existing tenant defaults on lease rentals obligations

2. Vacancy risk – Lease tenures in India are typically very short (about three years). If the CMBS tenure is longer than the lease tenure, then the leases have to be renewed. Vacancy risk refers to a situation where such renewals are not done in a timely manner.

3. Market risk – Reduction in market lease rental rates at the time of renewal of the lease

2. Risk of fall in property prices

Property price is the second key element in a CMBS transaction. Since the principal amount due on the CMBS is to be serviced out of refinancing or sale of property, the price of the property prevalent close to the schedule maturity period assumes importance.

3. Risk of insufficient time between schedule maturity and legal final maturity dates

The third key variable in a CMBS transaction is the time gap between the two maturity dates. The time has to be long enough for the security enforcement and sale of property to take place, so that the CMBS is fully redeemed before the legal final maturity.

Benefits of CMBS

CMBS has numerous benefits, from the perspectives of various players in the system:

1. Benefits of CMBS for issuers

1. CMBS helps in transforming relatively illiquid real estate loans into liquid and tradable capital market instruments.

2. CMBS acts as an additional source of funding for the bank/developer.

3. The rating of the bank/developer can be de-linked from the rating on CMBS, thereby making it possible to achieve a desired rating on the CMBS instrument.

4. CMBS reduces overall cost of funds and optimises the funds raised, as compared to bank lending, due to the possibility of having rated tranches of different maturities to suit different investor classes.

5. CMBS helps lenders manage risk, by securitising selected commercial mortgages and buying or selling suitable CMBS papers. Thus, lenders can achieve their target exposures to the overall sector, and/or segments within the sector.

2. Benefits of CMBS for investors

1. Investors are able to participate in real estate lending in amounts that are smaller than the principal balance of the mortgage loans in the pool.

2. It is possible to choose contracts in such a manner that the credit and maturity preferences of investors can be met.

3. Investors can gain access to segments of the sector at low transaction and information costs.

4. Internationally, defaults experienced on CMBS are much lower than on other types of securities.

3. Benefits for the commercial real estate as whole

1. CMBS leads to diversification of exposure among market participants. Thus the current situation, where over half of the system wide real estate exposure is on the books of only five banks, will not rise.

2. Capital inflows into real estate market become more evenly spread, as compared to the traditional bank lending system.

3. Monitoring of CMBS by training agencies will enable lending to the sector become more risk sensitive.

4. CMBS can help in reducing the severity of cyclicality in commercial real estate, since it enables the raising of funds from a diversified base of investors. This means that developers will not lack funds to undertake projects, even when markets are depressed.

Conclusion

Globally, CMBS are very popular form of financing real estate development. in India too, CMBS can be an effective way to fulfil the commercial real estate sector growing need for capital. The development of the CMBS market will pave the way for orderly growth of the commercial real estate market.