The document discusses various aspects of commercial mortgages, including: 1) Commercial mortgages always involve conveying a note and mortgage between the borrower and lender, with the note detailing financial obligations and the mortgage pledging the property as security. 2) Commercial mortgages are often partially amortized "balloon" loans with short maturities of 5-10 years to reduce the lender's interest rate risk. 3) Balloon loans are less sensitive to interest rate shocks than fully amortized 30-year loans.

1. With Jimmy Stepanian

2.  Legal foundations
 Mortgage products
 Application and underwriting
 Equity capital

3.  In a mortgage loan, the borrower always
conveys two documents to the lender: (1) a
note, and (2) a mortgage.
 The note details the financial rights and
obligations between borrower and lender, e.g.,
whether a loan can be paid off early and at what
cost, what fees can be charged for late
payments, etc.
 The mortgage pledges the property as security
for the debt.

4.  As in residential mortgage financing, the note is
the document used to create a legal debt.
 The note often deals with (1) amounts and
timing of periodic payments, (2) penalties for late
payments, (3) record keeping, (4) hazard
insurance requirements, (5) property
maintenance, and (6) default.

5.  Again, the mortgage comes with the note.
 The commercial mortgage ensures that lenders
can have the property sold to satisfy the debt if
borrowers default.
 Overall, commercial mortgages and notes are not
as standardized as home loans.

6.  A commercial mortgage loan is usually a partially
amortized fixed-rate “balloon” mortgage.
 25 to 30 year amortization of principle.
 5 to 10 year maturity.
 Balance of loan at maturity must be refinanced or paid
off with a “balloon” payment.
 Balloon loans reduces the lender’s interest rate risk
because of the short loan term of 5-10 years.

7.  A 30-year amortization schedule and a 5-year,
$5 million mortgage, at 5.56%
(5.56%/12=0.4633%) stated rate.
 The monthly payment is: -5,000,000 PV; 360 N;
0.4633 I/Y; CPT PMT = $28,577. This relative
low payment makes the loan “affordable.”
 The final, balloon payment at the end of the 5-
year contract is: 300 N; 0.4633 I/Y, 28577 PMT;
CPT PV = -4,626,716.

8.  Suppose that the market interest rate jumps from 5.56% to
6%(6%/12=0.5%) immediately after origination of the loan
(interest rate shock).
 The PV of the 5-year loan goes from $5 million to: 60 N;
28577 PMT; 4626716 FV; 0.5 I/Y; CPT PV = -4,908,280*.
 If this were a typical 30-year fully amortized (FV = 0)
contract (not a 5-year balloon one), the PV of the loan goes
from $5 million to: 360 N; 28577 PMT; 0 FV; 0.5 I/Y; CPT
PV = -4,766,404**.
 * is closer to $5 million than **. So, the balloon loan is less
sensitive to interest rate shocks.

9.  Most fixed-rate commercial mortgages do not
allow for prepayment. 2 mechanisms: (1) lock-
out, and (2) penalty.
 Lock-out: prohibition against prepayment for up to
5 years.
 Prepayment penalties, e.g., 2-4% of loan balance.

10.  Floating-rate loans (or I/O loans)
◦ Just like ARMs in residential mortgages.
◦ Based on prime rate or LIBOR (London Interbank Offer
Rate).
 Joint venture
 Sale-leasebacks
 Mezzanine financing

11.  Usually between a developer (with local
knowledge) of a large project and a:
◦ Pension fund.
◦ Life insurance company.
◦ REIT.
 The funding institution provides (1) construction
financing, (2) long-term mortgage, (3) equity
capital, or (4) a combination of them.

12.  “General Growth Properties Inc., the second largest mall owner, is
shopping its portfolio to potential joint-venture partners as it
scrounges for capital to pay off $18.7 billion of debt coming due
over the next 4 years.”
 “At the height of its buying binge in 2004, General Growth financed
nearly all of its $12 billion purchase with debt.”
 General Growth’s debt binge has left it with a debt-to-capitalization
ratio of 66%, well above those if its peers (38-48%).
 “The company is approaching pension funds and life-insurance
companies to first determine if they are interested in a deal before
hashing out which properties would be involved.”
 Source: WSJ, Apr. 16, 2008.

13.  Property user (initial owner) sells property to a
long-term investor, e.g., a pension fund, REIT, or
life insurance company.
 User leases property back from the investor and
occupies it under long-term net lease.

14.  User benefits:
◦ Lease payment is deductible for income taxes.
◦ Equity capital is freed up to invest in core business of
company.
◦ Restructure capital structure.
 Investor benefits:
◦ Can be safe investment (depending on credit
worthiness of tenant).
◦ Inflation hedged (especially if lease payments increase
with inflation).

15.  Mezzanine debts are supplements underlying first
mortgage debt.
 Mezzanine debt is often a non-mortgage loan
secured by a pledge of ownership shares.
 If borrower defaults, lender takes over the
borrower’s ownership position.

16.  1. Loan request application: the amount request,
borrower’s financial statement, credit report, etc.
 2. Property description: map, photo, etc.
 3. Legal aspects: precise, legal description of
the property, deed restrictions, etc.
 4. Cash flow estimates: pro forma, DCF
analysis, etc.
 5. Appraisal report.

17.  Lenders focus more on the income-generating
ability of the property. Recall that in residential
underwriting, lenders focus more on applicant’s
characteristics, e.g., creditworthiness and ability
to pay).
 Lenders must perform a due diligence to
determine, essentially, that potential borrowers
have not misrepresented the properties in any
way.
 Loan commitment: if ok, 45 to 90 days after
receipt of “package.”

18.  Land acquisition financing: finance the purchase
of raw land.
 Land development loan: finance the installation of
improvements to the land (sewers, utilities, etc.).
 Construction loan: finance the construction of
building.

19.  In general, short-term debt is cheaper than long-
term debt.
 Thus, firms have incentives to use short-term debt
to finance long-term properties and assets.
 This dangerous practice is characterized by
maturity mismatching.

20.  “Broadway, a closely held New York-based office
investor,… bought several billion dollars of property with
short-term debt near the top of the market in 2006 and
2007. When real estate markets sized up last summer,
Broadway was suddenly put on defense and is now
trying to shore up its finances.”
 “New York tycoon Harry Macklowe, unable to refinance
$7 billion in short-term debt, has agreed to five his
lenders the keys to 7 Manhattan towers.”
 Source: WSJ, Apr. 23, 2008.

21.  Commercial banks
 Thrift institutions
 Life insurance companies
 Mortgage bankers
 Commercial MBSs (CMBSs)

22.  Wells Fargo Commercial Mortgage offers a full line of commercial
mortgage lending and servicing solutions to middle-market investors and
developers across the nation. With a full suite of products and services, we
can serve virtually any commercial real estate need.
 Permanent Debt Finance — Non-recourse (secured), fixed- and variable-
rate financing on income-producing properties.
 Construction & Project Finance — Construction, interim, and mini-perm
financing; construction loan advisory services; and Freddie Mac multifamily
financing to middle-market investors, developers, and commercial banking
customers.
 Commercial Mortgage Servicing — A full range of commercial mortgage
backed securities (CMBS) loan servicing for third-party institutional
investors, government-sponsored agencies such as Freddie Mac and
Fannie Mae, investment banks, life insurance companies, and other
financial institutions.
 https://www.wellsfargo.com/com/realestate_fin/cmo/

23.  In 2007, Blackstone Group completed a huge deal: the
$26 billion leveraged buyout of Hilton Hotels Group.
 The equity was $6 billion and the debt was $20 billion.
 “The Hilton deal already has proved painful for the 7
banks that provided the financing…as they still are
struggling to sell pieces of the debt.”
 “Some analysts believe much, if not all, of that equity
has been wiped out, at least on paper.”
 Source: WSJ, Nov. 05, 2008.

24.  Investors can hold equity shares in commercial
RE through either (1) direct private investment, or
(2) RE securities.
 RE securities can be issued in either (1) private
markets or (2) public markets, e.g., NYSE.

25.  Individuals (families) can surely invest in commercial real
estate, say owning an office building in Manhattan.
 Pension funds, public funds (e.g., Alaska Permanent
Fund), life insurance companies, and other institutional
investors participate in direct private investments as well.
 However, most of direct private investments are owned
by syndicates.
 A syndicate is a group of persons or legal entities who
come together to carry out a direct RE investment.

26.  RE syndicates are usually organized as limited
partnerships (LP) or limited liability companies
(LLC).
 Limited partnership:
◦ Taxed at individual level (so no double taxation).
◦ Limited liability for some of the partners.
 Limited liability company:
◦ Limited liability for owners.
◦ No double taxation.

27.  Syndicator organizes the investors and
manages the activities of the enterprise.
 Usually a well-known RE businessperson in a
local RE community.
 Syndicator is general partner (GP) in LP or
managing member in LLC.
 Develop concept; raise money; acquire RE;
professional management; disposition.

28.  Under Federal Securities Acts of 1933 and
1934, all RE syndications are “securities.”
 All securities are subject to federal and state
securities laws.
 SEC has responsibility for administering federal
securities laws:
◦ All offerings are registered with SEC, unless exempted.
 Every state also has securities laws.

29.  RE securities have became increasingly important
over time.
 Among RE securities, real estate investment
trusts (REITs) are the dominant form of equity
financing.

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31.  Public, listed REITs
 Public, non-listed REITs
 Private (non-listed) REITs

32.  REITs are “pass-through” public corporations.
 REITs are not taxed at the corporate level if:
◦ At least 100 shareholders.
◦ At least 75% of assets in RE, cash, or government
securities.
◦ At least 75% of gross income comes from RE assets.
◦ 90% of REIT taxable income must be paid out in
dividends each year.

33.  REITs are closed-end mutual funds for investing
in real estate.
◦ Diversification benefits.
◦ Liquidity, thus higher RE values, if listed.

34.  Equity REITs
◦ Office
◦ Retail
◦ Industrial
◦ Hotel
◦ Health care
◦ Apartment
◦ Self-storage
◦ Non-traditional
 Mortgage REITs