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FIFTH EDITION 2005

Transforming
Real Estate
Finance
A CMBS Primer

Primary Analysts: Howard Esaki


Marielle Jan de Beur
Masumi Goldman
This book is an overview of the Commercial
Mortgage-Backed Securities (CMBS) market.

The contents of this publication are over eight


years in the making and include excerpts of
research reports from as early as 1997. In this
fifth edition of our primer, we have reorganized the
chapters to highlight the different investment
options within CMBS. New material since our last
edition includes sections on the various types of
AAA CMBS classes, total rate of return swaps,
floating rate large loan transactions, and an
updated version of the commercial mortgage
default study.

We hope you find this book useful and welcome


comments so that we can improve future editions.
FIFTH EDITION 2005

Transforming
Real Estate
Finance
A CMBS Primer

Primary Analysts: Howard Esaki


Marielle Jan de Beur
Masumi Goldman

The Primary Analyst(s) identified above certify that the views


expressed in this report accurately reflect his/her/their personal
views about the subject securities/instruments/issuers, and no
part of his/her/their compensation was, is or will be directly or
indirectly related to the specific views or recommendations
contained herein.
This report has been prepared in accordance with our conflict
management policy. The policy describes our organizational
and administrative arrangements for the avoidance,
management and disclosure of conflicts of interest. The policy
is available at www.morganstanley.com/institutional/research.
Please see additional important disclosures at the end of
this report.

Morgan Stanley & Co. Incorporated


450
December 16, 2004
Transforming Real Estate Finance
A CMBS Primer
1 INTRODUCTION T O C MBS 1 – 8
History and Structure 2
Rating Agency Methodology 4
2 MAJOR P ROPERTY T YPES I N C MBS 9 – 39
Property Classifications 10
Retail 12
Multifamily 14
Office 16
Manufactured Housing 18
Industrial 20
Self Storage 22
Health Care 24
Hotel 26
3 CALL P ROTECTION 41 – 5 3
Types of Call Protection 43
Allocation of Prepayment Penalties 47
Relative Value Analysis 48
4 AAA F IXED R ATE C MBS 55 – 7 0
Tight Window Bonds 56
Multifamily Directed Bonds 62
Amortizing Bonds 63
Premium Dollar Priced Bonds 68
5 TOTAL R ATE O F R ETURN S WAPS 71 – 7 4
Mechanics of the Swap 72
Break-even Analysis 73
6 CMBS I O s 75 – 9 1
Overview 76
PAC & Levered IO 81
Age-Adjusted Default Analysis 84
Pricing Benchmarks: E and J 88
7 FIXED R ATE L ARGE L OANS 93 – 9 9
Fusion vs. Single Asset 94
Characteristics 96
Rating Agency Approach 98
8 BBB C MBS A ND R EIT s 101 – 1 22
Overview 102
Performance 109
9 CMBS C ONDUIT S UBORDINATION L EVELS 123 – 1 77
The Right Subordination 124
Projecting Losses on BBB- CMBS 128
Projecting Losses on BB CMBS 146
Projecting Losses on B CMBS 162
10 MULTIFAMILY M BS 179 – 1 87
Fannie Mae DUS and DMBS 180
Ginnie Mae and Freddie Mac Programs 185
11 FLOATING R ATE L ARGE L OAN C MBS 189 – 2 07
Extension Risk 190
Ratings Drift 194
Available Funds Cap Mechanics 204
12 COMMERCIAL M ORTGAGE D EFAULTS 209 – 2 21
Characteristics of Defaulted Loans 211
Loss Severity 212
Study Results and Impact on CMBS 214
13 TRANSACTION M ONITORING 223 – 2 65
Monthly CMBS Delinquency Report 224
Conduit Tracking Report 228
Retail Study 234
CMBS Rating Actions 242
CMBS Loan Originators 252
14 EUROPEAN C MBS 267 – 2 75
15 JAPANESE C MBS 277 – 2 90
16 FACTORS T O C ONSIDER B EFORE I NVESTING I N C MBS 291 – 2 97
17 GLOSSARY 299 – 3 06
This Page Intentionally Left Blank
Chapter 1

Transforming Real Estate Finance


Introduction to CMBS

Please see additional important disclosures at the end of this report.


Transforming Real Estate Finance
chapter 1 Introduction to CMBS

Commercial Mortgage Backed Securities (CMBS) are bonds backed by pools of


mortgages on commercial and multifamily real estate. As of December 2004, the
global market capitalization of the CMBS market was slightly over $541 billion.
About 1 in 5 commercial and multifamily mortgages are in CMBS, compared to
a securitization rate of about 50% for residential mortgages.
CMBS offer several advantages over commercial whole loans. Securitization
allows for the division of the loan into credit classes so that an investor may buy
a class rated from AAA to single-B and unrated. In addition, CMBS are marked
to market on a daily basis and hence are more liquid than whole loans. CMBS
appeal to a wide array of investors because of attractive relative spreads and
stronger call protection than residential mortgage securities.
DEVELOPMENT O F T HE M ARKET
Before the mid-1990s the U.S. real estate business was predominately a private
market. Lending was dominated by a handful of banks, life insurance companies,
and pension funds. Real estate ownership was regionally focused with ownership
concentrated in a few hands. Families and private partnerships were the largest
owners. Small and diversified investments in real estate were almost nonexistent.
Real estate is a cyclical business moving through various stages of expansion,
equilibrium, slow growth, and recovery. Private ownership of real estate and lack
of public information fostered extreme real estate cycles. Development and
lending was done on a regional basis with little national information.
The steep real estate recession of the late 1980s and early 1990s was the worst
since the Depression of the 1930s. Prices of commercial real estate fell by 50%
or more in some areas and delinquency rates on loans soared to all-time highs.
Losses on commercial loan portfolios led to the exit of many traditional lenders
from the commercial mortgage market. Regulators and rating agencies turned
more negative on commercial mortgage holdings, so that the remaining lenders
became less willing to extend credit.
CMBS: D IVERSIFIED P UBLIC R EAL E STATE
Low real estate values combined with the failure or exit of traditional lenders
provided innovation opportunities and a shift from private to public ownership.
REITs began buying undervalued real estate portfolios funded through public
stock and bond offerings. REIT shares provided an opportunity for small, diver-
sified investments in real estate.
As with REITs, CMBS provide investment opportunities in diversified real estate
pools. Investment banks started to apply securitization legal structures, and tech-
nology developed during the 1970s and 1980s for residential mortgage-backed
securities to commercial mortgages. In the mid- to late-1980s, issuers securitized
a few loans on single properties into CMBS.
Packaging of diversified pools of mortgages into CMBS developed in the mid-
1990s when the Resolution Trust Corporation (RTC) pooled non-performing
loans from failed institutions. Some of these transactions exceeded $1 billion
and led to the growth in the investor base for CMBS. After the success of the
RTC transactions, CMBS gained wider acceptance with investors and non-gov-

2
ernment, or “private-label”, issuers. Issuance of CMBS in the U.S. grew rapidly
in the mid-1990s. In 2004, U.S. CMBS issuance is expected to reach an all-time
high of nearly $90 billion.
Outside the U.S., CMBS has also taken hold as a financing vehicle, with $18.5
billion issued in Europe in 2004. Most of the transactions are out of the United
Kingdom, but deals have been done in several other countries. In Asia, Japan is
facing an RTC-like situation, with distressed properties and lenders. In 2004,
about $5 billion of CMBS came to market in Asia.
STRUCTURES A ND R ATING A GENCIES
CMBS have very simple structures compared to their residential mortgage coun-
terparts. The bonds are almost always sequential pay, with amortization, prepay-
ments, and default recoveries paid to the most senior remaining class. The low-
est-rated remaining class absorbs losses. Since commercial mortgages almost
always have some form of prepayment penalty (Chapter 3), credit analysis plays
a more important role than prepayment analysis. For residential MBS, prepay-
ments are a much more important factor.
CMBS are static pools of commercial real estate loans divided into tranches with
varying subordination levels and credit ratings. A typical transaction has about
90% investment grade bonds concentrated in AAA securities, with the remaining
10% non-investment grade. Interest only (IO) bonds (Chapter 6) can be stripped
off all or part of the structure.
Structure
A typical fusion structure consists of sequential pay, fixed rate bonds. The AAA
bonds are time-tranched and include a front-pay wide window bond. In addition
to the front-pay class, the AAA CMBS market also includes tight window bullets,
multifamily directed classes, amortizing bonds, super senior and junior AAAs.
(See Chapter 4 for more information.)
In an environment of steadily declining subordination levels, the most recent
trend in CMBS issuance is the super senior deal structure. Prior to the emer-
gence of this structure, which includes multiple super senior AAA bonds sup-

exhibit 1

SAMPLE 20041
NEW ISSUE
MARKET CMBS
STRUCTURE

Based on Commercial Mortgage Default Study. See Chapter 12.


1

Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 3


Transforming Real Estate Finance
chapter 1 Introduction to CMBS

ported by a 10-year junior AAA bond, AAA subordination levels in 2004 ranged
in the low- to mid-teens. Issuers have been able to structure super senior AAA
classes with credit enhancement as high as 20% by carving out a smaller, subor-
dinate AAA class. The subordinate 10-year AAA has a lower credit enhance-
ment level than the other AAA-rated bonds.
In addition to the mortgage collateral, credit enhancements may be in the form
of reserve funds, guarantees, letters of credit, cross-collateralization and cross-
default provisions. Loans within the pool may have certain cash control provi-
sions such as a “lock box” that requires payments from tenants to go directly to
the trust instead of through the borrower if certain default triggers occur.
Virtually all loans within CMBS are bankruptcy remote.
The Trustee, Master Servicer and Special Servicer each play an ongoing role in
the transaction. The Pooling and Servicing Agreement, Prospectus, and other
legal documents outline each party’s responsibilities and fees. Typically, the
Trustee is responsible for reporting monthly payments and collateral perform-
ance data to certificate holders. The Master Servicer is responsible for servicing
all performing loans and monitoring loan document requirements. The Special
Servicer resolves defaulted or delinquent loan issues.
RATING A GENCY M ETHODOLOGY
Before each CMBS is issued, the rating agencies review the collateral in the
transaction and determine the tranche ratings and pool sizing. During the
process the agencies review the property level cash flows, perform physical
inspections, and run various stress analyses on the underlying cash flows. This
section examines the rating process for conduits, or diversified pools of mort-
gages. A conduit originates loans for sale or securitization, and not for hold-
ing in a portfolio.
When a conduit deal comes to market, the rating agency performs due dili-
gence on a subset of the properties (typically between 35% and 75%). The
larger loans in the deal are always underwritten while the remaining properties
are chosen such that they provide a representative cross section of the deal.
To determine credit enhancement levels, the underwritten cash flow (UCF)
produced by each property is then assigned a “haircut” based on various sub-
jective parameters. Following is a list of parameters that rating agencies con-
sider when evaluating a CMBS conduit1:
• Loan Specific • Deal Specific
Property type Number of loans in the deal
Loan-to-value ratio Loan size
Debt service coverage ratio Degree of subordination
Fixed/floating rate Balloon extension risk
Loan seasoning
Quality of master servicer
Direct versus and special servicer
correspondent lending
• Real Estate Outlook

1
The parameters are similar to those considered for a non-conduit deal except for adjustments for
loan diversification.

4
Loans collateralized by different property types are generally ranked in the
following order (best to worst): regional malls, multifamily, anchored community
retail, industrial, office and, finally, hotel. These rankings are based on historical
defaults and cash flow volatility of the different property types. The variation of
required credit enhancement levels with debt service coverage (DSC) and loan-
to-value (LTV) ratios is shown in Exhibit 2 for common property types. (The
credit enhancement levels are from Duff and Phelps, which merged with Fitch
in 2000. The levels are indicative only, and are different for each rating agency.)
For example at 80% LTV and 1.15 DSC, a regional mall requires 30.1% credit
enhancement for a AAA rating while an office property requires double that fig-
ure. The credit enhancement levels shown in Exhibit 2 are somewhat “sticky”
with respect to a credit/real estate cycle.
It is therefore sometimes possible to “arb” this fact by, say, buying conduit CMBS
backed by office properties in an environment where the fact that office proper-
ties are doing well is not reflected in credit enhancement levels. Obviously, AAA
securities are much less conducive to this kind of play than lower-rated classes.

exhibit 2 BASE-CASE CREDIT ENHANCEMENT


GUIDELINES FOR VARIOUS PROPERTY TYPES

OFFICE Individual Credit


PROPERTIES Loan Coverage Enhancement
LTV DSCR AAA AA A BBB BB B
30 2.50 3.9 2.9 2.2 1.5 1.0 0.5
40 2.00 7.8 5.8 4.3 3.0 1.6 1.0
50 1.75 13.1 9.7 7.2 5.0 2.7 1.1
60 1.50 20.9 15.5 11.5 8.0 4.4 1.7
65 1.45 27.2 20.2 14.9 10.4 5.7 2.3
70 1.35 35.8 26.6 19.6 13.7 7.5 3.0
75 1.25 47.1 34.9 25.8 18.0 9.9 3.9
80 1.15 60.2 44.6 33.0 23.0 12.6 5.0

REGIONAL Individual Credit


MALLS Loan Coverage Enhancement
LTV DSCR AAA AA A BBB BB B
30 2.50 2.0 1.5 1.1 1.0 0.5 0.5
40 2.00 3.9 2.9 2.2 1.5 1.0 0.5
50 1.75 6.5 4.8 3.6 2.5 1.4 1.0
60 1.50 10.5 7.8 5.7 4.0 2.2 1.0
65 1.45 13.6 10.1 7.5 5.2 2.8 1.1
70 1.35 17.9 13.3 9.8 6.9 3.8 1.5
75 1.25 23.5 17.5 12.9 9.0 4.9 2.0
80 1.15 30.1 22.3 16.5 11.5 6.3 2.5

Source: The Rating of Commercial Mortgage-Backed Securities, Duff and Phelps Credit Rating Co.

Please see additional important disclosures at the end of this report. 5


Transforming Real Estate Finance
chapter 1 Introduction to CMBS

exhibit 2 BASE-CASE CREDIT ENHANCEMENT


GUIDELINES FOR VARIOUS PROPERTY TYPES
(CONTINUED)
INDUSTRIAL/
ANCHORED Individual Credit
RETAIL Loan Coverage Enhancement
PROPERTIES
LTV DSCR AAA AA A BBB BB B
30 2.50 2.5 1.9 1.4 1.0 0.5 0.5
40 2.00 5.0 3.7 2.7 1.9 1.1 0.5
50 1.75 8.4 6.2 4.6 3.2 1.8 1.0
60 1.50 13.4 9.9 7.3 5.1 2.8 1.1
65 1.45 17.4 12.9 9.5 6.7 3.6 1.4
70 1.35 22.9 17.0 12.6 8.8 4.8 1.9
75 1.25 30.1 22.3 16.5 11.5 6.3 2.5
80 1.15 38.5 28.5 21.1 14.7 8.1 3.2
MULTIFAMILY Individual Credit
PROPERTIES Loan Coverage Enhancement
LTV DSCR AAA AA A BBB BB B
30 2.50 2.6 1.9 1.4 1.0 0.5 0.5
40 2.00 5.2 3.9 2.9 2.0 1.1 0.5
50 1.75 8.7 6.5 4.8 3.3 1.8 1.0
60 1.50 13.9 10.3 7.6 5.3 2.9 1.2
65 1.45 18.1 13.4 9.9 6.9 3.8 1.5
70 1.35 23.9 17.7 13.1 9.1 5.0 2.0
75 1.25 31.4 23.3 17.2 12.0 6.6 2.6
80 1.15 40.1 29.7 22.0 15.3 8.4 3.3

Source: The Rating of Commercial Mortgage-Backed Securities, Duff and Phelps Credit Rating Co.

Investors should also be concerned with the dispersion of DSC and LTV in the
entire deal; that is, having all loans with a DSC of 1.5x is better than having 50%
of the loans at 1.0x and the remainder at 2.0x. There may be some element of
“gaming” credit-support levels to the extent that Fitch uses discrete DSC and
LTV buckets while the other rating agencies use a continuous variation of credit-
support with DSC and LTV. However, this is usually mitigated by the fact that at
least two rating agencies rate the investment grade classes of a CMBS.
Given the volatility of short-term interest rates, an adjustable-rate loan is under-
written under an interest rate scenario that is substantially higher than current
rates. Loans without a track record of consistent payments are also rated more
conservatively than those seasoned at least five years. The origin of a loan,
whether direct or via a correspondent, matters less than it previously did. Many
subjective assessments also go into the rating process and Exhibit 2 shows the
addition and subtractions that rating agencies apply to the credit support level.

6
exhibit 3 SUBJECTIVE ADJUSTMENTS
TO CREDIT SUPPORT LEVELS

Special Adjustment1 Other Factors Applied


Additions Reductions on a Case-By-Case Basis
Amortization
Fully 5% Floating Interest Rates
Interest Only 20% — Asset Quality
Less Than
5 Years Seasoning 10-20% — Market Barriers to Entry
Servicer/Special Cash Flow Volatility
Servicer Assessment 10% 10% Loan Size
Quality Assessment
Origination 20% 5% Location Assessment
Information 20% 5% Concentration
Cash Control — 10-20%
Reserves — 5-10%

1
Adjustments are applied as a percentage of base-case credit enhancement levels; i.e., if base-case credit
enhancement is 10%, and the adjustment factor is 20%, the adjusted credit enhancement is 12% (10 x 1.2).
Source: The Rating of Commercial Mortgage-Backed Securities, Duff and Phelps Credit Rating Co.

On a deal level basis, conduits have diverged most significantly from the tradi-
tional CMBS model in the degree of diversification provided by the large num-
ber of underlying loans. It is not uncommon to see 200 or more loans in a con-
duit. The rating agencies like to see at least 50 loans underlying a deal with no
more than 5% of the deal (by dollar amount) in any one state. Any single loan
should not constitute more than 5% of the deal. Credit-support levels are often
tested by defaulting the three largest loans.
At the triple-A rating level, subordination levels are likely to be very similar
across rating agencies. However, some degree of rating shopping is likely to
occur for lower-rated pieces, given the many subjective aspects of the rating
process. One of these aspects is the quality of the master and special servicers.
The rating agency looks for a special servicer with a proven track record of real
estate workouts.
The rating agency would be concerned if a large number of loans came due at the
same time. This is because loan documents typically allow for three one-year exten-
sions, and this is not necessarily long enough to get through a credit downturn.
Finally, the rating agencies evaluate the real estate environment and where we are
in the credit cycle.

Please see additional important disclosures at the end of this report. 7


Transforming Real Estate Finance
chapter 1 Introduction to CMBS

RATING A GENCIES A ND I NVESTORS M ONITOR C ONDUIT Q UALITY


Some investors have expressed concerns that commercial mortgage conduits have
become too aggressive in lending and that the quality of loans in CMBS conduit
pools will deteriorate. Other investors worry that conduits will chase after loans
backed by “B” or “C” -quality properties, leaving the top-tier loans to insurance
companies. In our opinion, these fears are misplaced, since securitized loans must
ultimately pass through the filters of both rating agencies and investors. If rating
agencies recognize a slide in credit-quality rating, they will increase credit support
levels (or lower ratings). If investors perceive increased risk, they will demand
wider spreads on the securities. Investors can make adjustments to a recognized
drop in loan quality; it is the unrecognized slippage that is dangerous.
As discussed in the section above, rating agencies apply published standards to
loans pooled into a CMBS and adjust the result by making qualitative assess-
ments. Almost all CMBS carry at least two, and many have three, ratings.
Different rating agencies assign different levels of credit support to obtain a
given rating level. In order to avoid a split rating, an issuer must go with the
most conservative collateral assessment. For example, if Fitch and Moody’s have
AAA credit support requirements of 23% and 25%, respectively, an issuer must
use 25% enhancement to attain a dual AAA rating. (In a few instances, an issuer
will go with the lower credit support level and receive a split rating. Non-invest-
ment grade classes, however, are often rated by only one agency). If an issuer
starts to raise LTVs, reduce DSC ratios, or lend on more risky property types or
in more risky areas, rating agencies will respond by lifting credit support levels.
The rating agencies thus act as a first level of defense against a potential unob-
served fall in loan credit quality.

8
Chapter 2

Transforming Real Estate Finance


Major Property Types in CMBS

Please see additional important disclosures at the end of this report. 9


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

While CMBS investors don’t need to be real estate experts, particularly at the
AAA level, a general understanding of various real estate property types and ter-
minology is helpful. In this chapter we explain the various types of real estate
properties and fundamentals that impact their performance.
Information in a transaction prospectus may contain descriptions of various
assets as Class A, B, or C. Below is a description of those asset classes.
CLASSIFICATIONS
Class A
Newly built; higher quality finishes and prominent locations.
Class B
Generic real estate; 10-20 years old, well maintained, average locations,
fewer amenities.
Class C
Older properties needing frequent capital investment; uncertain future.
WHY D O P ROPERTY C LASSIFICATIONS M ATTER?
• Generally, it is believed that Class A properties are the least risky from a
cash flow volatility standpoint.
• The Class A properties set the rental rates in a market. They attract the most
credit worthy tenants and, by definition, typically have the least deferred
maintenance and the lowest risk of functional obsolescence.
• In a market downturn these properties will have the highest demand for
space, albeit at a lower rental rate.

10
class A

class B

class C

Please see additional important disclosures at the end of this report. 11


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Conduit CMBS transactions provide property type and geographic diversity.


Currently, retail properties account for about 30% of outstanding CMBS in the
market, multifamily accounts for about 18%, office properties account for about
24%, hotels account for about 8%, and the remaining 20% is composed of man-
ufactured housing, industrial, self-storage, and senior housing.

Retail Loans
Typical Loan Terms

• 1.4 DSCR
• 65% LTV (based on a 9–10% capitalization rate)
• $75–$125 Loan Per Square Foot Value

RELATED T ERMS
Credit Tenant Lease
All payments guaranteed by credit of tenant (i.e., WalMart).
Triple Net Lease
Tenant pays rent, real estate taxes, expenses, and maintenance.
Go Dark Provisions
Prevents tenant from vacating the space while continuing to pay rent; landlords
like this because this vacant space is a detriment to other stores’ sales at the center.
Co-T
Tenancy Provisions
Permits the tenant to cancel its lease if another major tenant closes.
Recapture Provisions
Permits the owner to cancel a lease and to regain control of space after a tenant
closes its store.
TYPES O F R ETAIL P ROPERTIES
Super Regional Mall
Over 1 million square feet with multiple department (4-5) stores as anchors.
Regional Mall
Over 750,000 square feet with several department stores (2-3) as anchors.
In-L
Line Store
Smaller store within a center (i.e., Foot Locker or Hallmark Cards store).
Community Center
Over 100,000–275,000 square feet of space; multiple anchors but not enclosed.
Anchored Strip Center
Grocery or discount retailer attracts tenants to small stores that are adjacent.
Shadow Anchored Strip
Same as the anchor strip, but the anchor is not part of collateral for the loan.

12
community center anchored strip

power center/big box unanchored strip

Unanchored Strip
No major destination type tenant. Usually smaller local tenants. A particular
location must have natural traffic to be successful. The best assets are located
in highly developed areas with little vacant land.
Power Center/Big Box
Anchor tenants and some small stores. Typically big discounters or mass retail-
ers. Examples include Circuit City, Best Buy, and Target.
CONVENTIONAL I NVESTOR W ISDOM
• Retail stores in general are under competitive pressures from alternative
distribution channels.
• Aggressive competition for market share leading to construction of big box/
large store formats.
• Super-regional malls are the least affected by the negative factors listed above. These
malls are anchored by strong department stores that support the in-line tenants.
• Mid-market malls are viewed as under the most pressure from alternative
retailing concepts. Anchor stores in these malls are less of a draw and
compete directly with value-based retailers.
• Grocery/drug anchor strips are life insurance company favorites.
RATING A GENCY V IEW
• Generally received favorable treatment from rating agencies as a result
of strong historical performance.
• Preference for longer leases; nationally or regionally rated credit tenants.

Please see additional important disclosures at the end of this report. 13


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Multifamily Loans
Typical Loan Terms

• 1.25x DSCR
• 75% LTV (based on a 8–9% capitalization rate)
• $20,000–$60,000 Loan Per Unit

RELATED T ERMS
Co-o
op Loans/Blanket Loans
Very low loan to value loans. Loans senior to co-op share loans.
Unit Mix
Desirable ratio of 1-bedroom versus 2-bedroom apartments depends on the
market. Older complexes had higher proportions of 1-bedrooms; higher per-
centages of 2-bedrooms are now preferred, since they provide more flexibility to
families and lifestyle renters.
Reserves
Underwriting usually includes $200-300 per unit per year for new paint, carpet,
appliances, etc.; as apartments may be remarketed annually.
TYPES O F M ULTIFAMILY P ROPERTIES
Garden Apartments
Multiple buildings; usually no more than 2-3 stories.
High Rise Apartments
Over three stories; usually located in downtown areas.

garden apartments high rise apartments

14
CONVENTIONAL I NVESTOR W ISDOM
• Potential overbuilding in high growth markets of the Southeast and Southwest
— Houston, Atlanta, Las Vegas.
• Multifamily was the first sector to recover from the real estate recession.
• Birth dearth has resulted in fewer households in prime renting years of 25-34.
This fact somewhat mitigated by the “lifestyle” renter.
• A lifestyle renter is someone who can afford a home but chooses to rent for
convenience: divorcees, empty-nesters.
• Healthy apartment properties have occupancies of 93% and higher.
Occupancies below 88% for existing properties are worrisome.
• Government sponsored entities desire transactions with high concentrations in
multifamily properties.
RATING A GENCY V IEW
• A “must have” property type for diversity.
• Lower default tendency due to constant mark-to-market of rental rates
(1-year-lease terms).
• Basic need housing.
• Tolerated lower DSCR and higher LTV than other commercial property types.
• Basket of individual home owner credits; not specific business risks.
• Concerns of military or single employer concentrations.

Please see additional important disclosures at the end of this report. 15


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Office Loans
Typical Loan Terms

• 1.4x DSCR
• 70% LTV (9–10% cap rate)
• $50–100 Loan Per Square Foot for Suburban Properties
• $70–150 Loan Per Square Foot for Downtown Central
Business District (CBD)

RELATED T ERMS
Tenant Improvements
Costs to build walls, ceilings, carpet for a new tenant, typically $5-40 per square
foot. The landlord usually incurs this expense. In strong demand markets the
landlord can pass this expense through to the tenant in terms of a higher rental
rate. In weak markets, landlords must take tenant improvements out of net
income, which reduces cash flow.
Leasing Commissions
Fees paid to brokers to bring tenants, typically $2–4 per square foot at lease sign-
ings. Landlords bear this expense.
Rollover
Term used to describe expiration of a tenant lease. Lease terms are generally for
5-10 years; credit tenants may be longer. It is preferable to not have rollover con-
centrations, which would expose an owner to uncertain rental market or poten-
tially reduce NOI below debt service.
TYPES O F O FFICE B UILDINGS

downtown suburban

16
CONVENTIONAL I NVESTOR W ISDOM
• Above market rents are a concern if the market rent is insufficient to support
the debt service. Rating agencies usually underwrite to market rents.
• Overbuilding: Investors that lived through the last real estate depression are
nervous about current levels of development.
• Downtown versus suburban: Suburban office has suffered recently. The recent
pop in the “tech bubble” has increased the supply of subleased space.
RATING A GENCY V IEW
• Very conservative approach makes underwriting these loans difficult.
• Very difficult to allow rollovers without cash reserves.
• Slow to accept market improvements in rental rates and values without many
other market comparable transactions.
• Want higher DSCR because of income volatility during lease rollover.
• Only give credit in underwriting for lesser of historical market rents or in
place rents.
• Tenant improvements/leasing commissions reserved for in escrow or excluded
from underwriting income, which reduces the amount of potential loan.
• Management fees of 5% used by rating agency underwriters are believed to
be above market rate of 1-3%.

Please see additional important disclosures at the end of this report. 17


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Manufactured Housing Community Loans


Typical Loan Terms

• 1.4x DSCR
• 70% LTV (9–10% cap rate)
• $10,000–$20,000 per pad

RELATED T ERMS
Manufactured Housing Communities
The land, streets, utilities, landscaping, and concrete pads under the homes com-
prise a manufactured housing community. The homes are independently
financed. Homeowners pay monthly rent for the pad to the manufactured hous-
ing community owner.
Pad
Concrete slab that supports each manufactured home.
Double Wide/Single Wide
Describes the size of manufactured home that a given slab will support. The
double wide segment has experienced the fastest growth due to the growing
acceptance of manufactured homes as a single family housing alternative.
TYPES O F M ANUFACTURED H OUSING C OMMUNITIES
3-S
Star Park
Older park lacking the amenities of a 5-star park; higher proportion of single
wide pads. Offer limited amenities and services.
4-S
Star Park
Usually double-wide units in good condition. Features may include concrete
patios or raised porches. Streets are generally paved. Many 4-star parks were for-
merly 5-star parks that are now showing their age by their dated look and type of
improvements.
5-S
Star Park
Curvilinear streets (streets that have curbs); neighborhood feel; well-landscaped;
high proportion of double wide pads. Located in desirable neighborhood with
convenient access to retail.
Trailer Park
This is a lower-end asset class, often confused with manufactured housing com-
munities. Trailer parks are highly transient, dense communities of homes on
wheels. Tenants are provided with no amenities other than simple utility
hookups. Not typically seen in conduit pools.

18
CONVENTIONAL I NVESTOR W ISDOM
• Lack of familiarity; confusion with asset-backed manufactured housing loans
to individuals.
• Insurance companies typically didn’t lend on this product, and it has some-
what of a stigma attached to it.
• Some investors have trouble distinguishing the relative investment stability of
manufactured housing communities from the credit of individual homeown-
ers. The credit characteristics are very different.
• Performance on these loans has been very strong. The security for loans
requires virtually no maintenance and very few manufactured homes are ever
moved from the pad.
• Cost to move ($3,000–5,000 a year) exceeds pad rental ($300–500 a month).
Upon homeowner foreclosure, bank will usually pay rent instead of moving
the foreclosed unit.
• Manufactured housing communities are also difficult to build as many
communities have restrictive zoning ordinances against them.
RATING A GENCY V IEW
• Rating agencies favorable on credit.
• Low volatility of cash flows.
• Physical turnover rate 3–5% in manufactured housing versus
50–60% in multifamily.
• Few capital reserves required.
• Often better than multifamily.

5-star park

Please see additional important disclosures at the end of this report. 19


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Industrial Loans
Typical Loan Terms

• 1.4x DSCR
• 70–75% LTV (8–10% Cap Rate)
• $10–25 PSF
• $30–50 PSF (if high office component)

RELATED T ERMS
Distribution Space
Principal use is distribution or light assembly. Minimal office space as a per-
centage of total space (typically 0-10%). “Clear heights”, 24´ ceiling heights,
are the minimum for modern distribution buildings. Higher clear heights are
more economical for tenants as they stack goods vertically and rent fewer
square feet.
Flex Space/Office Warehouse
Higher amount of office space as a percentage of total space. This results in
higher tenant improvement costs necessary upon lease renewals. These tenants
are less sensitive to clear heights and more sensitive to accessibility of qualified
labor pools.
Tilt-U
Up Construction
This is the preferred construction type for industrial buildings. It includes pre-
cast concrete panels that are “tilted-up” on a steel frame. Tilt-up is preferable to
corrugated metal exteriors for maintenance reasons.

distribution space

20
CONVENTIONAL I NVESTOR W ISDOM
• Frequently exposed to single tenant credit; but generally lower tenant improve-
ment costs makes rollovers more palatable than office.
• Older buildings with less competitive clear heights becoming functionally
obsolete. Constant roof repair is major expense item.
• Concerns over environmental contamination if property has had heavy
industrial use.
• Construction cycle for industrial properties generally shorter than other
property types (six to nine months versus two years for office); resulted in less
overbuilding in last downturn.
RATING A GENCY V IEW
• Like industrial for diversity.
• Review environmental issues from manufacturing uses.
• Very low cost to re-lease if tenant leaves, but short lease
terms create rollover risk.

flex space/office warehouse

Please see additional important disclosures at the end of this report. 21


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Self Storage Loans


Typical Loan Terms

• 1.3x, 1.4x DSCR


• 65–70% LTV
• $20–50 PSF

RELATED T ERMS
Self-S
Storage Facility
Commercial property that leases storage space to individuals or businesses on a
month-to-month basis. The average self-storage facility has between 40,000 and
10,000 square feet of rentable space divided among 400 to 1,000 individual units.
Management
Half of all self-storage facilities have a manager living in an on-site apartment.
The management team is important to solicit new business and to monitor any
delinquencies.
Tenant Profile/Turnover
Residential users make up more than two-thirds of self-storage facility renters.
The average length of self-storage rental is 12 months. Occupancy rates tend to
be in low-to mid-90s after long initial lease up period.

self-storage facility

22
CONVENTIONAL I NVESTOR W ISDOM
• Overbuilding and new competition are concerns, which are mitigated by
limited sites zoned for storage in populated areas.
• Properties are management-intensive.
• Population shifts affect demand; population inflow creates new demand but
population outflow may result in an increase in demand in the short term as
homeowners store excess items during relocation.
RATING A GENCY V IEW
• Approve of it as an additional diversifier.
• Higher volatility because of monthly rental contracts but rental base has been
relatively inert in moving stored items.
• Preference for infill or dense urban locations.

Please see additional important disclosures at the end of this report. 23


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Health Care/Senior Housing Loans


Typical Loan Terms

• 1.2–2.0X DSCR (depending on complexity of service)


• 50-80% Loan to Value
• $30,000-80,000 Loan Per Unit

TYPES O F H EALTH C ARE/SENIOR H OUSING P ROPERTIES


Independent Living Facilities
Multifamily apartment complexes catering to senior citizens. They supply few serv-
ices beyond building and ground maintenance. These facilities are unregulated.
Congregate Senior Housing
These are independent living facilities that provide a common dining facility and
other services. Congregate senior housing has no medical component, but may
provide access to emergency medical care through call buttons. Not licensed as
a nursing home.
Assisted Living Facilities
A product type targeted to elderly needing assistance, but not full time medical
care. These facilities typically consist of apartment style units with a kitchenette.
The operator of the facility provides three meals a day and assists residents with
daily activities such as feeding, bathing, dressing, and medication reminders.
Skilled Nursing Facilities
Independent nursing homes or a designated wing in a hospital. The facilities pro-
vide full-time licensed skilled nursing, medical and rehabilitative services. Average
length of stay can range from two months to two years, or more. Twenty-four
hour care is provided, with doctors and registered nurses on call. Facilities are
licensed by the state; operator must obtain a certificate of need from state before
beginning operation.
Continuing Care Retirement Communities
These facilities offer the entire continuum of seniors housing from independent
living to skilled nursing facilities. Residents move within the facility depending
on the level of care required. Licensed operator.

24
CONVENTIONAL I NVESTOR V IEW
• Recent changes in Medicaid reimbursements have negatively affected skilled
nursing and continuing care facilities.
• Excess supply of assisted living facilities has resulted in higher vacancy rates
and poor performance.
• Few recent additions to supply due to changes in Medicaid reimbursements.
• Concerns exist over the quality of management of the licensed facilities.
The license is owned by the manager; not the property owner. Many life com-
panies avoided the senior sector because of confusion with licensed “nursing
homes.” Foreclosure could result in license forfeiture and force economic
vacancy of asset until replacement manager is found and new license granted.
• Not easily converted to multifamily if license lost.
RATING A GENCY V IEW
• Positive demographics; aging of the baby boomers.
• They prefer densely populated areas with heavier capital reserves.
• Skilled nursing requires higher DSCR because high ratio of income derived
from medical services that are not derived from location of property but
rather need of specific patient.

Please see additional important disclosures at the end of this report. 25


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Hotel Loans
Typical Loan Terms

• 1.5x DSCR
• 65% LTV (10–12% cap rate)
• $20,000–60,000 Loan Per Room
• $80,000 + Full Service or Luxury

RELATED T ERMS
Average Daily Rate
Total guest room revenue divided by total number of occupied rooms.
Occupancy Rate
Number of occupied rooms divided by total number of rooms.
Revenue Per Available Room (RevPAR)
The revenue per available room is the total rooms revenue divided by the avail-
able rooms for a given period.
FF&E
Furniture, fixtures, & equipment; standard hotel underwriting includes a deduc-
tion as an operating expense for the ongoing replacement of FF&E, typically
4% to 5% of gross revenue. This differentiates hotel underwriting from apart-
ment underwriting where some of those same expenses are considered capital
expenditures and are not an operating expense deducted from NOI. Typical
refurbishment of common areas of the hotel should occur every seven years.
Franchise Fee
Fee paid to hotel company that allows hotel owner to “fly the flag” of a hotel
company (i.e., Marriott, Sheraton, etc.) and benefit from advertising and reserva-
tion network. Ranges from 4–7% of gross revenue.
TYPES O F H OTEL P ROPERTIES
Full Service
A hotel that offers banquet and convention services; one or more full service
restaurants.
Limited Service
No food service other than continental breakfast; minimal public space and small staff.

26
CONVENTIONAL I NVESTOR W ISDOM
• Hotels have the highest cash flow volatility of the four major property types
as they reprice rooms on a daily basis.
• The full service downtown hotels are more protected from new supply
because of high building costs and limited site availability.
• Limited service construction is up in many areas of the country.
• Full service hotels have higher fixed costs and lower operating margins than
limited service hotels.
RATING A GENCY V IEW
• Very conservative because use of average historical income often reduces
income to levels significantly below current highs.
• Maximum occupancy they will underwrite is 65–75%, despite actual figures
higher than that level.
• Use very conservative FF&E, franchise fee, management fees, instead of market fees.
• Bias toward national brands even if hotel is a niche segment that has strong history.

full service

limited service

Please see additional important disclosures at the end of this report. 27


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Hotel Collateral in CMBS


Rating agencies and many investors have often viewed hotels as one of the riski-
est property types. Unlike most other commercial real estate, which have long-
term leases, hotels have daily changes in occupancy and rental rates. In this chap-
ter, we examine the credit exposure of CMBS to hotels and discuss the history
of the hotel industry, hotel branding, and recent performance of hotels.
• Hotel demand is highly correlated with GDP and can be volatile.
• Supply of new hotel rooms built during the 1990s is 25% lower than the sup-
ply built in the 1980s.
• The hotel industry is typically profitable although it is a cyclical business.
• After September 11, 2001, the rating agencies commented on the corporate
ratings of most public hotel companies and revised some underwriting stan-
dards for new transactions.
• The aggregate CMBS market has about 8% exposure to hotels. Leverage levels are
more conservative on hotel loans than other property types, providing cushion.

exhibit 1

PROPERTY TYPE
MATRIX

Source: Morgan Stanley

GREATER S HOCK T O D EMAND T HAN E ARLY 1 990 S


Hotel demand is highly correlated to changes in GDP. When GDP is growing,
consumer confidence rises resulting in greater discretionary income. The events
surrounding September 11, 2001, resulted in a significant decline in hotel
demand. Industry data shows hotel demand declined significantly in late 2001,
2002 and 2003. In 2004, hotel demand recovered significantly with nationwide
revenue per available room (RevPAR) growth over 7% through August.

28
HOTEL S UPPLY S IGNIFICANTLY L OWER I N 1 990 S THAN 1 980 S
Over the past 15 years hotel ownership has experienced a significant shift from
private to public markets. The public capital markets have more efficiently
matched supply with demand than was the case in previous cycles.
The typical time frame for hotel development ranges between 12 and 36 months.
Between 1990 and 1991, demand declined significantly as the United States
entered a recession, at the same time supply continued to enter the market
through projects that were started in the late 1980s.
Currently, the industry is better suited from a new supply standpoint than it was
in the early 1990s.

exhibit 2

TOTAL
CONSTRUCTION:
1980s VS. 1990s

Source: Morgan Stanley, PricewaterhouseCoopers

exhibit 3

HOTEL ADDITIONS
TO SUPPLY
1972–2004P

Source: PriceWaterhouseCoopers

Please see additional important disclosures at the end of this report. 29


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

Rev PAR P ERFORMANCE A ND P ROJECTIONS


The hotel industry measures performance in revenue per available room
(RevPAR). RevPAR is defined as average daily rate (ADR) at a hotel multiplied
by its occupancy rate. For example, if a hotel has an ADR of $100 and an occu-
pancy of 80% its RevPAR is $80.00 ($100 x .80 =$80).
RevPAR has declined 3 out of the last 14 years, 1991 (Gulf War), 2001 (U.S. ter-
rorist attack), and 2002 (U.S. economic decline).
HOTEL F UNDAMENTALS C ONTINUE T O I MPROVE
Healthy economic growth and limited new hotel development fueled solid
nationwide RevPAR growth in 2004. The CPI numbers released for March and
April noted the “lodging away from home” component posted year-over-year
growth of 7.0% and 8.7%, respectively.
Year to date through August, nationwide RevPAR was up 7.1% over the same
period last year.
Hotel demand is highly correlated to GDP. Since our economists anticipate
strong GDP growth in the second half of 2004, we anticipate hotel fundamen-
tals to remain strong. Annual 2005 RevPAR growth is projected to be 4.5% by
PriceWaterhouseCoopers. PricewaterhouseCoopers uses its own GDP estimates
and other macroeconomic inputs to forecast RevPAR.

exhibit 4

NATIONWIDE
REVENUE PER
AVAILABLE ROOM
(RevPAR) GROWTH

Source: PricewaterhouseCoopers, Smith Travel Research

RATING A GENCY V IEWS O N H OTELS


After the events of September 11, 2001, rating agencies commented on the cor-
porate ratings of several hotel companies, and revised rating guidelines for
future CMBS transactions.
All three rating agencies commented on the ratings of several hotel operating
companies and hotel REITs.

30
In addition to the comments on corporate ratings, Moody’s and Fitch outlined
changes to underwriting guidelines for hotel loans within CMBS transactions.
Standard & Poor’s has not made any changes to its underwriting guidelines for
hotels in new issue transactions.
Fitch noted it was concerned about the performance of hotels. Therefore, for
transactions it will use the trailing 12-month RevPAR after August 31, 2001,
reduced by 20%, or the 1999 RevPAR number, whichever is lower. In place of
the significant RevPAR reduction, Fitch stated that the issuer could set up a 12-
month debt service reserve for hotel loans. Fitch also intends to make adjust-
ments to expenses based on any recently increased costs.
Fitch stated that for surveillance of CMBS transactions already issued, it will not
apply the severe haircut to hotels but will compare the current operating num-
bers to the performance when the transaction was issued.
Moody’s released a matrix outlining reserve requirements on hotel loans within
new issue CMBS transactions. Reserve requirements range from 1-13 months
depending on the type of hotel property, the anticipated stress environment, and
the underwritten debt service coverage ratio (DSCR). For example, a full-service
hotel with a 1.35 DSCR at issuance would require 13 months P&I reserves in a
high stress environment while a limited service hotel with a 1.35x DSCR would
require 5 months P&I reserves in a high stress environment. The rating agency
also noted that it would consider 1998-99 as stabilized operating performance
for hotels going forward.

Please see additional important disclosures at the end of this report. 31


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

exhibit 5 RATING AGENCY VIEWS ON HOTEL COMPANIES,


AS OF NOVEMBER 2004

Source: Morgan Stanley, Moody’s, Fitch, S&P

32
HOTEL D ELINQUENCIES I N C MBS T RANSACTIONS
Based on our October 2004 remittance reports data, delinquencies on hotel
loans accounted for 2.44% of current balances. During 2004, hotel collateral
within CMBS experienced significant improvement with delinquencies declining
3.08%. We anticipate hotel delinquencies will continue to improve based on our
current GDP forecast for 2005.

exhibit 6

CMBS
DELINQUENCIES
BY HOTEL
AND TOTAL

1
30/60/90/Foreclosure/REO.
Source: Morgan Stanley, Intex

Please see additional important disclosures at the end of this report. 33


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

BRANDING A ND S EGMENTATION
As the hotel industry has evolved, companies such as Marriott have segmented
the market in order to meet customers’ needs, increase profitability, and diversify
its customer base. Branding has been used to attract guests to various price
points and increase the parent company’s exposure.
Positive brand identity is beneficial for the hotel manager and the hotel owner. If
the brand is effective in producing demand, management will spend less time
marketing nationally and focus on local operations and solicitations. The owner
also benefits financially from increased business through the reservation system
and through potentially lower marketing costs.
As the economy weakens consumers move down one or two positions in service
and price from say a Hilton to an Embassy Suites. As the economy strengthens
guests typically move up in service level and price.

exhibit 7

HOTEL BRANDING
AND
SEGMENTATION

Source: Morgan Stanley

UPPER U PSCALE
These hotels are exclusive properties within major metropolitan markets that
provide extensive amenities and high levels of service. A hotel within this seg-
ment will have the highest ADR in its market and often the highest RevPAR in
the market. Amenities at these properties usually include health club/spa facili-
ties, three- or four-star food and beverage outlets, concierge service, 24-hour
room service, valet, and retail spaces. These properties are located in prime
downtown and resort real estate locations.
In general because of higher construction costs and high barriers to entry, luxu-
ry hotel construction tends to lag behind the general trend of the market cycle.
While this segment is the last to see new supply, during a recession it is the first
to experience a decline in occupancy as travelers become more budget-conscious
and move down the service-level curve to less expensive accommodations.

34
UPSCALE
Upscale hotels are full-service hotels that cater to individual business travelers,
groups, and conventions. Typically the price points at these hotels are between
upper upscale hotels and mid-scale hotels. Amenities at upscale hotels include
several food and beverage outlets, extensive meeting space, laundry service,
concierge, and exercise facilities. Most of these properties enjoy downtown loca-
tions near convention centers or strong suburban locations. These locations may
have some barriers to entry because of limited availability of land. The guest
profile for these hotels is transient business travelers, extensive corporate busi-
ness, and meeting/convention business.
MID-S
S CALE W ITH F OOD A ND B EVERAGE
These hotels encompass a broad range of brands and product types depending
on the market and the age of the property. Amenities at these hotels usually
include one restaurant, limited meeting space, and an exercise facility. Typically,
these hotels cater to the more budget-conscious business travelers or “road war-
riors.” Older properties in this segment can be somewhat outdated and suffer
from inefficiencies. Concerns about this segment center around older properties
in need of renovation and a tendency for travelers to prefer newer properties
that are entering many markets at similar price points.
MID-S
S CALE W ITHOUT F &B C HAINS
Properties in this segment typically have secondary locations such as major high-
way intersections, airports, or suburban locations. The properties do not offer
food and beverage amenities except for continental breakfast in some locations,
and may or may not have small exercise facilities. Food and beverage is provided
by nearby fast food or chain restaurants. The typical guest is a budget-conscious
business traveler, or transient guest from the highway. Extensive development
has occurred in this segment. Construction costs for these properties are signifi-
cantly lower than full-service hotels because of their secondary locations and
low rise nature.
ECONOMY/BUDGET S EGMENT
Smaller roadside motels with very limited amenities characterize these properties.
Construction is inexpensive, low barriers to entry exist, and the development
timetable is short. The typical guest at these properties is a transient budget-con-
scious business or pleasure traveler. Most bookings are made through the reser-
vation system and repeat business is not significant.
HISTORY O F T HE H OTEL I NDUSTRY
Lodging’s long history shows that demand for hotels and development of hotels
move in cycles. The time period of these cycles depends on the demand (affect-
ed by the overall state of the economy) and new supply.

Please see additional important disclosures at the end of this report. 35


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

1790–1920 G ROWTH O F A MERICA A ND F INANCIAL B OOM


The first American hotel, the 73-room City Hotel, was built in New York City in
1794, and was much larger than its predecessors, the colonial inns. Between the
late 1700s and the mid-1800s, similar hotels were built in major metropolitan
cities such as Philadelphia, Boston, and Baltimore. During the 1800s, hotels fol-
lowed the railroads westward and hotels were built in Chicago, Denver, and San
Francisco. Now famous historic spas such as The Greenbrier in West Virginia
were built during this period. The Buffalo Statler hotel, built in 1908, was revolu-
tionary because it offered baths in each guest room.
During the Roaring ’20s, as with many other areas of commerce, hotel demand
and hotel development boomed. The 3,000-room Hotel Stevens (currently the
Chicago Hilton) was built in 1927. Hotels were built through community funded
bonds and often without regard for feasibility. Conrad Hilton began his chain of
Hilton hotels during the 1920s by purchasing and developing eight hotels. So
many hotels entered the market nationwide in the 1920s that occupancy went
from 86% in 1920 to 68% in 1928, while room rates remained fairly constant.
1930–1940 s THE G REAT D EPRESSION
The boom of the ’20s was followed by the bust or Great Depression of the 1930s.
Due to overbuilding and a significant decline in demand, more than 80% of
American hotels went into foreclosure. Nationwide occupancy declined to 50%.
Enterprises that had cash during this period were able to obtain hotels at deep
discounts to the original costs. Ernest Hendersen founded the Sheraton hotel
chain in 1937 and was able to build the company’s portfolio during the 1930s
and 1940s. The hotel industry did not recover from the overbuilding of the
1920s until the early 1940s. World War II stimulated the economy and generated
demand for hotel rooms as troops and military personnel were moved domesti-
cally and globally, an effect that continued after the war. By the mid-1940s
nationwide occupancy had increased to 90%.
1950–1960 s BOOM A FTER W WII
With World War II over, the United States entered a stage of economic growth.
During the 1950s, transportation via the automobile became very popular. Most
Americans that had previously traveled by train were now using cars. This
increased prosperity and altered mode of transportation resulted in the develop-
ment of the first roadside “motor hotels” or motels. Kemmons Wilson devel-
oped the first Holiday Inn in 1952, and by 1960 there were more than 100
Holiday Inns. Marriott and Hyatt were founded in 1957, Howard Johnson’s in
1959, and Ramada and Radisson in 1962. Tax laws, highway development, and an
increase in franchising fueled the development of both hotels and motels during
this period.
1970 s QUICK C YCLE
With several chains established and the motel concept fully developed, the early
1970s became another boom for the hotel industry. At the same time, companies
such as Holiday Inn and Marriott were looking to expand their presence through

36
franchising. The extensive capital available in the markets and ability to franchise
brands encouraged development of hotels, which resulted in overbuilding.
In 1974, inflation caused construction costs and interest rates to rise. The energy
crisis reduced road travel and the recession prohibited business travel. This was
another period of foreclosures and excess hotel supply. Although the overbuild-
ing of the 1970s was similar to the 1920s the recovery to reasonable real estate
prices came about more quickly than in the 1920s. By the end of the late-1970s
hotel prices had recovered due to the lack of building during the end of the
decade. By the end of the 1970s supply and demand were more in balance than
five years prior and occupancy levels were rising.
1980 s
By 1983, inflation had slowed and new tax policies created a favorable environ-
ment for hotel development. The Savings and Loans (S&Ls) were in the process
of deregulation and were an eager source of financing for real estate develop-
ment. Lack of commercial real estate experience by the S&Ls resulted in loose
underwriting standards and liberal lending policies. During this time, syndicated
Limited Partnerships were the source of equity capital. Hotel partnerships were
sold to wealthy individuals attracted by the aggressive growth projections and the
trophy real estate. In order to capture the greatest tax benefits for these invest-
ments, this real estate was highly leveraged at 90%–100%. Investors benefited
from passive tax losses in the short term and real estate appreciation in the
longer term. A change in the tax laws in the late 1980s resulted in the revision of
the allowance for these losses, slowing new development, but overbuilding was
already under way, particularly in full-service hotels.

exhibit 8

CAPITALIZATION
RATES AND 10-
YEAR TREASURY
RATES

Source: PricewaterhouseCoopers, Smith Travel Research

Please see additional important disclosures at the end of this report. 37


Transforming Real Estate Finance
chapter 2 Major Property Types in CMBS

EARLY 1 990 s
The late 1980s to 1991 was a period of overbuilding in virtually all sectors of
real estate, and hotels were no exception. Profitability nationwide for the hotel
industry was negative between 1986 and 1992. Demand sharply declined from its
significant growth in late 1989, to a cycle low in 1991. Unfortunately, develop-
ment was already in the pipeline and supply growth was high. During this time,
many hotels defaulted on loans because they were so highly leveraged and unable
to meet debt payments. In the early 1990s, the federal government formed the
Resolution Trust Corporation (RTC) to resolve the problems of the S&Ls, who
were suffering from defaulted real estate loans. Development during the early
1990s was virtually halted and banks were unwilling to lend on real estate in gen-
eral, hotels in particular. Capitalization rates during this period climbed, as
investors demanded extremely high returns. Because of a lack of debt funding,
most hotel purchases were made by companies with cash reserves.
The real estate devaluation and lock up in capital reduced the number of individ-
ual hotel transactions from 130 in 1990 to 56 in 1991. Individual hotel transac-
tions did not return to 108 again until 1994. Purchase prices per room were well-
below development costs. Nationwide, the average purchase price per room in
1990 was $136,000. This figure declined significantly in 1991 to $96,000 and
reached a bottom of $80,000 in 1995.
MID- T O L ATE 1 990 s
By late 1995, the RTC disposed of most real estate previously held by the
defunct S&Ls. Demand for hotel rooms outpaced supply between late 1992 and
mid-1996. From 1993, increases in the average daily room rate (ADR) outpaced
the consumer price index. Beginning in 1994, the increase in profitability began
to attract investors. Prices began to increase as demand was outpacing supply
and transactions increased.
Beginning in 1993, hotel REITs began accessing the public capital markets. In
1993, $34 million was raised in the capital markets for hotel REITs. This
increased to $600 million in 1994, doubled to approximately $1.2 billion in 1995
and 1996, and reached a peak of almost $1.6 billion in 1997. This inflow of
public capital fueled supply growth and transaction activity for hotels as REITs
acquired more properties and consolidation occurred. The consolidation of
hotel ownership from private partnerships to public companies increased operat-
ing efficiencies and held owners accountable to shareholders, reducing hotel
leverage levels. In general, hotel REITs did not exceed 60% leverage.

38
Capital flow into hotel REITs declined significantly in 1998 to just over $500
million. This was due to Congress enacting legislation limiting acquisitions by
paired-share REITs, REIT investors’ fear of overbuilding in all real estate sec-
tors, slower growth in REIT earnings than the broader market, and the capital
flight to quality in the fall of 1998. The change in the paired-share legislation
significantly affected Starwood and Patriot American (now Wyndham) the two
largest paired-share hotel REITs, stopping their growth initiatives.
During the mid- to late-1990s, as the CMBS market grew, hotels were included
in pools of diversified mortgages. The nightly rents and intense on-site manage-
ment combined with poor performance prior to the RTC clean-up resulted in
lower LTV ratios for hotel loans than other types of real estate within CMBS
transactions.

Please see additional important disclosures at the end of this report. 39


This Page Intentionally Left Blank

40
Chapter 3

Transforming Real Estate Finance


Call Protection

Please see additional important disclosures at the end of this report. 41


Transforming Real Estate Finance
chapter 3 Call Protection

EXECUTIVE S UMMARY
• Commercial mortgage loans differ from residential mortgage loans in that they
are call protected. Commercial mortgage loans typically contain provisions
that either prohibit or economically penalize the borrower for prepaying the
loan before maturity.
• There are four main categories of call features in commercial mortgage loans:
hard or legal lockout, yield maintenance, fixed percentage penalty points and
defeasance. Most commercial mortgage loans contain at least one of these forms
of call protection, and many contain some combination of these penalties.
• Allocation of the loan level prepayment penalties to bond classes in a CMBS dif-
fers across deals and is an important characteristic in determining relative value.
• Lockout and defeasance provide investors with the greatest average life sta-
bility. Credit events are the only source of cash flow variability in CMBS
deals where the underlying loans are locked out or defeased. With yield
maintenance, some investors benefit from faster prepayments under some
interest environments.
• A number of major loan originators have gravitated to defeasance because of
favorable pricing in the CMBS market.
INTRODUCTION
Commercial mortgage loans differ from single-family residential loans in a very
important aspect: call protection. Unlike single-family loans, commercial loans
typically are not fully prepayable at the borrower’s option. Call protection in com-
mercial loans stems from the life insurance companies’ historical position as the
primary provider of capital to the real estate industry. As the dominant long-term
lender in the market, the life insurance companies required call protection as a
standard feature of the commercial loan market. Call protected loans were an
attractive asset for an insurer to match against long duration liabilities. The
growth of the CMBS market has altered the form of call protection found in
newly originated commercial loans. As an increasing percentage of commercial
loans are being securitized, the preferences of bond investors are playing a large
role in defining the terms of the commercial mortgage markets. This chapter will:
1) Define the various types of call protection found in commercial mortgage
loans;
2) Discuss different prepayment penalty allocation structures found in
CMBS transactions;
3) Explore relative value of various forms of call protection; and
4) Discuss our expectation for future trends in CMBS call protection.

42
DEFINITION O F T YPES O F L OAN L EVEL C ALL P ROTECTION
Several different types of call protection are found in commercial mortgage loans.
HARD L OCKOUT
The most straightforward form of call protection is a “lockout” provision. The
lockout provision legally prohibits a borrower from prepaying a loan prior to
scheduled maturity. The majority of commercial mortgage loans are not “locked
out” for the entire term of the loan. Lockout periods are usually three to five
years and are followed by penalty periods. During the penalty period, the borrow-
er is allowed to prepay the loan, but the borrower must compensate the lender
for the early termination right. The two forms of penalty are yield maintenance
and fixed percentage penalty points. Further, most lockout provisions allow a bor-
rower to assign the loan if the property is sold during the lockout period.
YIELD M AINTENANCE
A yield maintenance penalty is designed to compensate the lender for the inter-
est lost as a result of prepayments. The yield maintenance penalty in commercial
mortgage loans is analogous to the “make whole” provisions found in corporate
bond markets. Formulas used to calculate yield maintenance vary. Generally, the
formulas provide a present value calculation of the positive interest differential
between the remaining mortgage payments due on the original loan and the pay-
ments that would be due on a reinvestment of that repaid loan.
The yield maintenance penalty is designed to make the lender indifferent to a pre-
payment. If interest rates are significantly higher at the time of prepayment than
at the time of loan origination, the borrower would not be required to make a
penalty payment. The lender does not suffer an opportunity cost in this situation
as the lender can reinvest the prepaid proceeds at higher market interest rates.
The key variable in calculating yield maintenance penalties is the discount rate or
reference rate. The reference rate is compared to the existing mortgage loan rate
to calculate the prepayment penalty. Reference rates are usually a comparable
maturity Treasury rate, (referred to as “Treasuries flat”), or a comparable maturi-
ty Treasury rate plus a spread. Clearly, the lender/investor prefers Treasuries flat
as the reference rate. Treasuries flat results in a higher present value for the yield
maintenance calculation. The following is an example of a yield maintenance cal-
culation at Treasuries flat.
Assumptions
• Loan Origination Date: 1/01/98 • Original Loan Balance: $10,000,000
• Loan Maturity Date: 12/31/07 • Mortgage Rate: 7.25%
• Start of Yield Maintenance Period: 1/01/98 • Reference Treasury Rate: 5.75%

Please see additional important disclosures at the end of this report. 43


Transforming Real Estate Finance
chapter 3 Call Protection

To simplify the math, we will assume the loan prepays on the origination date.

Yield Maintenance Formula (PRESENT VALUE FACTOR) x (MORTGAGE


RATE – TREASURY RATE) x (REMAINING
LOAN BALANCE)

-Penalty Period
Present Value Factor =1-(1+Reference Treasury Rate)
Reference Treasury Rate
= 1-(1+5.75%)-10
5.75%
= 7.45%

Yield Maintenance = (7.45)x(7.25%-5.75%)x($10,000,000)=$1,117,500

= 11.18% of the remaining loan balance

As the term to maturity for the loan shortens, the yield maintenance penalty as a
percentage of the remaining balance decreases. Yield maintenance penalties pro-
vide less of a disincentive to the borrower to prepay as the remaining penalty
period declines. The importance of the yield maintenance penalty to the lender
also decreases as the remaining penalty period declines. As the term to maturity
decreases, the remaining loan payments represent a lower percentage of the
lender’s total return.
The following table illustrates the difference between reference rates of
Treasuries flat, Treasuries +25 bp, and Treasuries +50 bp as the penalty period
shortens from 10 years to three using the same assumptions as the prior example.

exhibit 1 PREPAYMENT PENALTY AS A PERCENTAGE


OF OUTSTANDING LOAN BALANCE
Penalty Period
Reference Rate 10-YR 5-YR 3-YR
Treasuries Flat 11.18 6.36 4.03
Treasuries + 25 bp 9.20 5.27 3.34
Treasuries + 50 bp 7.27 4.18 2.66
Source: Morgan Stanley

FIXED P ERCENTAGE P ENALTY P OINTS


Fixed percentage penalty points are potentially the weakest form of call protec-
tion. The prepayment penalty is a fixed percentage of the remaining loan bal-
ance. Fixed percentage penalty points typically decline over the life of the loan.
A representative example of the terms of a loan with fixed percentage penalty
points would include a lockout period of five years followed by declining penalty
points of 5% in year 6, 4% in year 7, 3% in year 8, 2% in year 9, and 1% in year
10. Large interest rate moves and large increases in property values may over-
whelm these fixed economic disincentives to prepay a fixed percentage penalty
loan as the penalties do not change with interest rates.

44
The following exhibit indicates the required drop in the mortgage rate that
compensates a borrower for fixed percentage penalty points. For example, if a
borrower wanted to prepay a loan with a term to maturity of six years and a 5%
fixed penalty, the borrower’s new mortgage rate would have to be 110 bp lower
than the existing mortgage rate to justify paying the penalty.

exhibit 2 ANNUAL BASIS POINTS OF SAVINGS REQUIRED TO PAY


FOR PREPAYMENT PENALTY POINTS (bp)

Penalty Loan Term to Maturity


Points 10-YR 8-YR 6-YR 4-YR 2-YR
10 150 180 220 300 540
9 140 160 200 270 490
8 120 140 170 240 430
7 110 130 150 210 380
6 90 110 130 180 330
5 80 90 110 150 280
4 60 70 90 120 220
3 50 60 70 90 170
2 30 40 50 60 110
1 20 20 20 30 60

Note: Calculation assumes a 10% initial mortgage rate, annual coupon payment, and cash flows discounted
at new mortgage rate. Table entries are rounded to the nearest 10 bp.
Source: Morgan Stanley

DEFEASANCE
Defeasance, a mainstay of the municipal market, has found its way into the com-
mercial mortgage market. From the investor’s perspective, a loan with a defea-
sance appears “locked-out” from prepayment. The borrower may prepay the loan,
but the cash flows to the investor will not change as a result of the prepayment.
In exercising the defeasance option, the borrower replaces a mortgage loan with
a series of U.S. Treasury strips which match the payment stream of the mort-
gage loan as collateral for the loan. Not only is an investor indifferent to a pre-
payment in a defeased loan, the investor actually prefers it. If the borrower exer-
cises a defeasance option, the investor receives the benefit of improved credit
quality on the collateral without a corresponding decline in return. Before the
prepayment, the investor was exposed to commercial real estate credit risk.
Following the prepayment, the investor is exposed to U.S. Treasury securities
credit risk.
As an example, consider a $10 million non-amortizing commercial mortgage
loan with a 7% coupon, three-year term to maturity, and annual payments. If the
borrower wanted to defease the loan, the borrower would purchase three U.S.
Treasury strips that would replicate the payments due on the mortgage loan. For
the U.S. Treasury strips, we assumed the following rates and prices:

Please see additional important disclosures at the end of this report. 45


Transforming Real Estate Finance
chapter 3 Call Protection

Rates(%) Dollar Price


• 1-Year 5.65 94.36
• 2-Year 5.68 89.20
• 3-Year 5.73 84.21
The chart shows the payments due from the borrower on the commercial mort-
gage loan, the cost to purchase the U.S. Treasury strips and the payments to the
CMBS trust from the U.S. Treasury strips.

exhibit 3
CASH FLOWS TO CMBS TRUST UNDER DEFEASANCE
Payment Due Cost to Borrower Payments From
From Borrower to Purchase U.S. Treasury Strips
Time on Loan U.S. Treasury1 to CMBS Trust
Year 1 $700,000 $660,520 $700,000
Year 2 $700,000 $624,400 $700,000
Year 3 $10,700,000 $9,010,470 $10,700,000
1
At time of prepayment.
Source: Morgan Stanley

The following steps describe the impact of a defeased prepayment on a


CMBS transaction.
When a borrower wants to prepay a loan:
1) The borrower buys multiple U.S. Treasury strips in amounts that replicate
the remaining principal and interest payments due on the mortgage loan.
2) The borrower delivers a legal agreement that designates the CMBS trust as
having the first priority on the U.S. Treasury securities.
3) The servicer is responsible for purchasing the U.S. Treasury securities on
behalf of the borrower. The borrower pays the execution costs.
In summary, the original loan remains an asset of the trust, but the mortgage,
which is the lien on the property to secure the loan, is removed, and the collater-
al securing the loan is now U.S. Treasury securities. A prepayment through the
exercise of a defeasance option provides no disruption in cash flow to the bond
investor whether interest rates are higher or lower.
The amount of defeased collateral in CMBS deals has increased dramatically.
Today CMBS transactions generally have > 90% defeasance. Investors are valuing
interest only bonds (“IOs”) from CMBS deals backed by defeased collateral at
tighter spreads than those backed by collateral with yield maintenance penalties.
The growth in CMBS issuance has resulted in an increase in both the number and
type of CMBS investors. CMBS backed by defeased mortgage loans offer
investors the opportunity to avoid the complexities of commercial mortgage pre-
payment analysis. The CMBS bonds that are created from defeased loans resem-
ble corporate bullet securities and have attracted corporate crossover buyers.

46
ALLOCATION O F P REPAYMENT P ENALTIES
For loans with yield maintenance penalties or fixed percentage penalty points,
the allocation of these penalties to the various securities in the CMBS structure
differs on a deal-by-deal basis. In older CMBS transactions (primarily 1996 and
earlier), the prepayment penalties generally were allocated 75-100% to the IO
bonds while the amount of penalty paid to the coupon bondholders was capped
at some percentage, typically 0–25%.
More recent deals generally allocate the prepayment penalties in a way that
makes the currently paying bond class “whole” and distributes the remaining
penalty to the IO. This more recent allocation method is analogous to the calcu-
lation of the yield maintenance penalty on the underlying loan. The currently
paying bond investor receives compensation for the early return of principal in a
lower interest rate environment. The IO holder generally receives 65–75% of the
penalty while the current principal paying bond receives the remainder making it
whole to the bond’s coupon, not “Treasuries flat.”
The following is a representative example of a yield maintenance, penalty sharing
formula found on post-1996 deals. The class that is currently receiving principal
would receive an amount equal to the ratio of the difference between the bond
rate and the reference Treasury rate and the difference between the mortgage
loan coupon rate and the reference Treasury rate.
As discussed earlier, the yield maintenance penalty is calculated based on the
difference between the commercial mortgage loan rate and the reference
Treasury rate. The CMBS bond coupon is generally lower than the mortgage
loan rate, so the investor needs a fraction of the entire yield maintenance penal-
ty to be “made whole.”
The IO class would receive the remaining 69.3% of the penalty. Both fixed rate and
IO investors need to be aware of the type of prepayment penalty sharing agree-
ment found on a particular CMBS transaction as it influences an investor’s return.

Bond Pass Through Rate - Reference Treasury Rate


Prepayment Distribution Formula =
Mortgage Loan Rate - Reference Treasury Rate
Bond Pass Through Rates = 6.45%
Mortgage Coupon Rate = 8.25%
Reference Treasury Rate = 5.65%

Currently Paying = 6.45%-5.65%


Bond Receives 8.25%-5.65%

= .80
2.60
= 30.7% of penalty

Please see additional important disclosures at the end of this report. 47


Transforming Real Estate Finance
chapter 3 Call Protection

RELATIVE V ALUE A NALYSIS O F D IFFERENT T YPES O F C ALL P ROTECTION


The relative value analysis of yield maintenance versus lockout/defeasance is an
analysis of the benefits of cash flow certainty versus the potential opportunities
of cash flow uncertainty. With respect to locked-out or defeased deals, the only
cash flow variability in the bond will be related to credit events. Movements in
interest rates, spread levels, and the credit performance of the underlying loans
will determine returns. Locked out and defeased CMBS deals are not exposed to
commercial mortgage prepayment risk.
The relative value analysis of yield maintenance securities, on the other hand, is
not as straightforward. Earlier, we compared yield maintenance to “make whole”
provisions found in the corporate market. Even if yield maintenance leaves the
commercial mortgage lender indifferent to prepayments, various securities within
a given CMBS transaction and across different CMBS deals will perform differ-
ently. In addition to the credit performance of the loans, the interest rate environ-
ment, prepayment speeds in various interest rate environments, and the allocation
of prepayment penalties within a particular deal structure will determine the yield
in a bond with yield maintenance loans. An investor in yield maintenance backed
CMBS must analyze all of these variables in assessing relative value.
Market convention in CMBS scenario analysis is to assume that loans do not
prepay during their yield maintenance periods. If 100% of the loans in the pool
are yield maintenance protected for their entire term, the assumption of “yield
maintenance equals lockout” provides the same result as defeasance or lockout.
For the sake of this analysis, we assumed that loans in yield maintenance do pre-
pay in order to ascertain under which scenarios an investor would prefer to own
bonds with yield maintenance over bonds with defeased collateral.
We analyzed several classes of bonds from different generations of CMBS trans-
actions with yield maintenance as the predominant form of call protection on
the underlying loans1. The purpose of this analysis was to determine which
bonds benefit in various interest rate and prepayment scenarios. We performed
prepayment and interest rate scenario analysis on CMBS deals that allocate all of
the prepayment penalties to the IO and on CMBS deals that allocate prepayment
penalties that make the currently paying bonds whole. We analyzed each bond at
prepayment speeds from 0–100% CPR in the following interest rate scenarios:
1) Interest rates 300 bp lower
2) Interest rates 100 bp lower
3) Interest rates unchanged
4) Interest rates 100 bp higher
5) Interest rates 300 bp higher
The results were based on interest rate levels and prices as of April 1998, and
may vary in different interest rate environments.

1
Not all of these deals were 100% protected by yield maintenance for their entire term. We chose actual secu-
rities to analyze rather than a hypothetical 100% yield maintenance for life bond, as we are not aware of such
a CMBS transaction in the marketplace. We also made the simplifying assumption that pricing spread levels
remain unchanged at different bond dollar prices.

48
SHORT A AA ( 1ST P AYMENT P RIORITY) B ONDS W ITH S HARED Y IELD
MAINTENANCE P ENALTIES
Because the short AAA bonds are at a discount dollar price in the interest rates
higher scenario, faster prepayments during penalty periods result in a higher yield
to maturity for the investor. The borrower is not required to pay a prepayment
penalty in an interest rates higher scenario, but the borrower is required to pay
the par amount of the loan. The investor has effectively bought the loan at a dis-
count and receives principal at a par dollar amount.
Why would a borrower prepay in a higher interest rate environment? There are
two potential reasons to prepay:
1) Sale of the property
2) Refinancing driven prepayment
a) Equity take-out refinancing
b) Fixed to floating rate refinancing
In the interest rates unchanged and lower scenarios, the yield to maturity also
increases as prepayments increase during yield maintenance penalty periods. The
amount of the prepayment penalty received by the short AAA holder exceeds
the premium dollar price on the bond.
As an example, assume:
• Bond Dollar Price: 106
• Mortgage Loan Rate: 8.80%
• Bond Coupon: 6.85%
• Reference Treasury Rate: 5.65%
• Yield Maintenance Penalty Period: 9 years

The yield maintenance penalty


in this example would equal:

Yield Maintenance Formula =Present Value Factor)x(Mortgage Rate-Treasury Rate)


Present Value Factor =1-(1+Reference Treasury Rate)-Penalty Period
Reference Treasury Rate
=1-(1+5.65%)-9
5.65%
=6.91%
Yield Maintenance (6.91)x(8.80%-5.65%)
=21.8%
Allocation to Short AAA =Bond Coupon Rate-Reference Treasury Rate
Loan Coupon-Reference Treasury Rate
=6.85%-5.65%
8.80%-5.65%
Allocation =38.1%
Penalty Points Allocated
to Short AAA =(38.1%)(21.8%)
=8.3%
vs. Premium Dollar Price
of Short AAA =6%
Advantage =2.3% (of current balances)

Please see additional important disclosures at the end of this report. 49


Transforming Real Estate Finance
chapter 3 Call Protection

The fact that the prepayment penalty allocated to the investor is higher than the
premium dollar percentage results in the prepayment benefiting the investor.
While the yield to maturity is higher in this scenario, the average life of this
bond decreases. For some investors, the shortening of the average life of the
bond mitigates the benefits of a higher yield to maturity.
SHORT A AA B ONDS W HICH D O N OT S HARE P REPAY P ENALTIES
The yield to maturity on short AAA bonds from earlier CMBS deals generally
does not increase as prepayments increase during yield maintenance periods.
These bonds do not receive any of the prepayment penalties. When they are
trading at a premium dollar price, they lose yield as they receive prepayments at
par. If interest rates were to increase enough so that the bonds were trading at a
discount dollar price, the yield to maturity would increase as prepayment speeds
increase during yield maintenance periods.

exhibit 4 EFFECT ON YIELD TO MATURITY AS PREPAYMENT


SPEEDS INCREASE—SHORT AAAs
Interest Rates
Bond Class –300 bp –100 bp Unchanged +100 bp +300 bp
Short AAA Decreases Decreases Decreases Decreases Increases
(IO Receives
All Penalties)
Short AAA Increases Increases Increases Increases Increases
(Make Bonds Whole)

Source: Morgan Stanley

AA B ONDS
The performance of the AA bonds generally follows the same pattern as the
short AAA bond. The AA bond, however, has a higher duration and a resulting
higher price sensitivity to interest rates. As a result, the AA bond is more likely to
be trading at a discount dollar price at smaller increases in interest rates than the
short AAA bond. So, in an interest rates up 100 bp scenario on an older deal, the
yield to maturity on the short AAA bond decreases as prepayments increase, but
the yield to maturity on the AA bond increases. The AA bond is priced at a dis-
count in the rates up 100 bp scenario while the short AAA bond is a premium.
For newer bonds with shared yield maintenance penalties, the actual speed of
prepayment will determine whether the investor receives a higher yield to maturi-
ty than the 0% CPR case. Prepayment speeds must be fast enough to retire the
AAA bonds during the yield maintenance period in order for the yield to maturi-
ty to increase on the AA bond. If the AAA securities are retired and the AA
bond becomes the currently paying bond, the AA bond receives a portion of the
prepayment penalties. If the AA bond does not become the currently paying
bond during the yield maintenance period, it does not receive any of the prepay-
ment penalties. The average life shortens in either case.

50
exhibit 5 EFFECT ON YIELD TO MATURITY AS PREPAYMENT
SPEEDS INCREASE (AA)
Interest Rates
Bond Class –300 bp –100 bp Unchanged +100 bp +300 bp
AA Decreases Decreases Decreases Increases Increases
(IO Receives
All Penalties)
AA Varies Varies Increases Increases Increases
(Make Bonds Whole)
Source: Morgan Stanley

INTEREST O NLY B ONDS


IOs from CMBS deals with yield maintenance loans generally benefit as prepay-
ment speeds increase during yield maintenance periods. The present value of the
penalty paid to the IO holder is usually greater than the present value of the
foregone interest that would have been received from the loan that prepaid.
When interest rates rise to the level where no prepayment penalty is due from
the borrower, the IO holder does not benefit from faster prepayments. In this
case, the IO bond loses the income stream from the prepaid loan and does not
receive a compensating prepayment penalty. Unlike a defeased IO, an IO from a
CMBS deal backed by yield maintenance loans offers investor(s), the potential
for higher returns with faster prepayments under certain interest rate scenarios.

exhibit 6 EFFECT ON YIELD TO MATURITY AS PREPAYMENT


SPEEDS INCREASE (IO)
Interest Rates
Bond Class –300 bp –100 bp Unchanged +100 bp +300 bp
IO Increases Increases Increases Increases Decreases
(IO Receives
All Penalties)
IO Increases Increases Increases Increases Decreases
(Make Bonds Whole)
Source: Morgan Stanley

TRENDS I N C MBS C ALL P ROTECTION


Conduit loan originators have established defeasance as the standard call protec-
tion in their origination programs. Which forms of prepayment protection do
borrowers prefer? In some scenarios, yield maintenance is more expensive for
borrowers and in some scenarios defeasance is more expensive for borrowers.
We present three numerical examples of the costs to the borrower of defeasance
versus yield maintenance in the Appendix. Yield maintenance and defeasance
have very similar penalty calculations in current to lower interest rate environ-
ments although defeasance may be slightly more expensive in steeper yield curve
environments. In rising interest rate environments, yield maintenance and defea-
sance prepayment disincentives tend to decline, but yield maintenance is eventu-
ally disadvantageous to the borrower. We think the increasing influence of the
CMBS market in commercial real estate finance will result in the dominance of
defeasance in commercial mortgage loans.

Please see additional important disclosures at the end of this report. 51


Transforming Real Estate Finance
chapter 3 Call Protection

Investors in CMBS have different sets of opportunities and investment decisions


with defeased deals versus deals with yield maintenance. The defeased deal elimi-
nates the cash flow volatility resulting from commercial mortgage prepayments.
Investors in CMBS with yield maintenance call protection have exposure to the
benefits and risks resulting from prepayment driven cash flow variability.
Investors should carefully analyze the effect of interest rate movements and pre-
payments on the yield of individual CMBS classes.
APPENDIX: T HE B ORROWER’S P ERSPECTIVE
The following example compares a prepayment under defeasance to a prepay-
ment under yield maintenance from the borrower’s perspective.
Assume the underlying loan has the following characteristics:
• Amount: $10,000,000
• Term: 10 years
• Amortization: 25 years
• Coupon: 7.50%
We will assume that the reference rate on the yield maintenance penalty is
Treasuries flat and that a minimum one percentage point fee is applicable to
any prepayment.
Scenario 1:
In five years, U.S. Treasury Rates are unchanged, but the borrower wants to sell
the property for personal reasons.
• Loan Balance at the End of Year 5: $9,189,718
• Yield Maintenance Penalty: $779,020 (8.48%)
• Cost of Treasury Strips: $9,970,826
• Total Defeasance Cost: $781,108 (8.50%)
($9,970,826–$9,189,718)
• Defeasance Advantage to Borrower: -$2,088 (0.02%)
So, the defeasance option in this case is more expensive to the borrower by
0.02% or $2,088.

52
Scenario 2
In five years, rates have risen just above the borrowers mortgage coupon, but the
borrower wants to refinance to monetize the equity appreciation in his property.
The 5-year Treasury is at 7.79%.
• Loan Balance at the End of Year 5: $9,189,718
• Yield Maintenance Penalty (min 1%): $91,897 (1.00%)
• Cost of Treasury Strips: $9,172,606
• Total Defeasance Cost: ($17,112) (0.19%)
• Defeasance Advantage to Borrower: $109,009 (1.19%)
The defeasance option is cheaper for the borrower by 1.19% or $109,009.
Scenario 3:
Five years from now, rates will have risen to their highest levels in a decade,
with 5-year Treasury rates at 9%. The borrower wants to sell the property.
• Loan Balance at the End of Year 5: $9,189,718
• Yield Maintenance Penalty (min 1%): $91,897 (1.00%)
• Cost of Treasury Strips: $8,741,211
• Total Defeasance Cost: $(448,507) (4.88%)
• Defeasance Advantage to Borrower: $540,404 (5.88%)
In this scenario, the borrower effectively has the option of prepaying the loan
on a discounted basis. This results in a cost savings of 5.88%, or $540,404 ver-
sus the amount paid under yield maintenance.
Our example assumes a fairly flat yield curve. All else being equal, the defea-
sance option gets more expensive to the borrower as the yield curve steepens.
Under the defeasance option, each mortgage loan payment is discounted at its
corresponding zero coupon Treasury rate. When there is a larger spread between
1-year rates and 10-year rates, the discounted present value of the Treasury strip
payments is higher, resulting in a greater cost to the borrower. Even in a steep
yield curve environment, however, the defeasance option still allows the borrow-
er the opportunity to prepay the loan at a discount. This option is not available
under yield maintenance since the best a borrower can do is prepay at par.

Please see additional important disclosures at the end of this report. 53


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54
Chapter 4

Transforming Real Estate Finance


AAA Fixed Rate CMBS

Please see additional important disclosures at the end of this report. 55


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

This chapter discusses some of the different types of AAA classes that have
evolved in the fixed-rate CMBS market over the past few years. Today, transac-
tions are issued with multiple AAA classes, and the characteristics of AAAs are
different from the classes issued in the past.
In addition to front-pay bonds and tight window bullets, the AAA CMBS mar-
ket also includes multifamily directed classes, amortizing bonds, wide window
bonds, super senior and junior AAAs as well as the traditional 10-year AAA
bullet. In this chapter, we discuss these bonds, as well as premium dollar price
10-year AAAs.

Tight Window AAA Bonds


In the late 1990s, the AAA CMBS world was a simpler place. Most conduit
transactions were issued with only two AAA classes: a current pay 5-year wide
window bond and a locked-out, 10-year bond.
The more recent breed of 5-year AAAs is typically not structured as the front-
pay class. With shorter classes ahead of the 5-year bond in the capital structure,
many 5-year AAAs resemble bullets. They are initially locked out from receiving
principal payments and ultimately pay down in a short period of time.

exhibit 1 CHARACTERISTICS OF 2004 5-YR AAA (TIGHT WINDOW) CLASSES

Principal # of Maturing
Tight-Window Window Loans Tied to Original
5-Year AAA Bond (Months) Payoff of Class WAL (yr)
CGCMT 2004-C1 A2 6 29 4.8
BACM 2004-2 A2 7 26 4.8
LBUBS 2004-C6 A2 3 17 4.9
COMM 2004-LB2A A2 4 13 4.8
CSFB 2004-C3 A3 6 9 4.8
LBUBS 2004-C2 A2 3 9 4.8
WBCMT 2004-C14 A2 8 9 5.2
BSCMS 2004-T14 A2 6 7 4.6
GCCFC 2004-GG1 A3 6 5 4.7
JPMCC 2004-PNC1 A2 6 5 4.7
LBUBS 2004-C4 A2 4 5 4.7
LBUBS 2004-C7 A2 3 5 4.9
MSC 2004-HQ4 A3 5 4 5.0
WBCMT 2004-C11 A2 2 3 4.9
COMM 2004-LB3A A2 12 2 4.9

Source: Morgan Stanley, Trepp, Annex A Files

56
In order to gain a better understanding of the risk within short, locked out AAA
classes, we analyzed a group of tight-window AAA bonds. We examined the
Trepp universe of 2004 conduit transactions and captured all 5-year average life
AAA bonds with tight windows1. Our analysis captures 15 deals that include 5-
year tight-window classes, most of which exhibit a strong dependence on the
performance of a small percentage of loans in the deal.
The timely repayment of principal on tight-window, locked out AAA classes
may be dependent on the ability of a few loans to pay off as scheduled.
That is, a transaction may be backed by more than 100 loans, but the payoff of the
tight-window AAA bond may be tied to the cash flows of only two or three loans.
This concentrated risk is not necessarily consistent with the level of risk an investor
may expect from a diversified pool of loans in a conduit/fusion transaction.
In our analysis, we found that the majority of 5-year, tight-window AAAs issued
in 2004 will be paid down by fewer than 10 maturing loans. (See Exhibit 1)

Property Type Concentration of Maturing Loans Tied to Tight Window Payoff


(Based on Original Balance)

Manufactured Self
Office Retail Multifamily Lodging Housing Storage
15% 0% 10% 0% 15% 60%
21% 51% 26% 0% 0% 2%
1% 51% 0% 8% 24% 16%
44% 19% 34% 0% 3% 0%
46% 11% 43% 0% 0% 0%
66% 18% 15% 0% 0% 1%
22% 77% 1% 0% 0% 0%
62% 26% 0% 9% 0% 3%
34% 66% 0% 0% 0% 0%
0% 87% 0% 13% 0% 0%
69% 30% 0% 0% 0% 1%
30% 70% 0% 0% 0% 0%
44% 0% 52% 0% 4% 0%
33% 31% 0% 0% 36% 0%
0% 92% 8% 0% 0% 0%

1
We define a tight principal window as being 12 months or less

Please see additional important disclosures at the end of this report. 57


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

RISK I S T IED T O T HE N UMBER O F M ATURING L OANS


Within the examined universe, COMM 2004-LB3A A2 has the most concen-
trated risk of the 2004 tight-window 5-year AAAs, with only two loans tied to
its principal repayment. Although five loans actually mature while the A2
principal window is open, three of these loans are tied to the repayment of
the multifamily directed class and do not contribute to the repayment of the
A2 class. The class diverts the cash flows of some multifamily loans away
from the tight-window class. Therefore, the impact of a few loans on the
tight-window class is intensified.
The COMM bond has concentrated risk in the performance of two loans, how-
ever, it is important to note a mitigating factor. Of the 15 bonds that we ana-
lyzed, this class has the longest principal window. Therefore, 15% of the bond’s
original balance is paid down through amortization of the collateral pool prior
to the two balloon maturities.
CGCMT 2004-C1 A2 has the least concentrated risk, in terms of number of
loans linked to final payoff of the bond. Principal cash flows from 29 loans are
involved in the payoff of the A2 class. However, there are other factors to con-
sider in addition to the number of loans involved in the payoff. For example,
60% of the loans (based on original balance) that will pay down the A2 class are
backed by self storage properties. Although CGCMT 2004-C1 A2 offers the

exhibit 2 EXPOSURE TO LARGEST MATURING LOANS INVOLVED IN


PRINCIPAL REPAYMENT OF 5-YR AAA (TIGHT WINDOW) CLASSES

Original Balance of
# of Maturing Maturing Loans
Loans Involved In Involved In Payoff
Class Payoff of Class of Class ($MM)
CGCMT 2004-C1 A2 29 163.0
BACM 2004-2 A2 26 242.2
COMM 2004-LB2A A2 13 162.4
CSFB 2004-C3 A3 9 244.7
LBUBS 2004-C6 A2 17 328.5
LBUBS 2004-C2 A2 9 317.1
WBCMT 2004-C14 A2 9 234.9
BSCMS 2004-T14 A2 7 176.2
GCCFC 2004-GG1 A3 5 280.5
WBCMT 2004-C11 A2 3 69.1
JPMCC 2004-PNC1 A2 5 126.1
LBUBS 2004-C4 A2 5 404.4
MSC 2004-HQ4 A3 4 46.8
LBUBS 2004-C7 A2 5 278.0
COMM 2004-LB3A A2 2 81.7

Source: Morgan Stanley, Trepp, Annex A Files

58
most diversified risk based on the number of loans tied to pay off, investors need
to decide if they are comfortable with heavy exposure to self storage assets.
CONSIDER L ARGE L OAN P APER A S A N A LTERNATIVE
We urge investors to examine the loans that are tied to the repayment of the
tight-window bond. An investor’s analysis of tight-window 5-year AAAs should
be in-line with the type of monitoring and analysis required for a large loan deal.
In fact, tight-window, AAA investors should consider fixed-rate large loan
paper as an alternative investment.
Currently, 5-year, tight-window AAAs are trading in the swaps + high teens area
in the secondary market. In comparison, 5-year bullets on clean, single asset
deals are trading in the low 30s to swaps.

Concentration Risk of Largest Maturing Loans Involved in Principal Repayment


(Based on Orig. Bal.)
Total
Exposure to
Largest 2nd-Largest 3rd Largest 4th Largest 5th Largest Largest 5
Loan Loan Loan Loan Loan Loans
15% 9% 7% 5% 4% 40%
19% 17% 10% 8% 8% 62%
16% 15% 15% 13% 10% 69%
31% 22% 11% 10% 9% 83%
24% 21% 21% 11% 8% 85%
59% 17% 7% 6% 4% 93%
64% 19% 5% 4% 3% 95%
42% 24% 20% 9% 2% 97%
32% 30% 17% 16% 4% 99%
36% 33% 31% NA NA 100%
44% 33% 10% 9% 4% 100%
46% 29% 23% 1% 1% 100%
52% 24% 20% 4% NA 100%
54% 24% 16% 5% 1% 100%
92% 8% NA NA NA 100%

Please see additional important disclosures at the end of this report. 59


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

RISK I S A LSO T IED T O T HE S IZE O F M ATURING L OANS


In analyzing 5-year, tight-window AAAs, investors should also examine a bond’s
exposure to the largest loans involved in paying down that class. Simply count-
ing the number of loans involved in the payoff of a class may not necessarily
capture the concentration risk accurately.
For example, at first glance, BACM 2004-2 A2 appears to offer more diversifica-
tion than COMM 2004-LB2A A2. With 26 loans tied to principal payoff, the
BACM bond is affected by the cash flows of twice as many loans as the COMM
bond, which is tied to 13 loans. However, on closer examination, the concentra-
tion risk of these bonds is more similar than the number of loans implies.
In the case of the BACM bond, the largest five loans (of the 26 total loans)
account for about 62% of the loan balances available for pay down of the A2
class. The largest five loans affecting the COMM bond account for 69% of
loans tied to the principal repayment of the A2 class.
EXTENSIONS O N 5 -Y
Y R T IGHT-W
W INDOW B ONDS
Principal loss is not a primary concern at the AAA level, but extension risk may
be. The CMBS market has not yet experienced a wave of loan maturities, but we
can look to the extension experience of floating rate large loans as a conservative
proxy for the extensions that may occur in the fixed rate market. We view the
extension experience of floating rate large loans to be a conservative proxy, as we
believe these loans are riskier and more likely to extend than fixed rate loans.
Floating rate loans are often made on transitional properties and are structured
with extension options, while fixed rate loans are typically backed by stabilized
assets. Some fixed rate loans may be ARD loans, but we would only expect credit
impaired loans to extend beyond their anticipated repayment dates. We recently

exhibit 4 2004 5-YEAR AAA (TIGHT WINDOW) CLASSES


LOANS SCHEDULED TO MATURE BEFORE OPENING
OF TIGHT WINDOW

Class Property Name


BACM 2004-2 A2 Cargill Office Building
COMM 2004-LB2A A2 Eldorado Mobile Home Estates
CSFB 2004-C3 A3 One Crown Center
CSFB 2004-C3 A3 Corona Plaza Shopping Center
GCCFC 2004-GG1 A3 DDR Portfolio
LBUBS 2004-C2 A2 Brittany Square
LBUBS 2004-C2 A2 Fairview Apartments
LBUBS 2004-C2 A2 Walgreens - Cheyenne Avenue
LBUBS 2004-C7 A2 Executive Plaza - Waco
MSC 2004-HQ4 A3 387-403 Fulton Avenue
WBCMT 2004-C11 A2 Pirate Plaza Shopping Center
Source: Morgan Stanley, Trepp, Annex A Files

60
exhibit 3
EXTENSION RATES BY PROPERTY TYPE
(BASED ON ORIGINAL BALANCE)

Property Type Extension Rate (%)


Hotel 40
Office 30
Multifamily 18
Retail 8
Other 13
Total 23

Extension rate represents % of loans that exercised extension options at maturity.


Source: Morgan Stanley, Intex, Trepp

published a piece that examined extension rates on floating rate large loans.2
Extension rates for floating rate loans are shown by property type in Exhibit 3.
Extension risk on a 5-year tight-window class may also be dependent on loans
that mature outside of its principal window. For example, if extensions occur
on loans that are scheduled to mature prior to the principal window opening, the
5-year AAA class may be affected. Of the 15 tight-window bonds that we
examined, eight contain loans that are scheduled to mature prior to the opening
of the tight window.3
Therefore, in addition to examining the loans that mature within the tight win-
dow, investors concerned with extension should also examine the loans that
mature prior to the opening of the tight window.

Original Loan Current Loan Maturity Property


Balance ($MM) Balance ($MM) Date Type
18.0 18.0 9/1/2008 Office
2.3 2.3 10/1/2008 Mobile Home
6.0 6.0 12/11/2008 Office
4.3 4.3 2/11/2009 Retail
48.8 48.4 3/1/2008 Retail
4.3 4.3 10/11/2008 Retail
4.1 4.1 11/11/2008 Multifamily
4.3 4.3 12/11/2008 Retail
3.4 3.4 5/1/2009 Office
3.3 3.3 3/1/2009 Retail
0.8 0.8 10/11/2008 Retail

2
For more information, see chapter 11 of this primer.
3
Does not include LBUBS 2004-C6, in which 2 maturing loans are tied to the paydown of the multifamily-
directed class.

Please see additional important disclosures at the end of this report. 61


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

Multifamily Directed Classes


Multifamily directed classes, often labeled as A-1A bonds in the structure, are
collateralized by multifamily commercial mortgages. If a deal has a multifami-
ly directed class, cash flows of most of the collateral pool’s multifamily mort-
gages are tied exclusively to paying down that class. The multifamily directed
class is intended to encourage GSE participation.
According to the Commercial Mortgage Alert database of new issue transac-
tions, 66% of the conduit/fusion deals issued in 2004 contain multifamily direct-
ed (A-1A) classes. Despite the widespread use of A-1A tranches, all else being
equal, we prefer transactions that do not contain multifamily directed classes.
The use of A-1A classes within deal structures essentially has the effect of
reducing collateral diversity for non-A-1A holders.
At first glance, bondholders in deals without A-1A classes look no better off
than bondholders in deals containing A-1A classes – that is, the collateral
composition of transactions containing A-1A classes looks as diverse as the
collateral composition of transactions without A-1A classes (see Exhibit 5).

exhibit 5a

2004 FIXED RATE


CMBS
COLLATERAL
COMPOSITION:
DEALS WITH
A-1A CLASSES

Source: Commercial Mortgage Alert

exhibit 5b

2004 FIXED RATE


CMBS
COLLATERAL
COMPOSITION:
DEALS WITHOUT
A-1A CLASSES

Source: Commercial Mortgage Alert

62
However, the majority of multifamily loans in transactions containing A-1A
classes are tied to multifamily directed classes. As a result, the existence of an
A-1A class results in a less diversified collateral pool for non-A-1A bondhold-
ers (in terms of extension risk) and exposes these investors to higher concen-
trations of fewer property types.
For example, in JPMCC 2004-CBX, multifamily loans comprise 23.6% of the
collateral pool. However, the majority of these loans are tied to the A-1A
class and do not contribute cash flows to the rest of the capital structure. If
we calculate property type exposures for the non-A-1A classes based on the
loans that contribute cash flows to these bonds, we find that the non A-1A
classes have less than 1% exposure to multifamily cash flows. Exposure to
office properties jumps to 38.4% from 29.6%, and retail exposure increases to
35.5% from 27.4%. Four other recent fixed rate CMBS with A-1A classes
exhibit a similar trend.
AAA classes with tight principal windows are particularly sensitive to the pres-
ence of an A-1A class. Since the principal repayment of tight window classes
is typically tied to a handful of loans, the A-1A class further reduces diversifi-
cation by diverting most multifamily cash flows away from the tight window
bonds. Multifamily cash flows that would have otherwise been used to pay
down bonds in the absence of a multifamily directed class are directed to pay
down A-1A instead.
In 2004, the IQ, HQ, TOP and PWR shelves were among the new issue pro-
grams that did not utilize multifamily directed classes.

Amortizing AAA Bonds


In November 2004, the BACM 04-5 transaction priced with 2 tight-window AAA
classes in addition to its 10-year AAA classes. The 5-year and 7-year tight win-
dow classes were created by incorporating a unique class (class A-AB) into the
deal’s structure.

exhibit 6
BACM 2004-5 AAA BONDS

Class Size ($MM) Subordination (%) A/L (Years) Principal Window Priced
A-1 57.600 20.00 2.89 1-56 S+26
A-1A 241.609 20.00 6.34 1-118 NA
A-2 250.910 20.00 4.77 56-60 S+17
A-3 305.377 20.00 6.77 80-84 S+24
A-AB 45.540 20.00 6.99 56-110 S+32
A-4 188.667 20.00 9.64 110-118 S+29
A-J 90.241 13.38 9.80 118 S+33

Source: Commercial Mortgage Alert, Trepp

Please see additional important disclosures at the end of this report. 63


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

In this section, we refer to Class A-AB as an amortizing bond. The A-AB bond
is structured to absorb the monthly P&I payments from loan amortization while
balloon payments are directed to pay down the tight window classes.
CONCLUSIONS
We believe that class A-AB is cheap relative to one other recently issued class
with a wide principal window, comparable average life and identical subordina-
tion level. We recommend this new type of bond for investors whose primary
market concern is extension risk.
Under no reasonable scenario were we able to extend class A-AB. We did find,
however, that the class A-AB principal window shortens with minimal default
stresses, although the bond will not pay off sooner than 2011 under our most
severe scenarios. Early repayment of principal will provide upside for investors
if they purchase this bond at a discount in the future. With rates on the rise, it
is likely that this bond will trade at a discount in the future.
LIMITED F UTURE I SSUANCE
We expect future issuance of amortizing bonds to be limited since its existence
is dependent upon having enough 5-year and 7-year loans in the collateral pool
to create tight window classes. If the market remains predominantly a 10-year
balloon mortgage market, and deals are issued with low percentages of 5- and
7-year loans, we will not see heavy issuance of amortizing bonds.
The BACM 2004-5 collateral pool contains 30% 5-year loans, 24% 7-year loans
and 46% 10+ year loans. Even with this seemingly heavy concentration of 5-
and 7-year loans, the size of the A-AB class is small ($45.5 million) compared to
other AAA classes.

exhibit 7

BACM 2004-5:
LOAN
CONCENTRATION

Source: Morgan Stanley, Trepp

64
EXTENSION P ROTECTION
As extension risk is a concern for many investors, the extension protection
offered by the A-AB class is attractive. We found the A-AB class to have virtual-
ly no extension risk.
This extension protection exists for two reasons:
• Payments to A-AB bond holders are not tied to balloon maturities.
• Class A-AB is at the top of the principal distributions waterfall, so its bal-
ance is reduced to the planned principal amount prior to other classes
receiving principal.
Under reasonable assumptions, we would expect the A-3 class to pay down
prior to the A-AB class. This is because the A-AB class will not receive addi-
tional payments greater than its planned principal amount until classes A-1, A-2
and A-3 are fully paid off. However, even in a scenario where all 15 loans tied
to the timely payoff of the A-3 class extend, the timing of the A-AB cash flows
will be unaffected. The A-AB class will continue to receive payments from the
monthly loan amortization of the remaining loans and pay off in 2014.

exhibit 8
BACM 2004-5 A-AB: EXTENSION STRESS SCENARIOS

Prepayment Principal A/L


Scenario Default Details Speed Window (Years)
Base Case 0% CDR 0 CPR 07/09-01/14 6.998
Extension 1 12-Month Extension of All Collateral 0 CPR 7/09-1/14 6.998
Extension 2 12-Month Extension of Loans Tied to the Payoff of A-3 0 CPR 7/09-1/14 6.998

Note: Loss severity in all scenarios is assumed to be 35% with a 12-month recovery period.
Source: Morgan Stanley, Trepp

We were only able to extend the average life of class A-AB under a very severe,
unrealistic scenario. When we defaulted and liquidated the largest five loans in
the transaction, which account for 29.8% of the deal, the A-AB class extended
by less than one month.

Please see additional important disclosures at the end of this report. 65


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

EARLY R EPAYMENT O F A -A
AB
Despite the lack of extension risk, the A-AB bond is sensitive to principal win-
dow contraction. The base case scenario of no prepayments or defaults pre-
dicts payoff in 2014, but the bond’s principal window shortens with minimal
default stresses.
The amortizing bond is sensitive to an earlier payoff because of its small class
size. This class was originally structured to receive loan amortization payments,
not balloon payments. Therefore, the small A-AB class can be reduced to zero
prior to its scheduled maturity date if a large balloon payment becomes tied to
its repayment. This can occur in a default scenario where liquidation proceeds
are passed through the top of the structure, thereby promoting the payoff of
the A1, A2 and A3 classes with unscheduled principal that would not otherwise
be tied to these classes. Any leftover principal cash flow that was originally
scheduled to pay down the A3 class in the base case scenario is now directed to
the A-AB class.

exhibit 9
BACM 2004-5 A-AB: DEFAULT STRESS SCENARIOS

Prepayment Principal A/L


Scenario Default Details Speed Window (Years)
Base Case 0% CDR 0 CPR 07/09-01/14 6.998
Default 1 0% CDR for 24 months; 0.5% CDR thereafter 0 CPR 07/09-07/13 6.782
Default 2 0% CDR for 24 months; 2% CDR thereafter 0 CPR 07/09-06/12 6.472
Default 3 0% CDR for 24 months; 5% CDR thereafter 0 CPR 07/09-11/11 6.408
Default 4 3% CDR starting immediately 20 CPR 07/09-11/11 6.351
Default 5 Default Bank of America Center on 12/06 0 CPR 07/09-01/14 6.998

Note: Loss severity in all scenarios is assumed to be 35% with a 12-month recovery period.
Source: Morgan Stanley, Trepp

66
In default scenario 1, we assume no defaults in the first 24 months and then a
constant annual default rate of 0.5% for the remainder of the deal. Loss severi-
ty is assumed to be 35% with a 12-month recovery period. Rather than paying
off in 2014, the bond pays off in 2013, reducing the length of the principal win-
dow by six months.
Using a more severe scenario, with 3% annual defaults starting immediately,
and a 20% CPR prepayment assumption, the final cash flow on the A-AB
bond is paid in 2011. The shortening of this class is limited to a 2011 payoff,
since there are not enough 5-year loans in the pool to pay off the A-AB class
prior to 2011.
BACM 2 004-5
5 A -A
A B L OOKS C HEAP
The BACM 2004-5 transaction priced on November 8, 2004. Class A-AB, a 6.99
year bond with 20% credit enhancement priced at swaps + 32 bp. One week
later, on November 15th, the JPMCC 2004-CBX deal priced. The JPMCC trans-
action does not have an amortizing bond, but does contain a comparable average
life AAA bond (6.61 yr) with a wide principal window and a subordination level
of 20%. This bond (class A-4) priced at swaps + 25 bp, 7 bp tighter than the
BACM amortizing A-AB class. Although there may be some spread conces-
sion for the small size of the A-AB class and for the wider principal win-
dow, we believe the BACM amortizing class, with its top priority in the
principal distribution waterfall and stable cash flows, offers value.

Please see additional important disclosures at the end of this report. 67


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

CMBS Premium Bonds


A premium priced CMBS bond can be examined for value by breaking it into
two components: a par priced fixed-rate bond and an IO. By examining the
spread on the embedded IO and comparing it to IOs in the market, we can
determine whether the premium bond is undervalued. To analyze our sample of
bonds, we used the Bond Splitter function on Trepp.
We examined a sample of second-pay AAA bonds with premium dollar prices.
For our analysis, we examined 2001 and 2002 conduit transactions. We examined
all embedded IOs under a 100CPY prepayment assumption. We chose to analyze
transactions from 2001 and 2002, as recent vintages tend to have stronger call
protection than deals issued in 1997 or 1998. Analyzing older transactions using
a 100CPY scenario may be too aggressive and would result in less attractive
embedded IOs than those found in premium bonds of more recent vintages.
We performed this analysis in June 2003, after interest rates rallied significantly,
resulting in premium priced CMBS trading at even higher dollar prices. At the
time, our trading desk estimated that on average, 10-yr AAA bonds off of con-
duit deals were trading 3-4 points higher than they were about 1 month earlier.
We found that some premium bonds offered 5-10 bp of upside potential
because their dollar prices rose high enough, such that the concession offered in
spread for each point of premium made the embedded IO look cheap in com-
parison to market priced PAC IOs. In the sample of AAAs that we examined for
this analysis, the premium dollar prices ranged between $112 and $119.
Besides very high premium dollar prices, an investor should also consider the
size of the front-pay AAA class. Second-pay AAAs that are preceded by larger

exhibit 10
ANALYSIS FOR CMBS PREMIUM AAA BONDS

Spread to Swaps
on Premium Bond
(Assuming Dollar
Deal Name Class 0,0,3CDR) Price
SBM7 2001-C2 A3 46 118-30.240
BAFU 2001-3 A2 43 112-3.750
JPMCC 2001-CIB2 A3 49 118-4.750
MSDWC 2001-TOP1 A4 47 119-15.875
GECMC 2001-1 A2 49 118-26.375
CSFB 2002-CKP1 A3 50 118-12.375
GMACC 2001-C2 A2 51 119-15.875
WBCMT 02-C1 A4 50 117-10.875
LBUBS 2002-C1 A4 52 118-18.875

Source: Morgan Stanley, Trepp

68
front- pay AAAs may look attractive compared to second-pay AAAs that are
preceded by smaller front-pay AAAs. A larger front-pay class can shield the pre-
mium priced second-pay AAA bond from recoveries on defaults, thereby pre-
serving yield on the embedded IO.
One of the bonds that we analyzed was GMACC 2001-C2 A2. This class cur-
rently has 23.4% credit enhancement and a dollar price of $119-15.875.
GMACC 2001-C2 A2 has an average life of 7.84, so we assumed that the
embedded par bond has a spread of swaps + 32 bp. New issue 10-year AAA
bonds from conduit transactions trade around swaps + 36 bp. We arrived at
swaps+32 bp for the 7.84-year embedded par bond by making the market
assumption that each year of seasoning is worth 2 bp of spread.
We then calculated spreads for the embedded IO under different default scenarios.
In each scenario, we applied defaults after 24 months. Assuming no defaults for
24 months and 3% CDR thereafter, the embedded IO yield was T+177 bp.
Running 6% CDR instead resulted in an IO yield of T+119 bp. We assumed a
34% loss severity on defaults and a 12-month recovery period.
We then compared spreads on the embedded IO to new issue PAC IO spreads.
The PAC IO is similar to the embedded IO in that it is well shielded from
losses. The PAC IO is typically structured to withstand up to 6% annual
defaults. Currently, new issue PAC IOs are pricing at T+95 bp. The embed-
ded IO in GMACC 2001-C2 A2 looks cheap in comparison, as yields range
from T+119 bp to T+177 bp, depending on the default scenario.

Premium
Embedded IO Spread Embedded IO Spread Spread to Swaps Cheapness to
to UST Assuming to UST Assuming on Premium Bond Hypothetical
3% CDR after 24 6% CDR after 24 when IO Spread PAC IO &
Months Months is T+95 bp AAA Combination
118.1 55.7 44.2 1.8
172.6 122.4 38.2 4.8
161.6 108.7 43.1 5.9
168.3 136.8 40.1 6.9
163.4 104.3 42.7 6.3
178.4 122.3 42.4 7.6
176.5 119.1 43.3 7.7
192.6 164.6 41.5 8.5
204.1 159.3 42.0 10.0

Please see additional important disclosures at the end of this report. 69


Transforming Real Estate Finance
chapter 4 AAA Fixed Rate CMBS

HOW C HEAP I S G MACC 2 001-C


C 2 A 2?
The analysis above shows that the GMACC 2001-C2 A2 bond is cheap, but does
not address the question of how cheap. We ran a breakeven analysis to figure out
how much the A2 bond would have to tighten before an investor would be indif-
ferent between owning the premium bond versus owning a par bond and PAC IO
at T+95 bp. We found that if we assume the embedded IO is priced at T+95 bp
under a 3% CDR scenario, the A2 bond would yield swaps+43 bp. This implies
about 8 bp of value, since the A2 bond currently trades at swaps +51 bp.
Using this methodology, we found that all of the bonds in our sample offer value
under a 3% CDR scenario. Under 6% annual defaults starting in 24 months, the
embedded IO in SBM7 2001-C2 A3 class yields T+56 bp. The PAC IO, in com-
parison, would not break under this default scenario and continue to yield T+95 bp.
For investors that consider the 6% CDR scenario to be a reasonable assumption,
the SBM7 2001-C2 A2 class would not provide good value (See Exhibit 10).

70
Chapter 5

Transforming Real Estate Finance


Total Rate of Return Swaps

Please see additional important disclosures at the end of this report. 71


Transforming Real Estate Finance
chapter 5 Total Rate of Return Swaps

While Total Rate of Return Swaps (TRS) are not a new innovation in the CMBS
market, they became an area of increased interest during the tight spread envi-
ronment in 2004. With AAA CMBS trading at swaps +25 bp in January 2004,
we received a number of questions on the TRS market during our roadshow, as
investors searched for spread outside of the cash market.
WHAT I S A T RS
A TRS is a method of synthetically replicating the returns from the CMBS mar-
ket. A TRS is a contract in which one party agrees to pay the total return on a
reference index or a basket of CMBS, while the other party pays a floating rate,
based on 1-month LIBOR.
Total return is comprised of two components: income and price appreciation or
depreciation. The income component includes any interest that is paid during
the life of the TRS contract, as well as interest that has accrued during that time.
TRS are short-term contracts, typically three to twelve months in length.
However, they reference a basket/index with durations typically found in 5-yr or
10-yr average life CMBS cash bonds.
Investors may choose to be TRS payers to hedge long CMBS or loan positions,
or choose to be receivers to obtain a diversified investment in CMBS through a
single trade.

exhibit 1

TOTAL RATE OF
RETURN SWAP
(TRS)

Source: Morgan Stanley

72
BREAK-E
E VEN A NALYSIS
How much CMBS spread widening can a TRS receiver tolerate before the trade
loses money? In order to answer this question, we first need to isolate the TRS
from other sources of profit and loss, such as interest rate or swap rate movements.
In the diagram below, we have created a hypothetical example where an
investor agrees to receive the total return on a basket of 10-year AAA CMBS,
and simultaneously enters into an interest rate swap to mitigate interest rate
risk. Let’s assume that the average yield on the basket of AAA securities is
swaps +30 bp, and the average duration on these bonds is about seven years.
In exchange for the total return on the AAA index, we will assume the investor
pays 1-month LIBOR - 40 bp. For simplicity, we will perform the calculation
assuming a 1-year time frame.

exhibit 2

THE RECEIVER
PAYS FIXED
ON INTEREST
RATE SWAP

Source: Morgan Stanley

We can calculate the investor’s income by examining the cash flows from the two
swaps. The investor receives a yield of swap rate + 30 bp on one leg of the
TRS and hedges the interest rate exposure by paying the fixed leg of an interest
rate swap.
The investor also receives LIBOR from the floating rate leg of the interest rate
swap and pays LIBOR - 40 bp on the TRS. Overall, the investor’s income
stream is (swap rate + 30 bp) - swap rate + LIBOR - (LIBOR-40 bp).
Therefore, the total income from these 2 trades is equal to 70 bp.

Please see additional important disclosures at the end of this report. 73


Transforming Real Estate Finance
chapter 5 Total Rate of Return Swaps

The investor’s break-even point on the trade occurs if the price of the AAA
CMBS bonds in the index declines by 0.70%, due to spread widening versus
swaps. A 0.70% decline in price corresponds to approximately 10 bp of spread
widening over the course of 1 year. (In a typical 3- or 6-month TRS contract, an
investor’s break-even point would be reached after 2.5 bp or 5 bp of CMBS
widening, respectively.)
∆P/P = -0.70%
∆P/P= Y*Duration
∆Y*Duration = -0.70%
∆Y = 0.70% ÷ 7
∆Y = ~10 bp
An investor who chooses to buy the same basket of AAA bonds in the cash
market could withstand about 4 bp of spread widening over the course of a year
(30÷7 = 4.3 bp). The TRS receiver can withstand more widening on the CMBS
basket because there is an additional 40 bp of cushion from the TRS that helps
mitigate any CMBS spread widening that occurs.
The 40 bp of cushion in the TRS fluctuates over time with the amount of hedg-
ing demand. Hedging demand comes from dealers hedging long secondary trad-
ing positions, loan originators hedging conduit pipelines, and basis traders selling
CMBS versus other asset classes. Historically, the floating leg of the TRS has
traded between LIBOR-70 bp and LIBOR-10 bp. In 2003 and during the first
half of 2004, the market ranged between LIBOR-70 bp and LIBOR-35 bp.
During the second half of 2004, increased investor interest in the TRS market
removed most of the spread advantage of receiving the index.
FACTORS T O C ONSIDER
Total rate of return swaps may not be ideal for all investors. TRS require
investors to have necessary swap documents before entering a trade. A consid-
eration for non-mark-to-market investors is that TRS are effectively marked to
market, since monthly payments are made based on the return of the index.
Therefore, a TRS investor would experience regular realized gains or losses.
Liquidity and counterparty risk are other factors to consider.

74
Chapter 6

Transforming Real Estate Finance


CMBS IOs

Please see additional important disclosures at the end of this report. 75


Transforming Real Estate Finance
chapter 6 CMBS IOs

The first five pages of this chapter are excerpted from a piece originally written in 1998.
INTRODUCTION
The CMBS interest-only securities (IO) market has both grown and matured
since its inception in the mid-1990s. In this chapter, we trace the growth and
development of the CMBS IO market and factors affecting issuance.
We examine current pricing conventions for IOs and look at several case studies to
evaluate the impact of changing prepayment and default scenarios on IO returns.
Some of our major findings are:
• IOs offer an opportunity to ERISA constrained investors to buy credit
sensitive CMBS.
• CMBS IO investors will benefit if prepayments fall short of the 100% CPR
pricing assumption or if loans are extended at the balloon date.
• CMBS IO investors may benefit from prepayment penalties during yield
maintenance periods.
WHAT I S A C MBS I O?
As in the single-family residential market, CMBS IOs receive a coupon stripped
from an underlying pool of mortgages or bond classes. Stripping a coupon
allows an issuer to sell par (or near par) priced securities, even if the coupon on
the underlying mortgages is well above the bond coupons. For example, a 1% IO
strip may be created off of collateral with a 7% coupon in order to sell 6% par-
priced securities.
Both residential and CMBS IOs are typically rated AAA/Aaa. These ratings are
based on priority of cash flow rather than credit, and are meaningless except for
regulatory purposes. Any loan default affects the yield of an IO, but from the
rating agency perspective, the default does not affect the IO’s senior priority in
receiving existing cash flow. CMBS IOs are ERISA eligible investments because
of their non-subordinated position in the structure.
Since the priority of the IO never changes, it is unlikely to be downgraded even
if the credit quality of the collateral declines. In a declining credit environment,
principal and interest bonds are more vulnerable to a downgrade. Owners of
these bonds may be forced to liquidate if they have minimum rating require-
ments. In such an environment, spreads on IOs could widen, but the rating for
regulatory purposes would probably not change.

76
For IOs backed by residential mortgages, prepayments are the most important
risk factor. Historically, defaults on residential mortgages have been a relatively
minor factor. Over the life of a residential mortgage pool, defaults have typically
totaled less than 5% of the original balance compared to prepayments that range
from 5% to 30% per year. For commercial IOs, the situation is reversed, with
defaults potentially having a greater impact than prepayments. Most securitized
commercial mortgages have either a prepayment lockout, yield maintenance or
defeasance. Historic cumulative lifetime commercial mortgage default rates at
insurance companies, however, have ranged from 4% to 32% for cohorts with at
least 10 years of seasoning (1972-1992).
STRUCTURE
A traditional structure for a WAC CMBS IO is shown in Exhibit 1. Note that
most of the IO’s cash flow is off of the AAA-rated classes, which typically con-
stitute 70% or more of the principal balances of a CMBS. In addition, the
coupons on the AA, single A, and BBB securities are higher than on the AAA
bonds, so less IO is stripped off of these classes.

exhibit 1

TYPICAL WAC IO
STRUCTURE

Source: Morgan Stanley

INVESTOR B ASE
Current buyers of CMBS IOs include life insurance companies and bank portfo-
lios to enhance portfolio yield. In addition, CMBS IOs appeal to money man-
agers who seek a high-yielding AAA-rated asset.
IOs also appeal to investors seeking shorter duration CMBS instruments – the
duration of a CMBS IO is about 4 years, compared to 7 years for classes rated
BBB or BB.
CMBS S PREADS A ND P REPAYMENT P RICING A SSUMPTIONS
Before analyzing the relative value of IOs versus other CMBS sectors, we discuss
some of the current prepayment pricing conventions for CMBS IOs and then
turn to credit analysis in the next section.

Please see additional important disclosures at the end of this report. 77


Transforming Real Estate Finance
chapter 6 CMBS IOs

The market currently prices CMBS IOs assuming that loans with yield mainte-
nance prepayment penalties are equivalent to loans with absolute prepayment
lockout provisions. Participants in the CMBS market examine IO yields and
spreads using a 100% CPY assumption, meaning that all loans prepay immedi-
ately after the lockout or yield maintenance period. Some investors also examine
yields under a 0% CPR1 assumption. The difference in spreads using the 0% and
100% CPR assumptions is often referred to as the “slope” or drop in spread
from the slowest to the fastest prepayment speed.
The actual prepayment experience of a pool of commercial loans backing a
CMBS can be quite different from the pricing assumptions. Loans can and have
prepaid in the yield maintenance period. Since a share of the penalty is passed
on to the IO holder, this can prove beneficial to a CMBS IO investor, depending
on the level of interest rates when the loan prepays.
In addition, both the 0% and 100% CPR assumptions are unrealistic. Actual pre-
payment speeds will vary on a monthly basis, with several months of 0% CPR
possibly followed by a sharp one-month increase if a loan prepays. Unlike the
residential mortgage market, there is very little historical data on commercial
mortgage prepayments.
Due to the high percentage of loans with defeasance or yield maintenance in
today’s CMBS transactions, the primary investor analysis on CMBS IOs is default
driven. Recoveries and losses on defaulted loans are now the primary factor
affecting early payment of principal in a CMBS transaction.
DEFAULT A SSUMPTIONS
Aside from prepayments, defaults are the major factor influencing CMBS IO
yields. Since default eventually may remove a loan from a pool, it is detrimental
to the return on a CMBS IO. The IO investor no longer receives the interest
strip after a defaulted loan is finally liquidated. A default, then, has a similar
effect on a CMBS IO investor as a prepayment. However, default at a balloon
date and subsequent extension of a mortgage, which lengthens its life, is benefi-
cial to the IO investor.
In pricing a CMBS IO, CMBS IO market participants examine a variety of
default assumptions, ranging from 0% CDR to 5% CDR or higher. “CDR”
stands for conditional default rate and is analogous to CPR for prepayments (see
footnote 1). Unlike prepayment assumptions, CDRs ignore any call protection
feature on the loans. Given the historical pattern of commercial mortgage
default rates, we believe that the expected average annual default rate on a newly
originated pool of commercial mortgages lies between 1% CDR and 4% CDR.

1
CPR stands for “conditional prepayment rate.” It is an annualized prepayment rate expressed as a
percentage of the remaining balance of the pool.

78
IMPACT O F P REPAYMENTS O N I O Y IELD
Exhibit 2 shows the effect of increasing prepayments on 5 different CMBS IOs.

exhibit 2
PREPAYMENT RISK: YTM OF CONDUIT IOs IN PERCENT

CPR 0 CPR 20 CPR 50 CPR 100


DMARC 98-C1 10.63 9.97 9.48 8.59
NASC 98-D6 8.83 8.82 8.80 8.68
LBCMT 98-C1 10.36 9.85 9.46 8.59
FULBA 98-C2 9.95 9.50 9.19 8.68
MSC 98-WF2 9.27 9.18 9.08 8.67

Priced at +350 at 100 CPR; yield maintenance equals lockout.


Source: Morgan Stanley

The current pricing convention for CMBS IOs, however, is 100% CPR after
yield maintenance or lockout. Reading exhibit 2 from right to left shows the
potential upside to an investor if prepayments are slower than the pricing
assumption. In the five examples cited, an investor has from 14 bp to 140 bp of
upside if actual prepayments are 20% CPR rather than 100% CPR.
The greater the slope of the increase in yield as prepayments decline, the greater
the potential benefit to the investor. The magnitude of this slope is determined
by the length of the open period between the end of the prepayment penalty
period and maturity. This window period can range from as little as one month
to as much as three years or more, depending on the terms of the loans in a
given transaction.
YIELD M AINTENANCE P ENALTIES A ND I O s
In most CMBS structures, IOs receive a share of any prepayment penalties paid
by borrowers. In early structures (pre-1997), the IO could receive as much as
100% of a yield maintenance penalty. More recently, CMBS IOs receive a share
of the penalty according to a formula such as:

P = % of penalty paid to IO =

(Bond Coupon – UST)


1 –
(Mortgage Coupon – UST)

In this example, if the principal and interest bond coupon were 6.0%, the mort-
gage coupon 7.5%, and the UST 4.75%, the IO would receive 55% of the yield
maintenance penalty. If the mortgage coupon is less than the UST, the borrower
does not pay a penalty. If a penalty is paid, and the bond coupon is less than the
UST, then the IO receives all of the penalty.

Please see additional important disclosures at the end of this report. 79


Transforming Real Estate Finance
chapter 6 CMBS IOs

For non-defeasance loans, prepayments during the yield maintenance period are
beneficial to the IO investor in a stable rate environment. Exhibit 3 shows that
in 4 out of the 5 sample deals, yields to maturity increase as prepayments
increase if interest rates remain unchanged. The sole exception, NASC 98-6, is a
CMBS backed by loans with defeasance.

exhibit 3
PREPAYMENT RISK: YTM OF CONDUIT IOs:
INTEREST RATES UNCHANGED (IN %)

CPR 0 CPR 20 CPR 50 CPR 100


DMARC 98-C1 10.63 13.51 15.42 17.66
NASC 98-D6 8.83 8.82 8.80 8.68
LBCMT 98-C1 10.36 11.44 12.48 14.31
FULBA 98-C2 9.95 10.72 11.37 12.10
MSC 98-WF2 9.26 10.85 11.63 13.48

Priced at +350 at 100 CPR; yield maintenance equals lockout


Source: Morgan Stanley

A sharp rise in rates coupled with high prepayments, however, is detrimental to


the yield to maturity of non-defeased IOs. Exhibit 4 shows the effect of an
instantaneous 300 bp increase in interest rates during the yield maintenance peri-
od. Under this scenario, the drop in yield from 0% CPR to 100% CPR ranges
from 15 bp to more than 1500 bp.

exhibit 4
PREPAYMENT RISK: YTM OF RECENT CONDUIT IOs:
INTEREST RATES UP 300 bp (IN %)
CPR 0 CPR 20 CPR 50 CPR 100
DMARC 98-C1 10.63 6.89 3.32 -1.03
NASC 98-D6 8.83 8.82 8.80 8.68
LBCMT 98-C1 10.36 6.13 1.48 -5.15
FULBA 98-C2 9.95 8.20 6.96 5.51
MSC 98-WF2 9.26 5.22 1.41 -2.31

Treasury rates up 300 bp; priced at +350 at 100 CPR; yield maintenance does not equal lockout;
dollar price has not been adjusted for rate change.
Source: Morgan Stanley

While IO bond yields decline greatly when prepayments and interest rates are
both high, we believe that these two factors are typically inversely correlated.
Higher rates clearly dampen the refinance incentive. On the other hand, if high
rates are coupled with increases in property prices, borrowers may be able to
refinance and take proceeds out of a property.

80
The most notable feature of exhibits 3 and 4 is the stable profile of CMBS IOs
backed by defeasance loans, as demonstrated by NASC 98-D6. The loans in this
transaction must be defeased upon prepayment by substituting Treasury securi-
ties for the mortgage in an amount such that the cash flow from the Treasuries
matches that of the prepaid loan. IOs from defeased transactions present a more
stable yield profile in rising rate/high prepayment environments, but less upside
in low prepayment scenarios or from penalty windfalls.
PAC & L EVERED I O S
The creation of two separate IO strips from one CMBS transaction is a more
recent structural nuance designed to accommodate the creation of larger IOs
while appealing to alternative IO buyers.3 The rapidly declining interest rates
resulting from a recessionary economy in early 2001 resulted in the creation of
much larger IOs, since the IO proceeds are directly proportional to the differ-
ence in the weighted average coupon (WAC) of the underlying mortgages vs. the
WAC of the bonds created. Ten year treasuries rallied over 100 basis points from
October of 2000 (5.80%) to March of 2001 (4.80%).
If the typical CMBS transaction in the fall of 2001 had a 40 basis point differen-
tial in the WAC of the underlying mortgage pool (8.20%) vs. the WAC of the
bonds (7.80%), approximately $25 million in IO would have been created on a
$1 billion transaction. If 10-year Treasuries rallied just 25 bp after the mortgage
pool was set, but prior to pricing the bonds, the mortgage pool WAC would be
65 bp greater than the bond WAC, resulting in approximately $43 million in IO
proceeds. This incremental increase in IO proceeds resulted in the development
of the PAC IO/Levered IO structure, appealing to an investor base of risk
adverse IO buyers drawn to the very stable yield profile of the PAC IO, with the
traditional IO investor base buying the higher yielding but less stable Levered
IO.

3
Some CMBS transactions in the early & mid-1990s had multiple IO classes, with individual IOs stripped off of
individual bond classes.

Please see additional important disclosures at the end of this report. 81


Transforming Real Estate Finance
chapter 6 CMBS IOs

The traditional single class IO was stripped off of all (or most all) bond classes
in the CMBS structure. The PAC IO is only stripped off of mezzanine bond
classes for a finite time; subsequently a Levered IO is stripped off of the more
senior and subordinate classes (See Exhibit 5). Recall, given the underlying call
protection of today’s commercial mortgages, the performance of any IO is pri-
marily a function of credit. If a mortgage pool is comprised of 100% defeased
collateral, the only unscheduled payment of principal is via default and recovery.
Because recoveries paydown the A1 class first, and losses are applied to the most
subordinate bond class, the yield profile on the PAC IO is insulated from
defaults in the underlying mortgage pool. Subsequently, the yield on the Levered
IO has more exposure to defaults in the mortgage pool.
A PAC IO is a AAA rated security that can survive a 6 CDR stress scenario
before giving up any yield. This stress is three times the standard commercial
mortgage default rate per the ELS Study. The Levered IO is also rated AAA.
This levered IO can be stressed at a 3 CDR (1.5 times the average default rate
per the ELS study). While the Levered IO gives yield in a stressed environment,
the investor is still buying a loss adjusted AAA.

82
exhibit 5
SERIES 2001 - TOP 4 CAPITAL STRUCTURE

Please see additional important disclosures at the end of this report. 83


Transforming Real Estate Finance
chapter 6 CMBS IOs

ANALYZING I OS: A PPLYING A GE-A


A DJUSTED D EFAULTS
Seasoning is an important factor to consider when comparing older WAC IOs to
more recent levered IOs. Traditional default analysis of CMBS IOs usually
ignores the impact of aging collateral. Default rates are often applied to transac-
tions in the same manner, whether the deal is newly issued or has seasoned for a
few years. We believe using an age-adjusted default curve that accounts for col-
lateral seasoning is a more accurate method of analyzing IOs.
Since defaults tend to be fairly low within the first couple of years after loan
origination, the results of an IO analysis may look quite different, depending on
whether the default curve is applied to a transaction beginning in year 1 or in
year 4 or 5.
Examining IOs with an age-adjusted default curve reveals that there is a pricing
discrepancy between recently issued levered IOs and some seasoned WAC IOs.
In our analysis, we use the commercial mortgage default curve developed by
Snyderman (1991) and later updated by Esaki (2001). The default curve reflects
the average default experience of life insurance company mortgages that were
originated between 1972 and 2000. In the commercial mortgage default study, the
peak years for loan defaults occurred within 3 to 7 years after loan origination.
In Esaki’s study, all points on the default curve are expressed as percentages of
original loan balances. In order to run scenarios in TreppAnalytics, we convert-
ed these default rates into numbers that mimic constant default rates (CDRs).

exhibit 6

DEFAULT CURVE
BASED ON ESAKI
COMMERCIAL
MORTGAGE
DEFAULT STUDY

Source: Morgan Stanley

84
APPLYING T HE D EFAULT C URVE
Under a base case pricing scenario (no defaults, 100CPY, yield to call), we see
that there are several 1999 WAC IOs that are currently trading in the low-to-mid
300 bp range over Treasuries.
If we perform a default analysis on the WAC IOs, using the default curve in
Exhibit 6 and assuming no seasoning of the collateral, the bonds lose about 80-
100 bp of yield. Although the loans in these CMBS deals have seasoned for a
minimum of 3 years, we applied the default curve beginning in year 1.

exhibit 7 AVERAGE RESULTS OF DEFAULT ANALYSIS

Base Case Pricing after Change


Pricing Scenario Defaults in Spread
Analysis (Spread to UST) (Spread to UST) (bp)
1999 WAC IO- Apply Default 308 220 -89
Curve, Beginning with Year 1
2002 Levered IO- Apply Default 409 214 -195
Curve, Beginning with Year 1
1999 WAC IO- Apply Default 308 112 -196
Curve, Beginning with Year 4
Source: Morgan Stanley, Trepp

exhibit 8 1999 WAC IO ANALYSIS: APPLY DEFAULT CURVE


BEGINNING WITH YEAR 1 DEFAULT RATE
Base Case Apply Default Change
Pricing Scenario Curve, Beginning in Spread
Deal Name Class CUSIP (Spread to UST) with Year 1 (bp)
BSCMS 1999-C1 X 07383FBB3 300 191 -109
CCMSC 1999-2 X 161505DL3 300 218 -82
JPMC 1999-C7 X 617059FC9 270 189 -81
LBCMT 1999-C2 X 501773DN2 300 208 -92
MSC 1999-WF1 X 61745MKW2 300 189 -111
NLFC 1999-1 X 63859CBT9 330 229 -101
NLFC 1999-2 X 63859CDR1 300 251 -49
PNCMA 1999-CM1 S 69348HAA6 375 289 -86
PSSF 1999-C2 AEC1 74436JFH5 300 213 -87
Total/Simple Avg 308 220 -89

Source: Morgan Stanley, Trepp

Please see additional important disclosures at the end of this report. 85


Transforming Real Estate Finance
chapter 6 CMBS IOs

Base case pricing on select levered IOs, issued in 2002, is in the low-to-mid 400
bp range over Treasuries. If we apply the same default curve to 2002 levered
IOs, the bonds experience a yield loss of about 200 bp.

exhibit 9 2002 LEVERED IO ANALYSIS: APPLY DEFAULT CURVE


BEGINNING WITH YEAR 1 DEFAULT RATE

Base Case Apply Default Change in


Pricing Scenario Curve, Beginning Spread from
Deal Name Class CUSIP (Spread to UST) with Year 1 Base Case (bp)
BACM 2002-2 XC* 05947UHT8 400 209 -191
BSCMS 2002-PBW1 X1* 07383FMR6 420 208 -212
CSFB 2002-CKN2 AX* 22540VV33 400 220 -180
GECMC 2002-1A X1* 36158YER6 400 210 -190
GMACC 2002-C2 X1* 361849UW0 400 221 -179
JPMCC 2002-CIB4 X1* 46625MKQ1 400 222 -178
LBUBS 2002-C2 XCL* 52108HKY9 390 207 -183
MSDWC 2002-HQ X1* 61746WNB2 400 213 -187
MSDWC 2002-TOP7 X1* 61746WPJ3 450 228 -222
WBCMT 2002-C2 IO1* 929766BY8 425 200 -225
Total/Simple Avg 409 214 -195
Source: Morgan Stanley, Trepp

Based on these analyses, the extra 100 bp of spread on the levered IO in the base
case pricing scenario appears warranted, since levered IOs lose about 100 bp
more of yield when subjected to defaults.
Applying an aged default curve to the 1999 transactions, however, leads us to a
different conclusion.
We adjusted the default curve for seasoning and applied it beginning in year 4 for
the 1999 WAC IOs. For each IO, we applied an immediate default rate of 2%,
followed by defaults of 2.2%, 2.4%, 3.1%, etc., in each of the following years.
On average, the bonds lost about 200 bp of yield. (These same bonds only lost
about 89 bp of yield in the traditional default analysis, which did not account for
collateral seasoning.) The 2002 levered IOs also lost about 200 bp of yield when
subjected to defaults (starting in year 1). Based on this analysis, both vintages
should actually be trading at similar spreads to Treasuries.

86
exhibit 10 1999 WAC IO ANALYSIS: APPLY AGE-ADJUSTED DEFAULT
CURVE BEGINNING WITH YEAR 4 DEFAULT RATE

Base Case Apply Default Change in


Pricing Scenario Curve, Beginning Spread from
Deal Name Class CUSIP (Spread to UST) with Year 4 Base Case (bp)
BSCMS 1999-C1 X 07383FBB3 300 95 -205
CCMSC 1999-2 X 161505DL3 300 115 -185
JPMC 1999-C7 X 617059FC9 270 74 -196
LBCMT 1999-C2 X 501773DN2 300 100 -200
MSC 1999-WF1 X 61745MKW2 300 66 -234
NLFC 1999-1 X 63859CBT9 330 118 -212
NLFC 1999-2 X 63859CDR1 300 167 -133
PNCMA 1999-CM1 S 69348HAA6 375 167 -208
PSSF 1999-C2 AEC1 74436JFH5 300 105 -195
Total/Simple Avg 308 112 -196

Source: Morgan Stanley, Trepp

OTHER F ACTORS T O C ONSIDER


From the analysis presented above, levered IOs appear to offer value relative to
older WAC IOs. However, we have examined age-adjusted defaults without con-
sideration for other factors, which could help explain why the older WAC IOs
trade at tighter spreads.
While we have taken into account the effects of seasoning on expected default
rates, we have not considered possible differences between the vintages, such as
the quality of the underlying collateral, call protection, underwriting standards
and investor comfort with real estate valuations/fundamentals in particular years.

Please see additional important disclosures at the end of this report. 87


Transforming Real Estate Finance
chapter 6 CMBS IOs

PAC IO Primer: E v. J
Although PAC IO spreads are currently quoted to the J-curve, traders are increas-
ingly examining these bonds to the E-curve. In this piece, we discuss the charac-
teristics of “J” and “E”, and why the E-curve makes sense for PAC IO pricing.
WHAT I S J 1 , A ND W HY I SN’T I T I DEAL F OR P AC I O S ?
The J-spread is defined as the difference between a bond’s yield and the interpo-
lated Treasury rate that corresponds to the bond’s average life. By definition, an
interest only strip does not have any principal cash flows. Therefore, the average
life of a PAC IO is actually the average life of the underlying securities from
which the IO is stripped.
Although the average life of a bond that pays principal is a fair proxy of where
the bond’s average interest rate risk lies, the average life of a PAC IO does not
describe the bond’s average interest rate risk. As a result, the average life of the
PAC IO can vary considerably from its duration. For example, a PAC IO may
have an average life of four years, while its duration may be closer to two years.
Since the duration of a PAC IO is often much shorter than its average life, it is
somewhat arbitrary to compare a PAC IO yield to its average life point on the
Treasury curve, which has considerably more interest rate risk.
The current steepness of the front end of the Treasury curve is another reason
why the J-curve is not an ideal pricing benchmark for PAC IOs. Currently, there
is a 137 bp slope between the 2-year and 5-year Treasury rates. Since the curve
is this steep, small average life variability between PAC IOs could translate into
large spread differences to the J-curve. Therefore, relative value between two
PAC IOs may not be readily apparent, since J-spreads can vary significantly with
average lives.
For example, in a recent bid list, LBUBS 2003-C7 XCP (avg life 4.90 yrs) trad-
ed near T+25 bp, while LBUBS 2003-C5 XCP (avg life 4.63 yrs) traded near
T+38 bp. Although the LBUBS 2003-C5 PAC IO traded 13 bp wider than the
LBUBS 2003-C7 PAC IO, does this mean that the 2003-C5 PAC IO offers signifi-
cantly better value? Pricing these bonds to the E-curve will answer this question.
WHAT I S E , A ND W HY I T M AKES S ENSE
The front end of the swap curve is constructed with eurodollar futures contracts,
which are future contracts on 3-month LIBOR. When a PAC IO is priced with
the E-curve, each bond cash flow is discounted by the E-spread plus the rate on
the eurodollar futures curve that corresponds to the timing of that cash flow.
Unlike the J-spread, which is a spread over the bond’s average life point on the
Treasury curve, the E-spread is a single constant spread that is added to each rele-
vant point on the Eurodollar futures curve. This method of pricing the PAC IO is
more appropriate than discounting all cash flows with a single rate at an average
life point that is somewhat arbitrary when looking at PAC IOs.

1
For more details on the J-curve as a pricing benchmark in CMBS, see the Appendix.

88
When using the E-curve, even if one PAC IO is slightly longer than another, the
E-spreads are still comparable to assess relative value. This is because the dis-
count rates for each cash flow on each bond are benchmarked off of the same
rates on the eurodollar futures curve. Using the J-curve, however, two bonds
with different average lives would be discounted with rates based on different
interpolated Treasury rates. The J-spreads for each bond, as a result, are difficult
to compare.
If we revisit our example of LBUBS 2003-C7 XCP and LBUBS 2003-C5 XCP, we
find that these bonds actually look very similar when compared to the E-curve.
The LBUBS 2003-C7 PAC IO prices at E+57 bp, while the LBUBS 2003-C5 PAC
IO prices at E+55 bp. This example shows that LBUBS 2003-C5 XCP, which had
an extra 13 bp in J-spread over LBUBS 2003-C7 XCP, does not appear to offer
better value using the E-spread methodology.

exhibit 11
PAC IOS: E-SPREAD VS J-SPREAD

Avg Life J-Spread E-Spread


Bond (yr) (bp) (bp)
LBUBS 2003-C7 XCP 4.90 25 57
LBUBS 2003-C5 XCP 4.63 38 55

Source: Morgan Stanley

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Transforming Real Estate Finance
chapter 6 CMBS IOs

Appendix: More Details on J


Until 2001, secondary desks quoted spreads off the interpolated Treasury curve,
otherwise known as the I-curve to Bloomberg users. Since then, they moved to
the convention of quoting CMBS spreads to the interpolated nominal Treasury
curve, or the J-curve. This change is primarily relevant for investors who price
bonds based on the Treasury curve.
Any spread difference between the curves results from assumptions used while
interpolating points on the Treasury curve. Pricing a 9.5-yr CMBS bond as a
spread to Treasuries involves interpolating yields for the on-the-run five- and
ten-year Treasury notes. The I-curve interpolates between the remaining maturity
of the two notes. If both notes were issued three months ago, the interpolation
would involve 4.75 years as the starting point and 9.75 years as the end point. In
contrast, the J-curve ignores any seasoning that may have taken place in either
issue. Therefore, no matter how long ago the on-the-run notes were issued, the
interpolation is based on the original maturities of five and ten years.
WHAT P ROMPTED T HE C HANGE?
Although this curve discrepancy has always existed, the issue for CMBS only sur-
faced in 2001. This is because of two technical factors present in the Treasury
market at the time: longer intervals between new issues and a steep yield curve.
• Longer intervals – Given the budget surplus, the Treasury Department
slowed the issuance of five-year and ten-year notes from monthly to quarter-
ly and also increased the frequency of reopenings. As a result, on-the-run
notes could be up to six months shorter than their original maturity, com-
pared to one month in earlier periods.
• Steep yield curve – Ten-year notes in 2001 yielded about 50 bp more than
the five-year notes, about 20 bp more than the historical average since 1980.

90
For example, consider pricing MSC 1999-LIFE A2, an 8.0-yr CMBS tranche, on
5/8/01 at LIBOR+45 bp:

exhibit 12 I VS. J SPREAD COMPARISON

I-Curve J-Curve
Maturity (yrs) Yield (%) Maturity (yrs) Yield (%)
Start point (5-yr UST) 4.52 4.74% 5.00 4.74%
End point (10-yr UST) 9.77 5.24% 10.00 5.24%
Interpolated (8-yr UST) 8.00 5.08% 8.00 5.05%
Spread Spread Spread Spread
to LIBOR to UST to LIBOR to UST
CMBS 45 122 45 125
Source: Morgan Stanley, Bloomberg

Yield = Swap Rate + LIBOR Spread


UST Spread = Yield – Interpolated UST
The yield of the CMBS is set by the spread to its benchmark, the swap rate of
5.85%. Accordingly, the CMBS tranche would yield 6.30%, or 5.85% plus 45 bp.
The I-curve results in an interpolated Treasury yield of 5.08% or CMBS spread
at UST + 122 bp. The J-curve, however, results in an interpolated Treasury yield
of 5.05% or CMBS spread at UST + 125 bp, a 3 bp disparity to the I-curve.

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92
Chapter 7

Transforming Real Estate Finance


Fixed Rate Large Loans

Please see additional important disclosures at the end of this report. 93


Transforming Real Estate Finance
chapter 7 Fixed Rate Large Loans

INTRODUCTION
Since the terrorist attacks of September 11, 2001, investors have been apprehen-
sive of the concentration risks associated with trophy properties. As a result,
fixed rate large loan deals and single asset transactions have virtually disappeared
from the new issue market place. While short-term large loan deals continue to
be issued today, the new vehicle for securitizing fixed rate large loans has
become the “fusion” transaction.
FUSION
Loans with large dollar balances are often mixed with smaller loans in deals that
the market labels as “fusion.” The definition of “fusion” varies, but for pur-
poses of classification, Commercial Mortgage Alert defines a fusion deal as a
transaction that has conduit style loans and either has one loan that is more
than 10% of the pool balance or all loans of $50 million or more are at least
15% of the deal. Many market participants classify a fusion transaction by
examining the top 10 loan concentration within a deal. The rule of thumb is to
classify the deal as a fusion transaction if the top 10 loans account for at least
40% of the collateral.
STAND-A
A LONE L ARGE L OANS
“Stand-alone large loans” refer to mortgages of $50 million or more on com-
mercial properties with an institutional borrower. Stand-alone large loan CMBS
have taken the form of single-asset or single-borrower deals or transactions
backed by a small number of commercial mortgages averaging $50 million or
more. For single asset transactions, the loan size may be as much as $500 million.
Stand-alone large loans tend to have lower leverage and more credit-worthy bor-
rowers than conduit loans.
Since the September 11th attacks, AAA securities from fixed rate large loan
transactions trade about 15 bp to 30 bp wider than AAA tranches from diversi-
fied conduit CMBS. At the lower investment grade level, large loan classes are
also trading at wider spreads to similarly rated classes from conduit deals.
HISTORY O F T HE F IXED R ATE L ARGE L OAN M ARKET
The CMBS market began in the 1980s with the securitization of commercial
mortgages on large “trophy” assets. The market evolved in the 1990s to one that
was dominated by large pools of small- to medium-sized loans. A typical pool
might consist of 200 loans on properties well diversified by geographic region
and property type. Mortgage conduits originate the loans and most range in size
from $1 million to $20 million.

94
exhibit 1

U.S. CMBS
ISSUANCE

1
Through November 1, 2004.
Source: Morgan Stanley, Commercial Mortgage Alert

As issuers sought to get loans off their books more quickly, deal size decreased
in line with loan accumulation periods. Smaller deal size meant that a large loan
made up a greater percentage of the transaction. In 1998, several CMBS transac-
tions exceeded $2 billion. For transactions that large, a $50 million loan is only
2.5% of the total balance and the deal does not receive a high concentration
penalty from the rating agencies. As deal sizes dropped below $1 billion, issuers
received better prices by issuing separate large loan deals rather than tainting an
entire pool with concentration risk.

exhibit 2 1200

AVERAGE U.S. 1000


DEAL SIZE
800

600

400

200

1
As of November 1, 2004 pricing.
Does not include Agency CMBS or resecuritizations.
Source: Commercial Mortgage Alert

Please see additional important disclosures at the end of this report. 95


Transforming Real Estate Finance
chapter 7 Fixed Rate Large Loans

CHARACTERISTICS O F S TAND-A
A LONE L ARGE L OANS
Credit
To date, the average stand-alone large loan has had a lower LTV and higher
DSCR than the average conduit loan. Although LTVs for stand-alone large loans
may range from 40% to 100%, most fall in the range of 45% to 60%. Conduit
transactions typically have weighted average LTVs in the 60% to 75% range.
DSCRs for stand-alone large loans are frequently in excess of 1.50x, while for
conduits, the weighted average DSCR is generally in the 1.25x to 1.40x range.
Some analysts believe that the reason for the lower leverage and higher debt
service coverage ratios for stand-alone large loans is that prices of large proper-
ties are more volatile than for smaller properties. There is very little confirmation
of this volatility, aside from anecdotal evidence about the fall in prices of “tro-
phy properties” in the early 1990s. That higher priced properties have more
volatile prices makes some intuitive sense, because there is a much smaller base
of buyers than for average or low-priced properties. In the residential home
market, for example, there is much evidence showing that high value homes
both rise and fall in price much faster than average value homes.
Stand-alone large loans tend to be on properties located in major markets, in con-
trast to smaller conduit properties, which are more evenly spread out in both larg-
er and smaller metropolitan areas. Location in larger markets has both advantages
and disadvantages. On the positive side, property markets in large markets are
probably more liquid and have more potential buyers than those in small markets.
On the other hand, the concentration of properties in large urban centers, for
example, can create volatility in prices should the market suffer a downturn.
Structural Features
Large commercial loans generally have structural protections that are often not a
feature of conduit loans. First, stand-alone large loans have “lock box” features
that separate the cash flow of the property from the borrower’s income. Second,
the loans are usually placed in a “special purpose entity,” or SPE, which sepa-
rates the loan from the other assets of the borrower in the case of bankruptcy.
(In a conduit CMBS, the SPE may be less well defined at the borrower level.)
Third, a stand-alone large loan often provides for removal of management, or
“kick-out,” should the cash flow of the property deteriorate beyond a specified
target level.
These features, while important in insulating investors against potential borrower
problems, are not a protection against a general deterioration in real estate credit.
For example, if a fall in operating income is caused by a regional economic
downturn, the replacement of management probably will not improve the credit
risk of the property.
Credit Strength of Borrower
Offsetting the risks of potentially more volatile asset prices is the better credit
of stand-alone large loan borrowers. These borrowers are often rated entities,
compared to most conduit lenders, who are not rated. A bankruptcy of a bor-
rower leading to default on a mortgage is thus more likely in the case of a con-
duit borrower than a stand-alone large loan borrower.

96
Many of the borrowers in stand-alone large loan transactions are well-capitalized
firms that have access to other sources of capital. This provides some protection
against default in a real estate downturn. Given the lower LTVs on most stand-
alone large loans, the borrower’s equity stake is typically larger than for conduits
and may in some cases reach over $100 million.
According to a Moody’s study of corporate defaults between 1970 and 1997, less
than 5% of investment grade corporations defaulted within 10 years. The default
rate is 20% for companies in the Ba category, and almost 50% for firms rated in
the single-B category. It should be noted, however, that the default of a borrower
does not necessarily mean a default or loss on a mortgage made by the borrower.
The CMBS is secured by the property, not the credit of the borrower. As long as
the value of the property is greater than the mortgage, or the cash flow greater
than the debt payments, the borrower is unlikely to default on the mortgage.
Prepayment Protection
Stand-alone large loans and conduit loans have very similar prepayment protec-
tion. Most currently have defeasance provisions. Earlier transactions had lockout
or yield maintenance periods followed by penalty points. For more details on
types of call protections, see the “Call Protection” chapter in this book.
Information Availability
In 1999, it was often difficult to obtain individual property cash flow and DSCR
data after issuance. The situation has improved since 1999 and stand-alone trans-
actions are now closely monitored after closing. Depending on the terms of the
borrower’s loan agreement, the following documents are available to investors on
a quarterly and/or annual basis from the servicer: property operating statements,
rent rolls, sales reports for retail properties and property inspections.
EMPIRICAL S TUDIES
Two recent studies addressed the relative risk of large loans. A default study by
Esaki, L’Heureux, and Snyderman (1999)1 found that default rates for small
loans at insurance companies over the period 1973 to 1997 were slightly less
than for large loans. The study, however, only had four categories of loans, of
which the largest size was “over $8 million.”
Another study published in April 1999 by Ziering and McIntosh2 examined the
risk-return profiles of properties by size. The study also looked at properties in
four categories, but the categories ranged from “less than $20 million” to “over
$100 million.” Over the period 1981 through 1998, the authors found that larger
properties generally had higher average returns, but also higher volatility of
returns. The authors cite the thin market for trophy properties as the reason for
higher volatility.

1
Howard Esaki, Stephen L’Heureux, and Mark Snyderman, “Commercial Mortgage Defaults: An Update,” Real
Estate Finance, Spring 1999.
2
Barry Ziering and Willard McIntosh, “Property Size and Risk: Why Bigger Is Not Always Better,” Prudential
Real Estate Investors Research, April 1999.

Please see additional important disclosures at the end of this report. 97


Transforming Real Estate Finance
chapter 7 Fixed Rate Large Loans

RATING A GENCY A PPROACH T O L ARGE L OANS


In rating single-borrower or single-asset transactions, the largest concern of rat-
ing agencies is concentration risk. For example, one agency stated, “The distin-
guishing characteristic of [single-asset] transactions is the concentration of
risk…This is in contrast to pooled transactions, in which the diversification of
properties and leases mitigates this risk.”3
To adjust for concentration risk, rating agencies have very conservative standards
for single-borrower and single-asset transactions. For example, to obtain a AAA
rating, a large office property must have a debt service coverage ratio in the
range of 2.30x to 2.75x and an LTV not exceeding 40%.
At the rating agencies, the advantage of diversified small to medium loan pools
is demonstrated in the level of credit support needed to obtain a higher rating
level than the collateral on a stand-alone basis. For example, consider a pool of
small multifamily properties, all with DSCRs of 1.35x and LTVs of 70%. Such a
pool would need 20% to 25% of subordination for the AAA class. A large loan
with equivalent characteristics would be shadow-rated BB. In order for a senior
portion of this loan to attain a rating of AAA, we estimate that a subordination
level of 35% is required. This subordination level would lower the effective LTV
of the senior tranche of the large loan to 46%, which is the standard for a
stand-alone AAA. The 10% to 15% difference in subordination levels reflects
the “penalty” for concentration.
In underwriting conduit transactions, rating agencies typically underwrite a sam-
ple of loans in the pool. The sample usually is about 30%, and includes most of
the largest loans. In contrast, a large loan or single-asset transaction will have
100% underwriting by the agencies.
In stand-alone large loan deals, full environmental and engineering reports are
provided for each property. This is not the case for all conduit loans. It is not
clear if the rating agencies adjust conduit subordination levels upward to adjust
for the uncertainty of less than 100% underwriting.
Based on their underwriting, rating agencies will adjust the cash flow and valua-
tion on a property, deriving “adjusted” LTVs and DSCRs. In almost all cases, the
LTV is adjusted upward (and NOI downward) from the reported number. Based
on our conversations with the rating agencies, these adjustments are usually in
the range of 10% to 20% for both stand-alone large loans and conduit loans.
DO R ATINGS C ORRECTLY A DJUST F OR R ISK?
Rating agencies universally state that a AAA rating means the same amount of
credit risk across all types of fixed-income securities. Theoretically, a AAA-rated
corporate bond should have the same degree of credit risk as a AAA-rated
CMBS. Within the CMBS sector, rating agencies state that they make adjust-
ments for collateral quality so that a AAA conduit transaction has the same
amount of risk as a AAA stand-alone large loan deal.

3
The Rating of Commercial Mortgage Backed Securities,” Duff and Phelps, November 1994.

98
In practice, we believe that there can be substantial differences in risk among
securities with the same rating. We have long maintained that rating agencies have
more conservative standards in rating structured securities than corporate bonds.
INVESTOR P REFERENCES
Some CMBS investors prefer diversified pools of loans because they feel they do
not have the real estate expertise to evaluate commercial mortgage credit risk on
a single property. Some of these investors rely on the rating agencies to analyze
default risk; others become comfortable with the general underwriting guidelines
of an originator. Investors preferring pool diversity tend to be money managers
with limited experience in underwriting real estate. They tend to view CMBS as a
fixed-income asset with good call protection, rather than a direct investment in
real estate.
Other investors prefer single-asset transactions, or those backed by only a few
loans, because they can then use their real estate expertise to underwrite each
loan in a CMBS pool. These investors tend to be insurance companies with large
underwriting staffs. These investors focus more on the real estate aspects of
CMBS investments and often purchase stand-alone large loan CMBS as a com-
pliment to their whole loan portfolio.
Because of this split in investor preferences, stand-alone large loan transactions
tend to trade differently than diversified conduit pools. Money managers tend to
shy away from single asset deals because of the lack of diversification and a per-
ceived lack in liquidity. Insurance companies re-underwrite a stand-alone large
loan, and if they are comfortable with the asset, prefer to buy the lower invest-
ment grade classes. The yield on the BBB class, for example, most closely match-
es the yield on whole loans, the alternative investment for insurers.
Insurance companies purchase about 85% of the mezzanine classes from stand-
alone large loan transactions and only 45% from conduit deals. In contrast,
money managers buy 50% of the AAA bonds from conduit deals, but only about
a third of the AAA-rated securities from stand-alone large loan transactions.
As a consequence of these preferences, the AAA class from a stand-alone large
loan transaction tends to trade at a wider spread to Treasuries than a conduit deal.
The difference has historically been in the range of 5 bp to 10 bp. The BBB class
of a stand-alone large loan deal, however, trades at a narrower spread difference
to conduit BBBs and, in some instances, actually trades at a tighter spread than in
a diversified pool. If insurers deem an asset as high quality, the small size of the
BBB class often results in excess demand at the initial pricing level.

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100
Chapter 8

Transforming Real Estate Finance


BBB CMBS and REITs

Please see additional important disclosures at the end of this report. 101
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

BBB CMBS and REIT unsecured corporate bonds are often used as proxies for
one another, as both are backed by real estate and have similar ratings. In this
chapter, we examine the volatility, ratings history, liquidity, structural differences,
the issuer’s perspective, the rating agencies’ perspective and performance of each.
We found that while differences exist among the security types, there is no
apparent advantage of one over the other. Since the credit is similar and spreads
have historically converged, we recommend that BBB CMBS investors consider
REIT debt as an alternative, particularly when spreads are wider on REIT debt.

exhibit 1 CHARACTERISTICS OF BBB CMBS AND REIT


UNSECURED DEBT

CMBS REITs
Rating BBB+/BBB/BBB- BBB+/BBB/BBB-
Trading Range Since April 1998 114-325 bp 97-321 bp
Spread Volatility in Standard
Deviation (bp) 22 36
Rating Actions in 2004 35 upgrades to 25 downgrades 1 upgrade and 7 downgrades
Market Capitalization $28 billion $58 billion
Bid Ask Spread 2 bp for on-the-run names 2-3 bp for large cap names
Monthly Trading Volume $750 million to $1 billion $1 billion
Leverage 70% LTV at BBB level 40% debt to market cap
Structural Differences Secured by specific properties Corporate debt covenants
Management Inactive management within the trust Active management of portfolio

Source: Intex, Remittance Reports

We also advise investors who have focused on REIT debt to consider BBB CMBS
as an alternative, particularly when CMBS spreads are wider than REIT debt.
SIMILAR V OLATILITY
Historically, BBB CMBS and REIT paper have traded close to parity, with
divergence resulting in very short-term opportunities. Since the end of 1998,
the average spread difference between both has been only one bp. Since we
began tracking the spreads in early 1998, the longest period that the spread
differential between BBB CMBS and REITs remained wider than 5 bp was
between August 2003 and May 2004. The average difference in spread during
that period was 17 bp.
The standard deviation of historical BBB CMBS spreads to Treasuries over the
past several years is 22 bp; it is 36 bp for REITs. BBB CMBS stability is simi-
lar to that of the BBB Industrial Index and is less volatile than REIT debt
(Exhibits 2 and 3).

102
exhibit 2

BBB CMBS VS.


REITS TO UST
(APRIL 1998 -
NOVEMBER
20041)

1
Through November 9, 2004.
Source: Morgan Stanley

exhibit 3 SPREAD VOLATILITY: APRIL 1998-NOVEMBER 2004

BBB
BBB CMBS REITS Industrials
Mean (bp) 116 133 104
Standard Deviation (bp) 22 36 22
Source: Morgan Stanley, Bloomberg

RATINGS H ISTORY
Rating Actions Best for BBB CMBS
Through September 2004, the upgrade/downgrade ratio for CMBS rated
BBB+/BBB/BBB- has been better than that of REIT paper. The rating agen-
cies have changed their ratings on 372 BBB+/BBB/BBB- CMBS tranches since
January, with 311 upgrades and 61 downgrades. The 2004 ratio of 5.1 upgrades
to 1 downgrade is a better record than the 3.3 to 1 ratio for all credit classes
within CMBS for the same period.
Appendix A at the end of this report details all rating actions for CMBS rated
BBB+/BBB/BBB- in 2004.

Please see additional important disclosures at the end of this report. 103
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

exhibit 4 2004 YTD RATING CHANGES1 FOR REITS

Company From To
Brandywine Realty Trust [P]Ba3 [P]Ba2
Crescent Real Estate Equities Ba3 B1
Equity Office Properties Baa1 Baa2
Glimcher Realty Trust Ba3 B1
iStar Financial, Inc Ba1 Baa3
National Health Investors B1 Ba3
Omega Healthcare B2 B1
Prime Property Funding II, Inc. A2 A3
Sun Communities Baa3 Ba1
United Dominion Realty Trust Baa3 Baa2
1
Based on Moody’s data only through October.
Source: Moody’s

Throughout the first 10 months of 2004, REITs experienced a 1 to 1


upgrade/downgrade ratio. Both CMBS and REITs have had a better ratings
record in 2004 than corporate bonds which experienced a 0.9 to 1 upgrade/
downgrade ratio.

exhibit 5 2004 RATING ACTIONS

BBB+/BBB/BBB- CMBS REITs1


2004
Upgrade 311 5
Downgrade 61 5
1
Based on Moody’s data only.
Source: Moody’s

LIQUIDITY
Liquidity Fairly Even for REITs & BBB CMBS
Market capitalization, trading volume, deal size and bid-ask spread all con-
tribute to liquidity within a sector. REIT paper has a market capitalization of
about $58 billion.
The market capitalization of CMBS rated BBB is less than half that of REIT
paper, with about $28 billion currently outstanding. On average, BBB bonds
account for 4% of U.S. issuance volume. We anticipate that $3 billion of BBB
CMBS was issued in 2004.

104
Several factors reduce liquidity for both CMBS and REIT debt. For instance,
the class sizes of BBB CMBS tranches have been shrinking over time, reducing
liquidity. Additionally, structured vehicles (CDOs) have been big buyers of BBB
CMBS and REIT paper. Recently insurance companies have been significant
buyers of BBB CMBS. Both CDOs and insurance companies tend to buy and
hold rather than trade for total return, reducing the amount of paper traded.
We anticipate that the street trades about $750 million to $1 billion of BBB
CMBS paper on a monthly basis. The inclusion of BBB CMBS as ERISA eligi-
ble securities contributed slightly to liquidity.
Liquidity in a particular name may vary depending on the seasoning and delin-
quencies within a transaction. Large blocks of on-the-run BBB CMBS with few
or no delinquencies trade with bid-ask spread of 2 bp or less.
Although the market capitalization is greater for REIT paper, REIT trading vol-
ume is similar to CMBS. On average, the street trades about $1 billion of REIT
paper per month, with heavier trading over the last several months. The most
liquid names are those with the most debt outstanding.
The more-liquid REIT names (EOP, SPG) trade with a 2-3 bp bid-ask spread in
on-the-run maturities. The remaining names in the universe are less liquid and
typically trade with a 10 bp bid-ask spread.
CDO Market Effect
The CDO market has had a significant impact on BBB CMBS and REIT debt.
On the positive side, the CDO bid keeps spreads in check. Liquidity, however,
may be limited by the buy-and-hold nature of CDOs.
About 7% of REIT unsecured debt has been put into various CDO deals, effec-
tively removing about $3.8 billion from REIT unsecured debt secondary trading.
Nevertheless, we do not consider the 7% of outstanding REIT debt locked up in
CDOs to be significant, despite the recent focus of CDOs on this sector. At the
peak of the CDO bid in the high yield market, many market participants noted
25-30% of high yield new issue flows into CDOs. In the credit derivatives mar-
kets today, flows from synthetic CDOs account for a similar percentage of that
market, as well.
The amount of BBB CMBS within CDOs is more significant than for REIT
debt. We estimate that about $5.5 billion BBB CMBS, which is about 18% of
the market, is contained in real estate CDOs.
STRUCTURAL D IFFERENCES
REIT paper and CMBS have very similar credit characteristics in that both are
backed by payments generated by commercial real estate. However, significant
differences arise in the structures of both credits.
Both CMBS and REIT paper benefit from the inherent diversity within a portfo-
lio of properties. However, diversification within CMBS conduit transactions is
greater than within REIT paper. Conduit CMBS transactions are made up of
100-200 smaller commercial loans providing diversity in terms of geography,
borrowers and property types. Typically, REIT management teams have expert-

Please see additional important disclosures at the end of this report. 105
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

ise in one property type that may be concentrated in several regions rather than
diversified across the country.
However, the balance sheets and credit characteristics of REITs are usually signif-
icantly stronger than the credit of borrowers within CMBS conduit transactions.
In CMBS, a default on one asset within a conduit has little or no impact on pric-
ing and liquidity. There has never been a default on REIT unsecured paper.
THE I SSUER’S P ERSPECTIVE
Although REIT debt often trades close to parity with BBB CMBS, REITs as
issuers of either secured or unsecured financing take into account the overall
cost of capital for the transactions, as well as the flexibility of the debt relative
to their portfolios.
Most REITs choose to issue CMBS in the form of large loan transactions.
Currently, approximately $12 billion of CMBS outstanding has been issued by
REITs (Appendix B). Typically, these transactions contain about 65% AAA
bonds, 11% AA bonds, 10% A bonds, 10% BBB bonds and 4% BBB- bonds.
While the actual cost of funding is lower for a large loan REIT CMBS transac-
tion than for unsecured REIT debt, issuers give up some financial flexibility
because securitization requires mandatory capex reserves and limits refinancing
and the sale or substitution of the assets. Large loan CMBS may have specific
covenants that require minimum debt service coverage ratios, lock boxes for
cash flows and specific insurance coverage.
Lastly, issuing CMBS requires a rather long lead-time for marketing and sale of
the transaction, while unsecured debt deals may be completed virtually
overnight. Documentation is much simpler and execution is much quicker in the
unsecured debt market.
RATING A GENCY P ERSPECTIVES
Unsecured REIT Debt
Rating agencies consider a number of factors when it comes to rating unsecured
REIT debt. These factors include depth of management and experience, quality
of property, geographic and tenant diversification, stability of cash flows, prof-
itability and financial flexibility. As Moody’s stated in its September 2000 Special
Comment report, The Qualitative Factors - It’s Not All in the Numbers, “Financial
ratios, although not the dominant element in Moody’s rating process, are a criti-
cal part of our rating methodology.” As none of the rating agencies will disclose
average ratios per category, we reviewed all the companies we cover and attempt-
ed to break out the ratios for each rating class.
With the many outliers, we found it difficult to discern specific ratios, as this
varies for different sectors, with retail clearly exhibiting the most aggressive
financial fundamentals. Generically, debt to gross real estate is in the low 40%
range for high BBBs, in the mid-to-high 40% range for mid-BBBs and in the
low-to-mid 50% range for low-BBBs. Typically high BBBs have a fixed charge
coverage of over 2.5x, with mid BBBs and low BBBs slightly lower than that.
Again, there are many outliers; our review serves to demonstrate that looking at
the financial fundamentals alone is only one piece of the rating process. Higher
ratings equate to greater availability on bank lines. Many high BBBs were not

106
reliant on their bank lines, while many low BBBs had drawn down significantly
on their bank lines.
Please see Appendix C for a breakdown of the rating agencies’ analyses of REITs.
CMBS Debt
Before each CMBS is issued, the rating agencies review the collateral in the
transaction and determine the tranche ratings and pool sizing. The rating agen-
cies apply published standards to loans pooled into a CMBS and adjust the result
by making qualitative assessments. Almost all CMBS carry at least two ratings,
and many have three. Different rating agencies assign different levels of credit
support to obtain a given rating level. During the process, the agencies review
the property level cash flows, perform physical inspections and run various
stress analyses on the underlying cash flows in order to simulate a worst-case
recession scenario.
When a conduit deal comes to market, the rating agency performs due diligence
on a subset of the properties (typically between 35% and 75%). The larger loans
in the deal are always underwritten, while the remaining properties are chosen
such that they provide a representative cross-section of the deal. To determine
credit enhancement levels, the underwritten cash flow (UCF) produced by each
property is then assigned a “haircut” based on various subjective parameters.
Exhibit 6 details a list of parameters that rating agencies consider when evaluat-
ing a CMBS conduit.
The parameters are similar to those considered for a non-conduit deal except for
adjustments for loan diversification.

exhibit 6 CMBS EVALUATION PARAMETERS

Loan Specific Deal Specific


Property type Number of loans in the deal
Loan-to-value ratio Loan size
Debt service coverage ratio Degree of subordination
Fixed/floating rate Balloon extension risk
Loan seasoning Quality of master servicer and special servicer
Direct versus correspondent lending Real estate outlook
Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 107
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

exhibit 7 ATTRIBUTES OF REITS RELATIVE TO CMBS

Positives Negatives
Active Management May be more geographically concentrated
Better Disclosure Must pay out 90% of earnings subject to refinancing risk
Covenants Backed by corporate guarantee, as opposed to explicitly secured by
assets
Lower Leverage Corporate entities subject to event risk
Source: Morgan Stanley

Loans collateralized by different property types are generally ranked in the fol-
lowing order (best to worst): regional malls, multifamily, anchored community
retail, industrial, office and hotel. These rankings are based on historical defaults
and cash flow volatility of the different property types.
Rating agencies review the dispersion of DSC and LTV in the entire deal; that is,
having all loans with a DSC of 1.5x is better than having 50% of the loans at
1.0x and the remainder at 2.0x.
Given the volatility of short-term interest rates, an adjustable-rate loan is under-
written using an interest rate scenario that is substantially higher than current
rates. Loans without a track record of consistent payments are also rated more
conservatively than those seasoned at least five years.
Lower Leverage and Better Borrower Credit in REITs
Typically, conduit CMBS transactions have a 75% loan to value (LTV) ratio, and
BBB bonds have subordination levels averaging about 5%, translating to a 70%
LTV for the BBB classes.
Large loan transactions have lower leverage, with LTV ratios ranging between
55-65%. Usually the BBB tranches within these transactions are the lowest-rated
classes with minimal subordination.
REITs have debt to market capitalization ratios that average 41% and debt to gross
real estate ratios of about 49%, below the leverage within CMBS transactions.
Most REIT debt covenants require maintenance of a 60% debt to assets ratio
based on the book value without depreciation. Additionally, typically no more
than 40% of a REIT’s assets can be encumbered by secured financing. REITs
have several avenues for financing, including lines of credit, unsecured corporate
debt, secured financing, selling properties and joint ventures. Most borrowers
within conduit transactions only have access to capital via secured financing.

108
PERFORMANCE
2004 CMBS Performance
Through October, CMBS has outperformed both corporate bonds and treasur-
ies. Within CMBS, BBBs have produced the best performance. According to
the MSCI CMBS Index, investment grade CMBS produced a 4.24% total
return through October, and BBBs produced a total return of 6.02% during
the same period.
Based on October data, delinquencies on deals with more than one year of
seasoning also remain low at 1.79% of current balances. When we examined
cumulative loss data through September 2004, we find the 1995 vintage had
the highest loss rate (1.05%), well below the 5% average credit enhancement
on BBB CMBS.
Since new issue CMBS have about 5% subordination to the BBB class, there is
significant cushion for current levels of delinquencies.

Please see additional important disclosures at the end of this report. 109
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix A 2004 RATING ACTIONS


THROUGH SEPTEMBER 30, 2004
Fitch
Old Current Date of
CMBS Transactions Class Rating Action Rating Rating Action
1211 Avenue of the Americas Trust, 2000-C7 D BBB Upgrade BBB+ 4/7/2004
1211 Avenue of the Americas Trust, 2000-C7 E BBB- Upgrade BBB 4/7/2004
1251 Avenue of the Americas Trust, 1999-XL 1251 E BBB Upgrade BBB+ 5/26/2004
277 Park Avenue Finance Corp, 1997-C1 B-2 BBB+ Upgrade A 6/9/2004
Aetna Commercial Mortgage Trust, 1997-ALIC H BBB Upgrade A 3/18/2004
American Southwest Financial Securities Corp, 1995-C1 B-3 BBB Upgrade A 2/3/2004
AMRESCO Commercial Mortgage Funding I Corp, 1997-C1 E BBB+ Upgrade A 2/3/2004
AMRESCO Commercial Mortgage Funding I Corp, 1997-C1 F BBB Upgrade A- 2/3/2004
Annapolis Mall Mortgage Trust 2000-C1B B-4 BBB+ Upgrade A- 7/29/2004
Artesia Mortgage CMBS, 1998-C1 E BBB Upgrade BBB+ 6/15/2004
Asset Securitization Corp, 1995-A5 A-5 BBB Upgrade AA 8/25/2004
Asset Securitization Corp, 1995-MD4 A-4 BBB+ Upgrade AAA 2/10/2004
Asset Securitization Corp, 1995-Md4 A-5 BBB Upgrade AA 8/25/2004
Asset Securitization Corp, 1996-D3 A-4 BBB Upgrade A- 3/25/2004
Asset Securitization Corp, 1996-MD6
Asset Securitization Corp, 1997-D4 A-6 BBB+ Upgrade A+ 3/24/2004
Asset Securitization Corp, 1997-D4 A-7 BBB Upgrade A 3/24/2004
Asset Securitization Corp, 1997-D4 A-8 BBB- Upgrade BBB+ 3/24/2004
Asset Securitization Corp, 1997-D5
Asset Securitization Corp, 1997-D5
Asset Securitization Corp, 1997-D5
Banc of America Large Loan, 2001-7WTC
Banc of America Large Loan, 2001-7WTC
Banc of America Large Loan, 2001-7WTC G BBB+ Downgrade B+ 4/8/2004
Banc of America Large Loan, 2001-7WTC H BBB Downgrade B 4/8/2004
Banc of America Commercial Mortgage Inc., Series 2000-2
Banc of America Commercial Mortgage Inc., Series 2000-2
Banc of America Commercial Mortgage Inc., Series 2000-2
Banc of America Commercial Mortgage, 2001-PB1
Banc of America Commercial Mortgage, 2001-PB1
Banc of America Commercial Mortgage, 2001-PB1
Banc of America Large Loan, 2002-FLT1
Banc of America Large Loan, 2002-FLT1
Banc of America Large Loan, 2002-FLT2
Banc of America Large Loan, 2002-FLT2
Banc of America Large Loan, 2002-FLT2
Banc of America Structured Notes, 2002-1 A BBB- Upgrade BBB+ 1/8/2004
Banc One/FCCC Commercial Mortgage Loan Trust, 2000-C1
Banc One/FCCC Commercial Mortgage Loan Trust, 2000-C1
Bear Stearns Commercial Mortgage Securities, 2000-WF1 E BBB Upgrade BBB+ 6/30/2004
Bear Stearns Commercial Mortgage Securities, 2000-WF1 F BBB- Upgrade BBB 6/30/2004
Chase Commercial Mortgage Securities Corp, 1996-1
Chase Commercial Mortgage Securities Corp, 1997-1 E BBB+ Upgrade A+ 6/15/2004
Chase Commercial Mortgage Securities Corp 1998-1
Chase Commercial Mortgage Securities Corp 1998-1
Chase Commercial Mortgage Securities Corp, 1998-2 D BBB Upgrade BBB+ 4/13/2004
Chase Commercial Mortgage Securities Corp, 1998-2
Chase Commercial Mortgage Securities Corp, 2000-2 E BBB Upgrade BBB+ 4/13/2004
Chase Commercial Mortgage Securities Corp, 2001-245 Park Avenue F BBB- Downgrade BB+ 6/16/2004
Commercial Mortgage Asset Trust, 1999-C2
Commercial Mortgage Asset Trust, 1999-C2
COMM 1999-1 E BBB Upgrade BBB+ 4/27/2004
COMM 2000-FL3 K-SR BBB Downgrade B 4/2/2004
COMM 2000-FL3 L-SR BBB- Downgrade B- 4/2/2004
COMM 2001-FL4
COMM 2001-FL4
COMM 2001-FL5 G BB Downgrade B+ 9/30/2004
COMM 2001-FL5
COMM 2001-FL5
COMM 2002-FL6 K-JP BBB Downgrade BBB- 6/10/2004
COMM 2002-FL6 M-JP BBB- Downgrade BB+ 6/10/2004
COMM 2002-FL6
COMM 2002-FL6
COMM 2002-FL6
COMM 2002-FL6
COMM 2002-FL7
COMM 2002-FL7
COMM 2002-FL7
COMM 2002-FL7
COMM 2002-FL7
COMM 2002-FL7 M-GR BBB- Upgrade BBB 5/27/2004
COMM 2002-FL7
COMM 2002-FL7
Commercial Capital Access One, Series 2 D BBB Upgrade A- 10/5/2004

Source: Fitch, Moody’s and S&P

110
Moody’s S&P
Old Current Date of Old Current Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action

E Baa2 Upgrade A3 5/28/2004

F BBB Upgrade AA+ 7/19/2004

A-6 BBB Upgrade AA 1/12/2004

A-8Z BBB- Upgrade A- 7/9/2004


A-2 Baa3 Upgrade Aa3 7/20/2004 A_2 BBB Upgrade AA- 7/9/2004
A-3 BBB- Upgrade A- 7/9/2004
E Baa2 Downgrade Ba2 2/3/2004
F Baa3 Downgrade Ba3 2/3/2004

F BBB+ Upgrade A- 10/8/2004


G BBB Upgrade BBB+ 10/8/2004
H BBB- Upgrade BBB 10/8/2004
G BBB+ Upgrade A- 7/2/2004
H BBB Upgrade BBB+ 7/2/2004
J BBB- Upgrade BBB 7/2/2004
F Baa1 Upgrade A1 2/10/2004
G Baa2 Upgrade A2 2/10/2004
J-OM BBB+ Upgrade AA 3/25/2004
K-OM BBB Upgrade AA- 3/25/2004
L-OM BBB- Upgrade A+ 3/25/2004

E BBB+ Upgrade AAA 9/28/2004


F BBB Upgrade AAA 9/28/2004

E BBB+ Upgrade AA- 5/14/2004


E BBB+ Upgrade A 10/19/2004
D Baa2 Upgrade Aa3 9/7/2004 D BBB Upgrade A 10/7/2004
E Baa3 Upgrade A1 9/7/2004 E BBB- Upgrade A- 10/7/2004
D BBB Upgrade A- 9/27/2004
E BBB- Upgrade BBB+ 9/27/2004

E BBB Upgrade AA-


F BBB- Upgrade A

K-CH Baa1 Downgrade Ba1 10/20/2004


M-CH Baa3 Downgrade Ba3 10/20/2004
G BBB Downgrade B- 9/22/2004
K-CP Baa2 Downgrade Baa3 3/24/2004
L-CP Baa2 Downgrade Baa3 3/24/2004

K-WP BBB+ Upgrade A- 6/28/2004


L-WP BBB Upgrade BBB+ 6/28/2004
M-WP BBB- Upgrade BBB 6/28/2004
L-DC BBB Upgrade A 6/28/2004
M-DC BBB- Upgrade A- 6/28/2004
K-CS Baa1 Downgrade Baa3 1/23/2004
K-RP Baa1 Downgrade Baa2 1/23/2004 K-GR BBB+ Upgrade A 6/2/2004
L-CS Baa1 Downgrade Baa3 1/23/2004 L-GR BBB Upgrade A- 6/2/2004
L-RP Baa2 Downgrade Baa3 1/23/2004 L-NM BBB Upgrade BBB+ 6/2/2004
M-CS Baa2 Downgrade Ba1 1/23/2004 M-NM BBB- Upgrade BBB 6/2/2004
M-RP Baa3 Downgrade Ba1 1/23/2004 M-GR BBB- Upgrade BBB+ 6/2/2004
N-CS Baa3 Downgrade Ba1 1/23/2004
O-CS Baa3 Downgrade Ba2 1/23/2004

Please see additional important disclosures at the end of this report. 111
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix A 2004 RATING ACTIONS


THROUGH SEPTEMBER 30, 2004 (CONTINUED)
Fitch
Old Current Date of
CMBS Transactions Class Rating Action Rating Rating Action
Commercial Mortgage Acceptance Corp, 1996-C1 G BBB Upgrade A 3/18/2004
Commercial Mortgage Acceptance Corp, 1996-C2 F BBB+ Upgrade AAA 3/15/2004
Commercial Mortgage Acceptance Corp, 1998-C1
Commercial Mortgage Acceptance Corp, 1998-C1
Commercial Mortgage Acceptance Corp, 1998-C2 D BBB+ Upgrade A+ 5/18/2004
Commercial Mortgage Acceptance Corp, 1998-C2 E BBB- Upgrade A- 5/18/2004
Commercial Mortgage Acceptance Corp, 1999-C1
Commercial Mortgage Acceptance Corp, 1999-C1
Commercial Mortgage Acceptance Corp, 1999-C1
Commercial Mortgage Acceptance Corp, 1999-C1 E BBB+ Upgrade A 7/27/2004
Commercial Mortgage Acceptance Corp, 1999-C1 F BBB Upgrade A- 7/27/2004
Commercial Mortgage Asset Trust, 1999-C1
Commercial Mortgage Asset Trust, 1999-C1
Commercial Mortgage Asset Trust, 1999-C2 E BBB Upgrade A+ 5/24/2004
Commercial Mortgage Asset Trust, 1999-C2 F BBB- Upgrade A- 5/24/2004
Credit Suisse First Boston Mortgage Securities Corp, 1997-C1 D BBB+ Upgrade A- 5/5/2004
Credit Suisse First Boston Mortgage Securities Corp, 1997-C2 D BBB+ Upgrade A+ 7/19/2004
Credit Suisse First Boston Mortgage Securities Corp, 1998-C2 D BBB Upgrade A 5/5/2004
Credit Suisse First Boston Mortgage Securities Corp, 1998-C2 E BBB- Upgrade BBB+ 5/5/2004
Credit Suisse First Boston Mortgage Securities Corp, 2001-CF2 E BBB+ Upgrade A- 6/30/2004
Credit Suisse First Boston Mortgage Securities Corp, 2001-CF2 F BBB Upgrade BBB+ 6/30/2004
Credit Suisse First Boston Mortgage Securities Corp, 2001-CF2 G BBB- Upgrade BBB 6/30/2004
Credit Suisse First Boston Mortgage Securities Corp, 2001-CK6
Credit Suisse First Boston Mortgage Securities Corp, 2001-CK6
Credit Suisse First Boston Mortgage Securities Corp, 2001-CK6
Credit Suisse First Boston Mortgage Securities Corp, 2001-FL1
Credit Suisse First Boston Mortgage Securities Corp, 2001-FL1 H BBB+ Upgrade AAA 3/25/2004
Credit Suisse First Boston Mortgage Securities Corp, 2001-TFL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-CKP1
Credit Suisse First Boston Mortgage Securities Corp, 2002-CKP1
Credit Suisse First Boston Mortgage Securities Corp, 2002-CKP1
Credit Suisse First Boston Mortgage Securities Corp, 2002-CP3 E BBB+ Upgrade A- 7/27/2004
Credit Suisse First Boston Mortgage Securities Corp, 2002-CP3 F BBB Upgrade BBB+ 7/27/2004
Credit Suisse First Boston Mortgage Securities Corp, 2002-FL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-FL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-FL2
Credit Suisse First Boston Mortgage Securities Corp, 2002-FL2
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1 F-WBC BBB+ Downgrade BB+ 3/9/2004
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1 G-WBC BBB- Downgrade BB- 3/9/2004
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1
Credit Suisse First Boston Mortgage Securities Corp, 2002-TFL1 H-ALH BBB- Downgrade BB+ 3/9/2004
CRIIMI MAE Trust I, 1996-C1 B BBB Upgrade AAA 6/15/2004
CRIIMI MAE Trust I, 1996-C1 C BB+ Upgrade AA 6/15/2004
CRIIMI MAE CMBS Corp, 1998-1
CRIIMI MAE CMBS Corp, 1998-1
CRIIMI MAE CMBS Corp, 1998-1
CRIIMI MAE CMBS Corp, 1998-1
DLJ Mortgage Acceptance Corp, 1996-CF1
DLJ Mortgage Acceptance Corp, 1996-CF2 B-3 BBB- Upgrade BBB+ 3/2/2004
DLJ Mortgage Acceptance Corp, 1997-CF2
DLJ Commercial Mortgage Corp, 1998-CF1 B-1 BBB Upgrade A 5/5/2004
DLJ Commercial Mortgage Corp, 1998-CF1
DLJ Mortgage Acceptance Corp, 1998-CG1 B-1 BBB+ Upgrade A- 9/28/2004
DLJ Commercial Mortgage Corp, 1999-CG2 B-1 BBB Upgrade A 5/18/2004
DLJ Commercial Mortgage Corp, 1999-CG2 B-2 BBB- Upgrade BBB+ 5/18/2004
DLJ Commercial Mortgage Corp, 2000-CKP1 B-1 BBB+ Upgrade A- 6/16/2004
Fashion Valley Mall Mortgage Trust, 2002-C1A
First Union National Bank Commercial Mortgage Trust, 1999-C1
First Union National Bank Commercial Mortgage Trust, 1999-C1
First Union National Bank Commercial Mortgage Trust, 1999 C-4 E BBB Upgrade BBB+ 5/18/2004
First Union National Bank Commercial Mortgage Trust, Series 2001-C4
First Union National Bank Commercial Mortgage Trust, Series 2001-C4
First Union National Bank Commercial Mortgage Trust, Series 2001-C4
First Union National Bank-Lehman Brothers Commercial Mortgage Trust, 1997-C1 D BBB Upgrade AA- 2/13/2004
First Union National Bank-Lehman Brothers Commercial Mortgage Trust, 1997-C1 E BBB- Upgrade A 2/13/2004
First Union National Bank-Lehman Brothers Commercial Mortgage Trust,1997-C1
First Union National Bank-Lehman Brothers Commercial Mortgage Trust,1997-C1
First Union National Bank-Lehman Brothers Commercial Mortgage Trust, 1997-C2 D BBB+ Upgrade A- 7/15/2004
First Union National Bank-Chase Manhattan Bank Commercial Mortgage Trust, 1999-1E BBB Upgrade BBB+ 4/27/2004
First Union National Bank-Chase Manhattan Bank Commercial Mortgage Trust, 1999-1F BBB- Upgrade BBB 4/27/2004
GE Capital Commercial Mortgage Corp, 2001-2 E BBB+ Upgrade A 7/20/2004

Source: Fitch, Moody’s and S&P

112
Moody’s S&P
Old Current Date of Old Current Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action

D BBB Upgrade A 5/27/2004


E BBB- Upgrade BBB+ 5/27/2004
D BBB+ Upgrade A+
E BBB- Upgrade A-
E Baa2 Upgrade A3 5/19/2004
F Baa3 Upgrade Baa2 5/19/2004
G Baa3 Upgrade Baa2 5/19/2004

D Baa2 Upgrade Baa1 7/8/2004


E Baa3 Upgrade Baa2 7/8/2004

D Baa2 Upgrade A3 2/11/2004


E Baa3 Upgrade Baa1 2/11/2004

F BBB+ Upgrade A- 8/26/2004


G BBB Upgrade BBB+ 8/26/2004
H BBB- Upgrade BBB 8/26/2004
D Baa1 Upgrade Aa2 1/9/2004
E Baa2 Upgrade A2 1/9/2004
K-CR BBB- Downgrade D 10/5/2004
F BBB+ Upgrade A 8/27/2004
G BBB Upgrade BBB+ 8/27/2004
H BBB- Upgrade BBB 8/27/2004

D Baa2 Upgrade Aaa 10/20/2004


E Baa3 Upgrade Aa2 10/20/2004
D Baa2 Downgrade Ba2 5/11/2004 D BBB Downgrade BBB- 6/7/2004
E Baa3 Downgrade Ba3 5/11/2004 E BBB- Downgrade BB+ 6/7/2004
F-ALH Baa2 Downgrade Ba1 6/7/2004 F-ALH BBB Downgrade BBB- 9/3/2004

F-POR Baa1 Downgrade Baa3 6/7/2004


G-ALH BBB- Downgrade BB+ 9/3/2004
G-WBC Baa2 Downgrade Ba2 6/7/2004
G-POR Baa3 Downgrade Ba2 6/7/2004
H-WBC Baa3 Downgrade Ba3 6/7/2004
B BBB+ Upgrade AAA 8/27/2004
C BBB Upgrade AAA 8/27/2004
B BBB+ Upgrade AAA 9/22/2004
C BBB Upgrade AAA 9/22/2004
D Baa1 Upgrade Aa1 6/8/2004
E Baa3 Upgrade A1 6/8/2004
B-2 BBB+ Upgrade AAA 8/25/2004

B-2TB BBB- Upgrade BBB 1/30/2004


B-1 BBB Upgrade A 7/12/2004
B-2 BBB- Upgrade BBB+ 7/12/2004

B-5 Baa1 Upgrade A2 5/11/2004


D BBB Upgrade BBB+ 4/16/2004
E BBB- Upgrade BBB 4/16/2004

G BBB+ Upgrade A 9/2/2004


H BBB Upgrade A- 9/2/2004
J BBB- Upgrade BBB+ 9/2/2004
D Baa2 Upgrade A2 3/9/2004
E Baa3 Upgrade A3 3/9/2004
D BBB Upgrade A- 8/2/2004
E BBB- Upgrade BBB+ 8/2/2004

Please see additional important disclosures at the end of this report. 113
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix A 2004 RATING ACTIONS


THROUGH SEPTEMBER 30, 2004 (CONTINUED)
Fitch
Old Current Date of
CMBS Transactions Class Rating Action Rating Rating Action
GE Capital Commercial Mortgage Corp, 2001-2 F BBB Upgrade BBB+ 7/20/2004
GE Capital Commercial Mortgage Corp, 2001-2 G BBB- Upgrade BBB 7/20/2004
GGP Mall Properties Trust, 2001-GGP1 D-2 BBB Upgrade BBB+ 3/30/2004
GGP Mall Properties Trust, 2001-GGP1 D-3 BBB Upgrade BBB+ 3/30/2004
GGP Mall Properties Trust, 2001-GGP1
GGP Mall Properties Trust, 2001-GGP1
GMAC Commercial Mortgage Securities, 1997-C1 E BBB Upgrade A 2/18/2004
GMAC Commercial Mortgage Securities, 1997-C1 F BBB- Upgrade BBB+ 2/18/2004
GMAC Commercial Mortgage Securities, 1998-C2
GMAC Commercial Mortgage Securities, 1998-C2
GMAC Commercial Mortgage Securities, 1999-C1 D BBB+ Upgrade A 5/18/2004
GMAC Commercial Mortgage Securities, 1999-C1 E BBB Upgrade A- 5/18/2004
GMAC Commercial Mortgage Securities, 1999-C2
GMAC Commercial Mortgage Securities, 1999-C2
GMAC Commercial Mortgage Securities, 1999-C3 E BBB Upgrade BBB+ 5/24/2004
GMAC Commercial Mortgage Securities, 2000-C3
GMAC Commercial Mortgage Securities, 2000-C3
GMAC Commercial Mortgage Securities, 2000-FL1
GMAC Commercial Mortgage Securities, 2000-FL1
GMAC Commercial Mortgage Securities, 2000-Fl-F D BBB Upgrade AA 2/25/2004
GMAC Commercial Mortgage Securities, 2000-Fl-F E BBB- Upgrade A 2/25/2004
GMAC Commercial Mortgage Securities, 2001-FL1
GMAC Commercial Mortgage Securities, 2001-FL1
GMAC Commercial Mortgage Securities, 2001-FLA
GMAC Commercial Mortgage Securities, 2001-FLA
GS Mortgage Securities Corp II, 1997-GLl F BBB+ Upgrade A 2/4/2004
GS Mortgage Securities Corp II, 1997-GLl G BBB Upgrade BBB+ 2/4/2004
GS Mortgage Securities Corp II, 2001-GLIII
GS Mortgage Securities Corp II, 2001-GLIII
GS Mortgage Securities Corp II, 2001-GLIII
GS Mortgage Securities Corp II, 2001-GLIII
GS Mortgage Securities Corp II, 2001-GLIII
GS Mortgage Securities Corp II, 2002-GSFL V
Heller Financial Mortgage Asset Corp, 1999-Ph1 F BBB Upgrade A 6/17/2004
Heller Financial Mortgage Asset Corp, 1999-Ph1 G BBB- Upgrade A- 6/17/2004
iStar Asset Receivables (Stars) Trust, 2002-1
iStar Asset Receivables (Stars) Trust, 2002-1
iStar Asset Receivables (Stars) Trust, 2002-1
iStar Asset Receivables (Stars) Trust, 2002-1 L BBB+ Upgrade A- 10/27/2004
iStar Asset Receivables (Stars) Trust, 2002-1 M BBB- Upgrade BBB 10/27/2004
JP Morgan Commercial Mortgage Finance Corp, 1997-C4 F BBB+ Upgrade A 10/26/2004
JP Morgan Commercial Mortgage Finance Corp, 1997-C5
JP Morgan Commercial Mortgage Finance Corp, 1997-C5
JP Morgan Commercial Mortgage Finance Corp, 1999-PLS1 D BBB+ Upgrade AA- 2/25/2004
JP Morgan Commercial Mortgage Finance Corp, 2000-Fl1 D BBB+ Upgrade A- 2/10/2004
JP Morgan Commercial Mortgage Finance Corp, 2000-Fl1 E BBB Upgrade AAA 3/17/2004
JP Morgan Commercial Mortgage Finance Corp, 2000-Fl1 F BBB- Upgrade AAA 3/17/2004
JP Morgan Chase Commercial Mortgage Finance Corp, 2002-WHALE1 J BBB- Upgrade A- 8/24/2004
JP Morgan Chase Commercial Mortgage Finance Corp, 2002-WHALE1 K BBB Upgrade BBB+ 8/24/2004
JP Morgan Chase Commercial Mortgage Finance Corp, 2002-WHALE1 L BB Upgrade BBB- 8/24/2004
JP Morgan Chase Commercial Mortgage Securities Corp, 2001-A D BBB Upgrade AA 3/16/2004
JP Morgan Chase Commercial Mortgage Securities Corp, 2001-A E BBB- Upgrade A 3/16/2004
JP Morgan Chase Commercial Mortgage Securities Corp, 2001-Fl1 E BBB+ Upgrade AAA 1/7/2004
JP Morgan Chase Commercial Mortgage Securities Corp, 2001-Fl1 F BBB Upgrade AAA 1/7/2004
JP Morgan Chase Commercial Mortgage Securities Corp, 2001-Fl1 G BBB- Upgrade AA 1/7/2004
JP Morgan Chase Commercial Mortgage Securities Corp, 2001-Fl1 G BBB Upgrade AAA 7/1/2004
J.P. Morgan Chase Commercial Mortgage Securities Corp, 2002-FL1
Lakewood Mall Finance Co., Series 1995-C1
LB Commercial Conduit Mortgage Trust II, 1996-C2 E BBB Upgrade A 3/25/2004
LB Commercial Mortgage Trust, 1998-C1 D BBB Upgrade A+ 6/23/2004
LB Commercial Mortgage Trust, 1998-C1 E BBB- Upgrade A- 6/23/2004
LB Commercial Mortgage Trust, 1998-C4
LB Commercial Mortgage Trust, 1998-C4
LB Commercial Mortgage Trust, 1999-C1
LB-UBS Commercial Mortgage Trust, Series 2000-C4
LB-UBS Commercial Mortgage Trust, Series 2000-C4
LB-UBS Commercial Mortgage Trust, Series 2000-C4
LB-UBS Commercial Mortgage Trust, 2000-C3 E BBB+ Upgrade A- 7/27/2004
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7 K BBB Upgrade AA 8/17/2004
Lehman Brothers Floating Rate Commercial Mortgage Trust 2002-LLF C3
Lehman Brothers Floating Rate Commercial Mortgage Trust 2002-LLF C3
LTC Commercial Mortgage Pass-Through Certificates Series 1996-1 D BBB- Upgrade AAA 5/10/2004
LTC Commercial Mortgage Pass-Through Certificates Ser 1998-1
Meristar Commercial Mortgage Trust, 1999-C1

Source: Fitch, Moody’s and S&P

114
Moody’s S&P
Old Current Date of Old Current Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action

D-2 Baa2 Upgrade A2 8/18/2004 D-2 BBB Upgrade AA+ 8/20/2004


D-3 Baa2 Upgrade A2 8/18/2004 D-3 BBB Upgrade AA+ 8/20/2004
E-2 Baa3 Upgrade A3 8/18/2004 E-2 BBB- Upgrade AA 8/20/2004
E-3 Baa3 Upgrade A3 8/18/2004 E-3 BBB- Upgrade AA 8/20/2004

D Baa2 Upgrade A3 2/23/2004 D BBB+ Upgrade A- 10/18/2004


E Baa3 Upgrade Baa1 2/23/2004 E BBB- Upgrade BBB+ 10/18/2004
D BBB Upgrade BBB+ 3/18/2004
E BBB- Upgrade BBB 3/18/2004
E BBB Upgrade A 5/21/2004
F BBB- Upgrade A- 5/21/2004

S-MAC-2 Baa2 Downgrade Ba2 9/30/2004


S-MAC-3 Baa3 Downgrade Ba3 9/30/2004
D Baa2 Downgrade Ba1 1/26/2004
E Baa3 Downgrade Ba2 1/26/2004

D Baa1 Upgrade Aaa 4/6/2004 D BBB Upgrade AA 2/25/2004


E BBB- Upgrade A 2/25/2004
D BBB Upgrade AA 6/3/2004
E BBB- Upgrade AA- 6/3/2004

F-NFC Baa1 Upgrade A1 8/13/2004


F-GGP Baa1 Upgrade A3 8/13/2004
G-NFC Baa2 Upgrade A2 8/13/2004
G-GGP Baa2 Upgrade Baa1 8/13/2004
H-GGP Baa3 Upgrade Baa2 8/13/2004
E Baa2 Upgrade A3 8/12/2004

H Baa1 Upgrade A3 1/26/2004 H BBB+ Upgrade A 1/26/2004


J Baa2 Upgrade Baa1 1/26/2004 J BBB Upgrade A- 1/26/2004
K Baa3 Upgrade Baa2 1/26/2004 K BBB- Upgrade BBB 1/26/2004

D Baa2 Upgrade A2 8/17/2004


E Baa3 Upgrade Baa1 8/17/2004

J BBB+ Upgrade A+ 5/12/2004


K BBB Upgrade A 5/12/2004
L BBB- Upgrade BBB 7/22/2004

E BBB+ Upgrade A- 8/19/2004


C BBB+ Upgrade AA 10/13/2004

D Baa2 Upgrade A3 1/22/2004


E Baa3 Upgrade Baa1 1/22/2004
D BBB Upgrade BBB+ 8/9/2004
E BBB- Upgrade BBB 8/9/2004
D Baa2 Upgrade Baa1 6/21/2004
E BBB+ Upgrade A- 9/16/2004
F BBB Upgrade BBB+ 9/16/2004
G BBB- Upgrade BBB 9/16/2004

J BBB+ Upgrade AA 8/23/2004


L BBB- Downgrade BB+ 8/23/2004
D BBB Upgrade A+ 9/15/2004
D BBB Upgrade A+ 9/15/2004
C Baa1 Downgrade Ba1 10/15/2004

Please see additional important disclosures at the end of this report. 115
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix A 2004 RATING ACTIONS


THROUGH SEPTEMBER 30, 2004 (CONTINUED)
Fitch
Old Current Date of
CMBS Transactions Class Rating Action Rating Rating Action
Merrill Lynch Mortgage Investors, 1995-C2 E BBB- Upgrade BBB+ 3/15/2004
Merrill Lynch Mortgage Investors, 1996-C1
Merrill Lynch Mortgage Investors, 1996-C2 D BBB+ Upgrade AA 4/23/2004
Merrill Lynch Mortgage Investors, 1996-C2 E BBB Upgrade A+ 4/23/2004
Merrill Lynch Mortgage Investors, 1997-C1
Merrill Lynch Mortgage Investors, 1997-C1
Merrill Lynch Mortgage Investors, 1997-C2 D BBB+ Upgrade AA- 5/11/2004
Merrill Lynch Mortgage Investors, 1998-C2
Merrill Lynch Mortgage Investors, 1998-C2
Morgan Stanley Capital I, 1996-C1 E BBB Upgrade BBB+ 6/23/2004
Morgan Stanley Capital I, 1996-WF1
Morgan Stanley Capital I, 1997-C1 F BBB+ Upgrade A- 6/30/2004
Morgan Stanley Capital I, 1997-HF1 E BBB+ Upgrade AA 2/23/2004
Morgan Stanley Capital I, 1997-RR C BBB Upgrade AAA 2/17/2004
Morgan Stanley Capital I,1997-WF1
Morgan Stanley Capital I,1997-WF1
Morgan Stanley Capital I, 1997-XL1 E BBB Upgrade BBB+ 2/5/2004
Morgan Stanley Capital I, 1998-CF1
Morgan Stanley Capital I, 1998-HF2 E BBB Upgrade BBB+ 5/18/2004
Morgan Stanley Capital I, 1998-HF2 F BBB- Upgrade BBB 5/18/2004
Morgan Stanley Capital I, 1998-WF1 D BBB+ Upgrade A- 6/30/2004
Morgan Stanley Capital I, 1998-WF1
Morgan Stanley Capital I, 1998-XL1
Morgan Stanley Capital I, 1998-XL1
Morgan Stanley Capital I, 1999-CAM1 E BBB Upgrade A- 6/15/2004
Morgan Stanley Capital I, 1999-CAM1 F BBB- Upgrade BBB+ 6/15/2004
Morgan Stanley Capital I, 1999-LIFE1 E BBB Upgrade BBB+ 6/30/2004
Morgan Stanley Capital I, 1999-LIFE1 F BBB- Upgrade BBB 6/30/2004
Morgan Stanley Capital I, 1999-RM1 E BBB+ Upgrade A 7/15/2004
Morgan Stanley Capital I, 1999-RM1 F BBB Upgrade BBB+ 7/15/2004
Morgan Stanley Capital I, 1999-RM1 G BBB- Upgrade BBB 7/15/2004
Morgan Stanley Capital I, 2001-XLF
Morgan Stanley Capital I, 2001-XLF
Morgan Stanley Capital I, 2001-XLF
Morgan Stanley Dean Witter Capital I, 2001-PPM E BBB Upgrade BBB+ 8/3/2004
Morgan Stanley Dean Witter Capital I, 2001-PPM F BBB- Upgrade BBB 8/3/2004
Morgan Stanley Dean Witter Capital I, 2002-XLF
Mortgage Capital Funding, 1996-MC2
Mortgage Capital Funding, 1996-MC2
Mortgage Capital Funding, 1997-MC1 D BBB+ Upgrade A+ 4/21/2004
Mortgage Capital Funding, 1997-MC1
Mortgage Capital Funding, 1998-MC1
Mortgage Capital Funding, 1998-MC1
Mortgage Capital Funding, 1998-MC1 G BBB Upgrade BBB+ 6/22/2004
N-45 First CMBS Issuer Corp, 2000-1
NationsLink Funding Corp, 1998-2
NationsLink Funding Corp, 1998-2
NationsLink Funding Corp, 1999-1 D BBB+ Upgrade A+ 7/20/2004
NationsLink Funding Corp, 1999-1
Nomura Asset Securities Corp, 1996-MD5 A-4 BBB Upgrade AA 7/21/2004
Nomura Asset Securities Corp, 1996-MD5 A-5 BBB- Upgrade A+ 7/21/2004
Nomura Asset Securities Corp, 1998-D6 A-4 BBB Upgrade A- 1/6/2004
Nomura Asset Securities Corp, 1998-D6 A-5 BBB- Upgrade BBB+ 1/6/2004
NSS Mortgage Securities II Corp C BBB+ Upgrade A- 3/10/2004
Opryland Hotel Trust, 2001-OPRY
Opryland Hotel Trust, 2001-OPRY
Park Square Mortgage Trust. 2000-C5
Park Square Mortgage Trust. 2000-C5
Penn Mutual Life Insurance Company, 1996-PML M BBB Upgrade BBB 3/17/2004
PNC Mortgage Acceptance Corp, 1999 CM-1
PNC Mortgage Acceptance Corp, 1999 CM-1
PNC Mortgage Acceptance Corp, 2000-C1 E BBB Upgrade BBB+ 5/18/2004
PNC Mortgage Acceptance Corp, 2000-C2
PNC Mortgage Acceptance Corp, 2000-C2
PNC Mortgage Acceptance Corp, 2000-C2
Prudential Mortgage Capital Funding, ROCK 2001-C1 E BBB+ Upgrade A- 8/10/2004
Prudential Mortgage Capital Funding, ROCK 2001-C1 F BBB Upgrade BBB+ 8/10/2004
Prudential Mortgage Capital Funding, ROCK 2001-C1 G BBB- Upgrade BBB 8/10/2004
Prudential Securities Secured Financing Corp, 1998-C1
Prudential Securities Secured Financing Corp, 1998-C1
Prudential Securities Secured Financing Corp, KEY 2000-C1
Red Mountain Funding LLC, 1997-1 D BBB Downgrade BB+ 4/21/2004
Red Mountain Funding LLC, 1997-1 E BBB- Downgrade BB 4/21/2004
Salomon Brothers Mortgage Securities VII, 1993-9

Source: Fitch, Moody’s and S&P

116
Moody’s S&P
Old Current Date of Old Current Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action

D BBB Upgrade A 10/19/2004


D BBB Upgrade AA 4/7/2004
E BBB- Upgrade A- 4/7/2004
D Baa1 Upgrade A2 4/29/2004 D BBB Upgrade AA- 4/7/2004
E Baa3 Upgrade Baa2 4/29/2004 E BBB- Upgrade A- 4/7/2004

D BBB Upgrade A- 10/14/2004


E BBB- Upgrade BBB+ 10/14/2004

E Baa2 Upgrade Aa1 9/16/2004

D Baa2 Upgrade Aa3 2/26/2004


E Baa3 Upgrade A2 2/26/2004

C BBB Upgrade AA- 7/12/2004

E Baa2 Upgrade Baa1 8/5/2004


E BBB+ Upgrade AA+ 4/20/2004
F BBB Upgrade AA 4/20/2004

E BBB Upgrade BBB+ 8/25/2004


F BBB- Upgrade BBB 8/25/2004

F Baa2 Downgrade Ba1 5/17/2004


G1 Baa3 Downgrade Ba3 5/17/2004
G7 Baa3 Downgrade Ba2 5/17/2004

G1 Baa3 Downgrade Ba2 10/20/2004


D Baa1 Upgrade Aaa 9/30/2004
E Baa2 Upgrade Aa2 9/30/2004
D Baa2 Upgrade A2 10/6/2004
E Baa3 Upgrade Baa2 10/6/2004
E BBB+ Upgrade A+ 4/17/2004
F BBB Upgrade A 4/17/2004

D Baa2 Upgrade A2 7/30/2004


D Baa2 Upgrade A2 1/22/2004 D BBB+ Upgrade A 4/21/2004
E BBB- Upgrade BBB+ 4/21/2004
D Baa2 Upgrade A2 5/17/2004
E Baa3 Upgrade A3 5/17/2004 F BB Upgrade BBB- 7/19/2004

C A3 Upgrade A2 5/19/2004 C BBB Upgrade A+ 5/26/2004


D Baa3 Upgrade Baa2 5/19/2004 D B Upgrade BB+ 5/26/2004
B-2 Baa2 Downgrade Baa3 4/15/2004
B-3 Baa3 Downgrade Ba1 4/15/2004

B-1 BBB+ Upgrade A 9/7/2004


B-2 BBB Upgrade A- 9/7/2004

E BBB+ Upgrade A 8/6/2004


F BBB Upgrade A- 8/6/2004
G BBB- Upgrade BBB+ 8/6/2004

D Baa2 Upgrade A3 2/4/2004 D BBB Upgrade A 6/29/2004


E Baa3 Upgrade Baa1 2/4/2004 E BBB- Upgrade A- 6/29/2004
E BBB+ Upgrade A- 2/12/2004

B-4 BBB- Upgrade BBB+ 6/15/2004

Please see additional important disclosures at the end of this report. 117
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix A 2004 RATING ACTIONS


THROUGH SEPTEMBER 30, 2004 (CONTINUED)
Fitch
Old Current Date of
CMBS Transactions Class Rating Action Rating Rating Action
Salomon Brothers Mortgage Securities VII, 1999-AQ1
Salomon Brothers Mortgage Securities VII, 1999-C1 E BBB Upgrade A+ 6/9/2004
Salomon Brothers Mortgage Securities VII, 1999-C1 F BBB- Upgrade A 6/9/2004
Salomon Brothers Mortgage Securities VII, 1999-LB1
Salomon Brothers Mortgage Securities VII, 2000-1
Salomon Brothers Mortgage Securities VII, 2000-NL1 E BBB+ Upgrade AA 2/3/2004
Salomon Brothers Mortgage Securities VII, 2000-NL1 F BBB Upgrade AA- 2/3/2004
Salomon Brothers Mortgage Securities VII, 2000-NL1 G BB+ Upgrade BBB+ 2/3/2004
Salomon Brothers Mortgage Securities VII, 2000-NL1 G BBB+ Upgrade AA 3/25/2004
Salomon Brothers Mortgage Securities VII, 2000-NL1 H BBB Upgrade A 3/25/2004
Salomon Brothers Mortgage Securities VII, 2001-CDC
Salomon Brothers Mortgage Securities VII, 2001-CDC
Salomon Brothers Mortgage Securities VII, 2001-CDC G-DS BBB- Downgrade BB+ 2/25/2004
Salomon Brothers Mortgage Securities VII, 2001-CDC
Salomon Brothers Mortgage Securities VII, 2002-CDC
Salomon Brothers Mortgage Securities VII, 2002-CDC
Salomon Brothers Mortgage Securities VII, 2002-CDC
Salomon Brothers Mortgage Securities VII, 2002-CDC
SASCO Floating Rate Commercial Mortgage Trust, 2001-C8
SASCO Floating Rate Commercial Mortgage Trust, 2001-C8 J BBB+ Upgrade AAA 5/14/2004
SASCO Floating Rate Commercial Mortgage Trust, 2001-C8 K BBB Upgrade AAA 5/14/2004
SASCO Floating Rate Commercial Mortgage Trust, 2001-C8 L BBB- Upgrade AAA 5/14/2004
Sawgrass Mills Trust, 2001-XLSGM
Sawgrass Mills Trust, 2001-XLSGM
Scottsdale Fashion Square Trust D-1 BBB Upgrade A+ 5/6/2004
Scottsdale Fashion Square Trust D-2 BBB Upgrade A+ 5/6/2004
Scottsdale Fashion Square Trust E-1 BBB- Upgrade BBB 5/6/2004
Scottsdale Fashion Square Trust E-2 BBB- Upgrade BBB 5/6/2004
Strategic Hotel Capital LLC SHC, 2003-1 H BBB+ Downgrade BBB 4/19/2004
Strategic Hotel Capital LLC SHC, 2003-1 I BBB Downgrade BBB- 4/19/2004
Strategic Hotel Capital LLC SHC, 2003-1 J BBB- Downgrade BB+ 4/19/2004
Structured Asset Securities Corp, 1995-C1 F BBB- Upgrade AAA 5/26/2004
Structured Asset Securities Corp, 1997-LL1
SunAmerica Mortgage Trust, 1999-C2B
SunAmerica Mortgage Trust, 1999-C2B
TrizecHahn Office Properties Trust, 2001-TZH D-3 BBB Upgrade A- 7/29/2004
TrizecHahn Office Properties Trust, 2001-TZH D-4 BBB Upgrade A- 7/29/2004
TrizecHahn Office Properties Trust, 2001-TZH E-3 BBB- Upgrade BBB 7/29/2004
TrizecHahn Office Properties Trust, 2001-TZH E-4 BBB- Upgrade BBB 7/29/2004
UBS 400 Atlantic Street Mortgage Trust, 2002-C1A
UBS 400 Atlantic Street Mortgage Trust, 2002-C1A
UBS 400 Atlantic Street Mortgage Trust, 2002-C1A
Vornado Finance LLC, 2000-VNO
Vornado Finance LLC, 2000-VNO
Wisconsin Avenue Securities, 1995-M4 B BBB Upgrade AAA 10/14/2004
Wisconsin Avenue Securities, 1996-M3 C BBB Upgrade AAA 10/14/2004
Wisconsin Avenue Securities, 1996-M5 B BBB- Upgrade A 1/15/2004

Source: Fitch, Moody’s and S&P

118
Moody’s S&P
Old Current Date of Old Current Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action
M-3 BBB Upgrade A 6/15/2004
E Baa2 Upgrade A1 10/28/2004
F Baa3 Upgrade A3 10/28/2004
M-3 BBB Upgrade A 6/15/2004
B-3 BBB Upgrade AA+ 6/15/2004

G BBB Upgrade AA 9/20/2004

E-DS Baa1 Downgrade Ba1 6/25/2004


F-DS Baa2 Downgrade Ba1 6/25/2004
G-DS Baa3 Downgrade Ba3 6/25/2004
H-DS Baa3 Downgrade B3 6/25/2004
X-2B Baa3 Downgrade Ba1 8/26/2004
H-DEN Baa1 Downgrade Baa2 8/26/2004
J-DEN Baa2 Downgrade Baa3 8/26/2004
K-DEN Baa3 Downgrade Ba1 8/26/2004
H Baa1 Upgrade Aaa 5/27/2004
J Baa2 Upgrade Aaa 5/27/2004
K Baa3 Upgrade Aaa 5/27/2004

E BBB Upgrade BBB+ 6/24/2004


F BBB- Upgrade BBB 6/24/2004

E Baa1 Upgrade A2 10/15/2004


B-4 Baa2 Downgrade Baa3 1/23/2004
B-5 Baa3 Downgrade Ba1 1/23/2004
D-3 Baa3 Upgrade Baa2 9/16/2004 D-3 BBB Upgrade AA 7/19/2004
D-4 Baa3 Upgrade Baa2 9/16/2004 D-4 BBB Upgrade AA 7/19/2004
E-3 BBB- Upgrade A 7/19/2004
E-4 BBB- Upgrade A 7/19/2004
B-2 Baa1 Downgrade Baa2 9/14/2004
B-3 Baa2 Downgrade Baa3 9/14/2004
B-4 Baa3 Downgrade Ba1 9/14/2004
E Baa2 Upgrade Baa1 9/14/2004
F Baa3 Upgrade Baa2 9/14/2004

Please see additional important disclosures at the end of this report. 119
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix B LARGE LOAN CMBS WITH REITS AS BORROWERS

REIT Property Type


Arden Realty Inc. Office - Suburban
Associated Estates Realty Apartments
Associated Estates Realty Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
BRE Properties Inc. Apartments
Crescent Real Estate Equities Diversified / Misc.
Crescent Real Estate Equities Diversified / Misc.
Crescent Real Estate Equities Diversified / Misc.
Equity Office Properties Trust Office - CBD
Equity Office Properties Trust Office - CBD
Getty Realty Corp. Triple-Net Lease
Getty Realty Corp. Triple-Net Lease
Getty Realty Corp. Triple-Net Lease
Getty Realty Corp. Triple-Net Lease
Getty Realty Corp. Triple-Net Lease
Host Marriott Corp. Hotel
HRPT Properties Trust Office - Suburban
Kimco Realty Corp. Shopping Center
Macerich Co. Regional Mall
MeriStar Hospitality Hotel
MeriStar Hospitality Hotel
Prentiss Properties Trust Office - Suburban
Prentiss Properties Trust Office - Suburban
Ramco-Gershenson Properties Shopping Center
Reckson Associates Realty Corp Office - Suburban
Simon Property Group Inc. Regional Mall
Simon Property Group Inc. Regional Mall
Simon Property Group Inc. Regional Mall
Simon Property Group Inc. Regional Mall
Tanger Factory Outlet Centers Outlet
Town & Country Trust Apartments
Vornado Realty Trust Diversified / Misc.

Source: Morgan Stanley, Commercial Mortgage Alert and Intex

120
Deal Name Amount (in $MM) Closing Date
Lehman Large Loan, Series 1997-LL1 175.0 10/15/1997
Chase Commercial Mortgage Securities Corp, 2000-1 98.5 3/28/2000
Chase Commercial Mortgage Securities Corp, 2000-2 98.8 6/28/2000
COMM, 2002-FL7 123.0 10/21/2002
GS Mortgage Securities Corp II, 2003-GSFL VI 83.0 12/17/2003
Credit Suisse First Boston Mortgage Securities Corp, 2004-TFL1 77.2 4/6/2004
Bear Stearns Commercial Mortgage Securities Inc., 2004-ESA 2,050.0 6/29/2004
Bear Stearns Commercial Mortgage Securities Inc., 2004-HS2 660.0 4/1/2004
Bear Stearns Commercial Mortgage Securities Inc., 2002-HOME 400.0 2/22/2002
Structured Asset Securities Corp, 1998-C3 64.8 10/29/1998
Greenwich Capital Commercial Funding Corporation, 2004-FL2 235.0 11/23/2004
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2003-LLF C2 69.4 6/9/2003
Bear Stearns Commercial Mortgage Securities Inc., 2003-BBA1 160.0 5/6/2003
Banc of America Large Loan, 2001-7WTC 383.0 8/9/2001
Structured Asset Securities Corp, 1997-L1 275.0 10/15/1997
iStar Asset Receivables Trust, 2000-1 97.1 5/17/2000
Asset Securitization Corp, 1995-MD4 239.0 10/30/1995
Nomura Asset Securities Corp, 1996-MD5 161.0 4/2/1996
Columbia Center Trust, 2000-CCT 195.0 6/21/2000
LB Commercial Mortgage Trust, 1999-C2 146.5 10/14/1999
Thirteen Affiliates of General Growth Properties 560.0 11/25/1997
GGP Ala Moana, 1999-C1 500.0 8/26/1999
GGP/Homart Commercial Mortgage-Backed Securities, 1999-C1 590.0 11/30/1999
GGP - Ivanhoe Commercial Backed Securities, 1999-C1 700.2 9/30/1999
Morgan Stanley Capital I Inc., 2003-XLF 53.0 7/9/2003
Host Marriott Pool Trust, 1999-HMT 665.0 8/18/1999
Office Portfolio Trust, 2001-HRPT 260.0 2/28/2001
First Union - Chase Manhattan Commercial Mortgage Trust, 1999-C2 120.9 5/20/1999
Morgan Stanley Dean Witter Capital I Inc., 2000-XLF 60.0 8/9/2000
MeriStar Commercial Mortgage Trust, 1999-C1 330.0 8/30/1999
Structured Asset Securities Corp, 1998-C3 250.0 10/29/1998
Lehman Large Loan, 1997-LL1 180.1 10/15/1997
Structured Asset Securities Corp, 1998-C2 120.0 4/29/1998
Morgan Stanley Capital I, 1998-XL1 50.0 6/11/1998
Morgan Stanley Dean Witter Capital I Inc., 2000-XLF 50.0 8/9/2000
Chase Commercial Mortgage Securities Corp, 1999-2 89.0 11/23/1999
Credit Suisse First Boston Mortgage Securities Corp, 2001-SPG1 277.0 8/22/2001
iStar Asset Receivables Trust, 2000-1 54.2 5/17/2000
Morgan Stanley Dean Witter Capital I Inc., 2003-HQ2 61.3 3/27/2003
Morgan Stanley Capital I Inc., 2003-XLF 115.0 7/9/2003
GS Mortgage Securities Corp II, 2004-GG2 71.5 8/12/2004
Morgan Stanley Dean Witter Capital I Inc., 2000-XLF 105.3 8/9/2000

Please see additional important disclosures at the end of this report. 121
Transforming Real Estate Finance
chapter 8 BBB CMBS and REITs

appendix C TOP RATING AGENCY CRITERIA FOR REITS

Moody’s breaks down its five key credit characteristics as follows: strength and stability of cash
flow, profitability and operational efficiency, liquidity, asset quality, and capital adequacy and
structure. Within those, the rating agency focuses on earnings momentum, fixed charge cover-
age, operating margins, funding capacity and structure, unencumbered assets to total assets,
portfolio diversification, development focus, asset market value, capital structure, stock market
valuation and bond pricing.

Fitch breaks the same characteristics down quite clearly into three main components: financial
analysis, a review of the management team and a review of the property portfolio. Fitch con-
siders the ability to adapt to changing business environments one of the most important
aspects of a management team.

When examining financials, Fitch looks at the following:


• Cash flow coverage
• Property level data
• Unencumbered/Encumbered cash flow
• Refinance risk
• Constant refinance rate
• Debt maturity schedule
• Capital Structure
• Leverage
- Capitalization of Cash Flow
- Debt/EBITDA
- Debt to Book Value (not as effective)
- Debt to Market Capitalization (not as effective)

Though the list is long, Fitch’s most important financial tests are unencumbered debt service
coverage, total debt service coverage and total fixed charge coverage.

Within Fitch’s review of the property portfolio, investment diversity and asset quality are
examined. Market, location, site plan, building, property management, tenant breakdown
and lease expiration schedule can all affect the quality of a portfolio.

S&P defines its two main components as business profile and financial profile, quite similar to
Fitch. Within the business profile, S&P examines a REIT’s market position, its asset quality,
diversification/stability of operations and operating strategy/management evaluation.

S&P’s analysis of the financial profile breaks down into five separate parts:
• Financial Policy (dividend, leverage, accounting, bank line usage, acquisitions/development, etc.)
• Profitability (efficiency measures, returns, property level performance, etc.)
• Capital Structure (debt/capital, character of debt, cost/flexibility of debt, fixed/variable
rate debt, debt maturity schedule, etc.)
• Cash flow protection (coverage measures, liquidity, etc.)
• Financial flexibility (degree to which holdings are encumbered, leveragability of assets,
sources of financing, quality of ownership base, etc.)

All in all, there are no hard and fast rules used when rating a REIT, but the main factors
examined by the different rating agencies are quite similar.

122
Chapter 9

Transforming Real Estate Finance


CMBS Conduit Subordination Levels

Please see additional important disclosures at the end of this report. 123
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

Subordination: The Right Range


Until the super senior structure emerged in fixed-rate CMBS in October 2004,
AAA credit enhancement levels continued to shrink. In the first five months of
2004, AAA CMBS subordination levels fell to an average of 14%. Five years ago,
sub levels of 14% were consistent with single-A CMBS.

exhibit 1 AVERAGE SUBORDINATION FOR


CONDUIT/FUSION TRANSACTIONS

1998 1999 2000 2001 2002 2003 20041


AAA 29% 27% 23% 21% 20% 17% 14%
AA 24% 22% 19% 17% 16% 14% 12%
A 18% 17% 14% 13% 12% 10% 9%
BBB 13% 12% 11% 9% 8% 7% 5%
BB 6% 6% 5% 4% 4% 3% 3%
B 3% 3% 3% 2% 2% 2% 2%

1
As of August 19, 2004.
Source: Commercial Mortgage Alert, Morgan Stanley

Particularly at the top of the capital structure, the rating agencies have been
reducing the subordination levels required to obtain a CMBS rating. Each year
since 1995, subordination levels on investment grade CMBS have declined in an
effort to recalibrate CMBS bond ratings with corporate bond ratings.
In this section, we estimate what the original subordination levels should have
been on 1997-2001 conduit deals in order to make their original ratings consis-
tent with the credit of unsecured corporate bonds.
TODAY’S S UB L EVELS F ALL W ITHIN O UR C ALCULATED R ANGES
After running two scenarios on the seasoned transactions, we found that the
“right” original subordination levels for AAA conduit CMBS should have been
between 9% and 15%. In our estimate, those levels would have resulted in
identical default rates for AAA CMBS and AAA corporates. Our hypothetical
“right” subordination level range is much lower than the 21%-29% range used
by the rating agencies during 1998-2000. For BBB CMBS, our calculated
“right” range is about 4% to 8%. That is, 4% to 8% subordination would have
resulted in the same percentage of BBB CMBS defaults as historical BBB cor-
porate defaults.

124
The results of this study show that today’s average subordination levels on new
issue transactions are in a reasonable range, assuming commercial mortgage per-
formance in the next decade is similar to the loan loss experience of seasoned
deals to date. Based on our estimates, however, there is still some room for sub-
ordination levels to decline further.
At the June 2004 CMSA conference, the rating agencies said that they will exer-
cise caution and refrain from lowering sub levels further (for now), even though
empirical data supports lower levels.

exhibit 2 CMBS SUBORDINATION LEVELS CONSISTENT WITH


CORPORATE BOND RATINGS

Avg Default Timing 1986 Default Timing


34% Severity 43% Severity
Aaa 9.1% 15.4%
Aa2 8.3% 14.3%
A2 4.9% 9.8%
Baa2 3.8% 7.8%
Ba2 2.1% 4.1%
B2 1.1% 1.6%

Source: Morgan Stanley

METHODOLOGY
In our recent Projecting Losses studies, we used the Esaki-Snyderman default tim-
ing curves to project expected losses for conduits issued from 1997 to 2001. We
compared those losses to remaining subordination levels to estimate lifetime
default rates for bonds issued during that period. We now calculate the hypo-
thetical original subordination levels that result in expected default rates that
match historical corporate bond default rates.
In the Projecting Losses pieces, we calculated expected future losses on 159 conduit
transactions that were issued between January 1997 and December 2001. After
calculating future losses for each transaction, we compared these numbers to
current subordination levels on BBB-, BB and single-B bonds. A subordination-
to-loss ratio that is less than one implies a bond default prior to maturity.

Please see additional important disclosures at the end of this report. 125
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

For this chapter, we adjusted subordination levels on the 159 bonds until the
number of bonds with ratios below one was consistent with the corporate bond
default rate for a particular rating. For example, according to Moody’s, the aver-
age 10-year cumulative default rate for single-A corporate bonds is 1.88%. Since
we are examining a universe of 159 deals, this 1.88% default rate corresponds to
2.99 CMBS bonds out of 159 defaulting. We rounded the 2.99 bond defaults to
3 defaults, and kept lowering subordination levels across all deals until the uni-
verse had 3 bond defaults and was on the verge of experiencing 4 bond defaults.
We repeated this procedure for all ratings from Aaa to B2 under two different
scenarios that we used in the Projecting Losses articles to forecast future losses.
One scenario assumed the average default timing curve from Esaki’s commercial
mortgage default study and the average severity rate of 34%. The other scenario
assumed the default timing curve of the 1986 origination cohort from the Esaki
Study, and a 43% severity rate, which is the severity experienced by liquidated
CMBS loans. For more details on these scenarios and the assumptions we used
to forecast losses, see our Projecting Losses pieces1.

1
Projecting Losses on BBB- CMBS, April 16, 2004; Projecting Losses on BB CMBS, May 21, 2004; Projecting
Losses on Single-B CMBS, May 28, 2004.

126
exhibit 3 CMBS DEFAULTS CALIBRATED TO CORPORATE
BOND DEFAULTS

Moody’s Average 10-Year Corresponding # of CMBS


Cumulative Default Rates for Defaults Necessary to be
Corporate Bonds, 1983-2002 (%) Consistent With Corporates
Aaa 0.38 0.60
Aa2 0.73 1.16
A2 1.88 2.99
Baa2 5.71 9.08
Ba2 15.81 25.14
B2 46.22 73.49
Source: Moody’s Investors Service, Morgan Stanley

Please see additional important disclosures at the end of this report. 127
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

Section I: Projecting Losses on BBB- CMBS


SUBORDINATION V S. E XPECTED L OSSES
In order to test the hypothesis that current credit enhancement levels continue
to provide adequate support for mezzanine and subordinate CMBS, we examine
the ratio of BBB- subordination to expected losses on all conduit deals issued
between 1997 and 2001. (We describe the methodology for predicting expected
losses later in this section.)
A ratio that is less than 1 means that we expect the class to default before matu-
rity; a ratio of greater than 1 means we expect no default. Depending on the
severity assumption and timing curve used to project future losses, between 0
and 5 bonds have subordination-to-loss ratios of less than 1. (See Exhibit 4)
Under the most severe assumptions, about 11% of classes have a ratio between
1 and 2. We believe that classes with a ratio between 1 and 2 may be vulnerable
to a downgrade.
The majority of BBB- bonds, however, have a ratio of greater than 5. In our
view, this shows that there is currently minimal default risk in the investment
grade CMBS sector. If the majority of BBB-s are well protected from real estate
risk, higher rated classes are even more insulated.

exhibit 4 BBB- SUBORDINATION-TO-EXPECTED-LOSS RATIOS


FOR 1997-2001 CONDUITS

Ranges for BBB- Average Default Average Default


Subordination to Timing Curve; Timing Curve;
Expected Loss Ratio 34% Severity 43% Severity
# of Deals % of Deals # of Deals % of Deals
0-1 0 0.0 0 0.0
1-2 4 2.5 4 2.5
2-3 5 3.1 9 5.7
3-4 8 5.0 9 5.7
4-5 6 3.8 4 2.5
5-6 4 2.5 6 3.8
6-7 4 2.5 5 3.1
7-8 5 3.1 4 2.5
>8 123 77.4 118 74.2

Source: Morgan Stanley, Intex, Trepp

128
In Exhibit 8 of this section, we rank our universe of BBB- CMBS based on sub-
ordination to expected loss ratios. We believe that the bonds at the bottom of
the list (with the highest ratios) have the highest level of principal protection and
greatest chance for rating agency upgrade. Likewise, we believe that the bonds
at the top of the list (with the lowest ratios) have a higher chance of default and
downgrade.
SCOPE O F T HE S TUDY
This study analyzes and ranks bonds based on the level of principal protection
from losses. Our analysis does not assess the risk of potential downgrades that
may occur for other reasons, such as interest shortfalls.
For example, while ASC 1997-D5 A2 has a high subordination to expected loss
ratio,1 this class was downgraded by Moody’s in September 2003 to Baa3 from its
original A1 rating. The downgrade was prompted by interest shortfalls caused
by servicer reimbursements of non-recoverable advances. Likewise, S&P down-
graded this class to BBB from A+.

1986 Default 1986 Default


Timing Curve; Timing Curve;
34% Severity 43% Severity
# of Deals % of Deals # of Deals % of Deals
4 2.5 5 3.1
14 8.8 17 10.7
8 5.0 10 6.3
11 6.9 12 7.5
7 4.4 6 3.8
6 3.8 10 6.3
8 5.0 10 6.3
8 5.0 9 5.7
93 58.5 80 50.3

1
Ratio of 60.8, assuming average default timing curve from Esaki study and 34% severity rate; Ratio of 96.2,
assuming 1986 default timing curve and 43% severity rate.

Please see additional important disclosures at the end of this report. 129
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

A high subordination to expected loss ratio1 does not mean a BBB- class neces-
sarily offers good value. The market may have already priced in the probability
of an upgrade. There may be cases, however, where the spread has not fully
adjusted for the credit. For example, JPMC 1997-C4 F is currently rated BBB-
by S&P. With a current subordination level of 13.09% and a subordination-to-
loss ratio of 1581.4, we would argue that this class is a good upgrade candidate.
This class currently has a $109 price and trades around S+100 bp.
PROJECTING L OSSES - M AY 2 003
In order to assess the strength of this study as a predictor of rating actions, we
reviewed rating changes on BBB- bonds from the prior version of this study.2

exhibit 5 PROJECTING LOSSES STUDY - MAY 2003


RATING AGENCIES UPGRADED 13 OF THE 20 CLASSES WITH THE
HIGHEST SUBORDINATION-TO-LOSS RATIOS
Subordination Ratings Old Old Current
to Expected Actions Since Moody’s Fitch Moody’s
Deal Loss Ratio1 May 2003 Rating1 Rating1 Rating
CCMSC 2000-3 NA2 - - BBB- -
MSC 1997-WF1 1090.0 Upgraded Baa3 - A2
JPMC 1999-C7 326.0 Upgraded - BBB-* -
JPMC 1997-C4 309.4 Upgraded Baa2 BBB+ A3
MSC 1998-WF2 159.8 - - BBB- -
MSC 1997-HF1 150.8 Upgraded - BBB+ -
NLFC 1999-2 120.0 Upgraded - BBB -
CCMSC 1997-1 118.5 Upgraded - BBB -
PNCMA 2000-C2 113.6 - Baa3 - Baa3
MSDWC 2000-LIF2 110.1 - Baa3 BBB- Baa3
GMACC 1999-C2 91.5 Upgraded Baa3 BBB- Baa3
MCFI 1997-MC2 87.9 - Baa3 - Baa3
FULB 1997-C1 77.1 Upgraded Baa3 BBB- A3
CMAC 1999-C1 72.6 Upgraded Baa3 BBB- Baa3
NASC 1998-D6 69.9 Upgraded Baa3 BBB- Baa3
ACMF 1997-C1 66.0 Upgraded - BBB- -
GMACC 1997-C1 62.6 Upgraded Baa3 BBB- Baa3
JPMC 1997-C5 53.6 Upgraded Baa3 BBB-* Baa3
DLJCM 1999-CG2 48.4 - Baa3 BBB- Baa3
CCMSC 1998-2 47.9 - - BBB- -
1
As of May 2003.
2
Expected loss ratio equals zero.
*S&P Rating
Source: Morgan Stanley, Rating Agencies

2
See Projecting Losses: BBB- Upgrade Potential, May 2003

130
Over the course of a year, we would expect the bonds with the highest subordi-
nation-to-loss ratios to experience the greatest number of upgrades. We found
that 65% of the 20 BBB- classes with the highest subordination-to-loss ratios
were upgraded during the past year (Exhibit 5). The upgrade percentage
declined for the next highest 20 (40%).
We would also expect the BBB- bonds with the lowest subordination-to-loss
ratios to experience fewer upgrades and potentially experience some down-
grades. We found that 2 of the 20 BBB- classes with the lowest ratios were
downgraded during the past year. Only 1 class was upgraded.

Date of Current
Moody’s Fitch
Upgrade Rating Date of Fitch Upgrade
- BBB- -
2/26/2004 - -
- BBB* 7/22/2003*
7/23/2003 AAA Two Upgrades: 11/12/2003 and 3/30/2004
- BBB- -
- AA 2/23/2004
- A- 9/10/2003
- BBB+ 9/10/2003
- - -
- BBB- -
- BBB 7/7/2003
- - -
3/9/2004 A 2/13/2004
- BBB 11/25/2003
- BBB+ Two Upgrades: 11/18/2003 and 1/06/2004
- AA+ Three Upgrades: 7/11/2003, 2/3/2004 and 3/17/2004
- BBB+ 2/18/2004
- BBB* 9/23/2003*
- BBB- -
- BBB- -

Please see additional important disclosures at the end of this report. 131
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

METHODOLOGY
In this section, we analyze the lowest rated investment grade class of 159 conduit
transactions tracked by Trepp. Each conduit transaction was issued between
January 1997 and December 2001. 140 of 159 classes are currently rated BBB- by
Moody’s, Fitch or S&P; the other 19 classes are rated single-A, A-, BBB+ or BBB.
For each transaction, we calculate a future expected loss rate based on historical
losses and losses implied by the current level of 30, 60, and 90-day delinquencies,
REO, foreclosures, performing specially serviced loans and servicer watchlisted
loans. We do not account for the impact of defeased collateral within the deals.
We begin by assigning a probability of liquidation for each delinquency category,
based on results from Esaki’s commercial mortgage default study.
Assumptions for Probabilities of Liquidation
In Esaki’s study, about 55% of loans that became more than 90 days delinquent
were ultimately liquidated. For this section, we borrow the results from the
Esaki study and assume that 55% of 90+ day delinquent loans will be liquidated.
We then assume that 60-day delinquent loans will have a 25% liquidation rate,
and 30-day delinquent loans will have a 10% liquidation rate.
To be conservative, we assume that all foreclosed and REO loans will be liqui-
dated. We assign a 2.5% liquidation rate to servicer watchlisted loans and a 5%
liquidation rate to performing specially serviced loans. We assume a low proba-
bility of liquidation for the performing specially serviced loans because these
loans could have been transferred to the special servicer for technical rather than
monetary defaults.
Calculating Loan Losses: Average Timing of Defaults
We then multiply the projected liquidated loan total by a severity rate to compute
each deal’s expected loss rate for the year. For our analysis, we consider two loss
severity rates: 34% and 43%3.
The first severity rate that we assume is 34%. Liquidated life insurance company
loans in the Commercial Mortgage Default Study: 1972-2000, by Howard Esaki,
experienced a 34% severity rate. The average severity rate on liquidated CMBS
loans is higher, at 43%3. The calculated loss rates for the year are then used in
conjunction with historical losses to project future loss rates.
Since the calculated losses are based on current delinquency levels, we assume
that the resulting losses will occur within one year from today.
For example, with a 34% severity rate assumption, DLJCM 2000-CKP1, is
expected to have a 0.4% loss rate based on current levels of delinquencies, spe-
cially serviced loans and watchlisted loans. This transaction has seasoned for 3
years, so we assume losses will occur in year 4. The projected loss based on cur-
rent delinquencies (0.4%) is then added to the deal’s historical losses of 2.5%.
To project future losses, we assume that the timing of CMBS loan losses in this
study mirrors the average timing of defaults on the life insurance company loans
from Esaki’s study.

3
See special servicer severities, February 6, 2004.

132
According to the timing of defaults presented in Esaki’s study, about 33% of
loans default by the end of year 4. The DLJCM 2000-CKP1 transaction is
expected to have a 2.9% loss rate by year 4, based on historical losses and pro-
jected losses of currently delinquent loans. If we apply the results of Esaki’s
study, this 2.9% loss rate should correspond to 33% of total loan losses.
Therefore, we conclude that this transaction may suffer from a 5.9% loss rate
(based on original balances) during its remaining lifetime, since 67% of loan loss-
es have yet to occur. (2.9*(1-33%)¸33%=5.9% loss rate) A 5.9% loss rate based
on original balances corresponds to a 6.3% loss rate, based on current balances.

exhibit 6 AVERAGE TIMING OF DEFAULTS FROM ESAKI’S


COMMERCIAL MORTGAGE DEFAULT STUDY1

Total Cumulative
Default Rates from Defaults That Occur Level of Defaults
Year Esaki’s Study (%) Each Year (%) Through Time (%)
1 0.2 1.5 1.5
2 1.0 6.9 8.4
3 1.7 11.5 19.9
4 2.0 13.1 33.0
5 2.1 13.9 46.9
6 2.3 15.2 62.1
7 2.8 18.9 81.0
8 1.5 9.7 90.7
9 0.9 5.7 96.4
10 0.5 3.6 100.0
1
Real Estate Finance, Commercial Mortgage Defaults: 1972-2000, by Howard Esaki, Winter 2002 Edition.
Source: Morgan Stanley

The timing of defaults presented in Exhibit 6 is fairly evenly distributed, with


47% of loan losses occurring in the first five years after loan origination, and the
remaining 53% of losses occurring in years 6 through 10. If the timing of
defaults in CMBS deviates from this average, it is possible that our analysis
would yield different results.

Please see additional important disclosures at the end of this report. 133
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

We repeated our analysis, applying the default timing curve experienced by life
insurance company loans that were originated in 1986. The 1986 origination
cohort experienced the highest default rate of any origination year between 1972
and 1995. For the purposes of this analysis, we do not focus on the absolute
level of defaults, but we apply the 1986 default timing curve as a proxy for the
timing of CMBS loan losses in a real estate downturn. Life insurance company
loans originated in 1986 experienced 70% of all defaults in years 6 through 10
after origination.
Since most of the CMBS transactions in our study have seasoned for less than
six years, the 1986 default timing curve assumes that the majority of losses have
not yet occurred. Using this back-loaded timing curve, the projected future loss-
es for these CMBS transactions are higher than in our initial analysis, resulting in
lower subordination-to-loss ratios.

134
exhibit 7 TIMING OF DEFAULTS FOR 1986 COHORT FROM
ESAKI’S COMMERCIAL MORTGAGE DEFAULT STUDY1

Total Cumulative
Default Rates from Defaults That Occur Level of Defaults
Year Esaki’s Study (%) Each Year (%) Through Time (%)
1 0.0 0.0 0.0
2 0.9 3.2 3.2
3 2.3 7.9 11.1
4 2.1 7.5 18.6
5 3.3 11.3 29.9
6 5.8 20.2 50.2
7 10.3 35.8 86.0
8 2.5 8.6 94.6
9 1.3 4.6 99.2
10 0.2 0.8 100.0
1
Real Estate Finance, Commercial Mortgage Defaults: 1972-2000, by Howard Esaki, Winter 2002 Edition.
Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 135
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 8 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
DLJCM 2000-CKP1 B1 Baa3 BBB+ 0.00 0.02 0.08 0.25 0.20
BACM 2001-PB1 J Baa3 - 0.00 0.00 1.71 0.00 0.00
CCMSC 2000-1 F - BBB- 0.84 1.64 7.95 1.21 7.45
JPMCC 2001-C1 G - BBB- 0.18 0.00 1.59 0.00 1.87
BACM 2001-1 H Baa3 BBB- 0.35 0.00 4.83 0.11 1.05
BAFU 2001-3 J - BBB- 0.00 0.00 0.54 0.00 0.00
SBM7 2000-C2 G Baa3 BBB- 0.00 0.00 0.00 5.46 1.93
SBM7 2001-C1 G Baa3 - 0.13 0.00 3.62 0.00 1.77
GMACC 2001-C1 G - BBB- 0.77 1.25 3.98 0.00 1.66
JPMC 2000-C9 F Baa3 BBB- 0.00 0.24 0.78 0.00 0.00
FUNBC 2001-C4 J Baa3 - 0.00 0.00 0.48 1.03 0.33
GECMC 2000-1 F Baa3 BBB- 1.69 1.37 2.41 0.00 0.00
SBM7 2000-C3 G Baa3 - 2.41 0.11 0.00 0.00 1.63
GMACC 2000-C2 F - BBB- 1.18 0.00 3.16 0.00 0.00
MLMI 1999-C1 E - BBB-* 0.40 0.00 6.26 1.71 2.69
MSDWC 2001-TOP1 F - BBB- 0.00 0.00 2.86 0.00 0.00
CSFB 2001-CF2 G Baa3 BBB- 0.11 0.22 1.27 0.00 0.33
BSCMS 2001-TOP2 F - BBB- 0.00 0.00 2.65 0.00 0.00
GMACC 2000-C3 F Baa3 BBB- 0.33 0.00 0.86 0.00 0.54
LBUBS 2000-C5 G Baa3 - 0.00 0.00 2.40 0.00 0.47
CSFB 2001-CKN5 H Baa3 - 0.00 0.00 0.00 0.50 0.00
JPMC 1999-C8 F Baa3 BBB 0.67 0.00 1.69 0.00 0.30
GECMC 2001-3 G - BBB- 0.00 0.00 0.00 0.85 0.00
CSFB 1999-C1 F Baa3 BBB- 0.00 0.00 0.10 0.58 2.91
KEY 2000-C1 G Baa3 - 0.00 0.00 1.11 0.74 3.08
JPMCC 2001-CIBC F - BBB- 0.00 0.00 1.31 0.00 0.57
MLMI 1998-C3 D Baa3 - 0.63 0.00 1.88 0.00 0.00
SBM7 2001-C2 H Baa3 - 1.44 0.00 0.79 0.00 0.00
COMM 2000-C1 F - BBB- 0.00 0.00 0.00 1.48 0.00
GMACC 2000-C1 F Baa3 BBB- 0.00 1.14 4.56 0.00 0.50
CSFB 2000-C1 F - BBB- 0.00 0.69 0.83 0.00 2.05
FUNBC 2000-C2 G - BBB- 0.00 0.00 0.00 1.21 0.07
GECMC 2001-2 G Baa3 BBB- 0.00 0.50 0.00 0.00 0.50
LBUBS 2000-C3 G Baa3 BBB- 0.74 0.00 1.28 0.16 0.08
FUBOA 2001-C1 H Baa3 BBB- 1.14 0.00 0.00 0.00 0.00

Source: Morgan Stanley, Trepp


* S&P Rating

136
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and Current BBB-
or Performing Exp. Loss for Subordination Ratio of BBB-
Perf. Specially Historical Current (or lowest Subordination
Spec. Serviced Cumulative Delinquency investment to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of grade class Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) subordination) Loss
0.00 25.88 0.4 2.5 6.3 9.8 1.6
0.00 12.35 0.4 0.6 4.4 8.0 1.8
0.00 43.93 4.8 0.0 5.6 10.3 1.8
0.00 11.34 1.0 0.0 4.2 7.7 1.8
0.40 25.85 1.5 0.1 3.4 8.7 2.5
0.00 12.76 0.2 0.6 3.3 8.5 2.6
2.67 25.66 2.5 0.6 3.9 10.0 2.6
4.57 14.68 1.4 0.1 3.2 8.9 2.7
0.00 24.00 1.6 0.0 3.3 9.2 2.8
0.00 37.22 0.4 1.8 2.9 8.9 3.1
0.09 19.13 0.7 0.0 2.9 9.3 3.2
0.00 29.26 0.8 0.5 2.9 9.2 3.2
0.00 6.58 0.7 0.4 2.3 8.1 3.5
0.00 27.93 0.8 1.0 2.1 7.9 3.7
1.12 13.68 2.6 0.0 3.2 12.4 3.9
0.80 13.34 0.6 0.0 1.3 5.2 3.9
0.06 19.47 0.5 0.4 2.0 7.8 3.9
2.45 12.86 0.6 0.0 1.3 5.3 4.0
0.00 30.38 0.6 0.2 1.6 7.4 4.5
0.65 21.28 0.8 0.0 1.6 7.4 4.5
0.00 17.34 0.3 0.1 1.7 8.1 4.7
0.75 17.69 0.5 2.5 2.1 9.8 4.8
0.00 19.98 0.4 0.0 1.9 9.2 5.0
8.63 17.57 1.4 0.4 2.1 10.8 5.0
0.00 16.12 1.5 0.2 2.1 10.8 5.2
4.81 26.45 0.7 0.1 1.6 9.1 5.5
0.00 31.19 0.5 2.3 2.1 12.6 6.0
0.00 16.31 0.3 0.0 1.4 8.6 6.4
0.35 47.64 0.8 0.3 1.4 9.2 6.7
0.73 19.01 1.2 0.0 1.5 9.8 6.7
0.56 27.67 1.1 0.0 1.3 9.1 6.8
0.53 22.56 0.6 0.0 1.3 9.3 7.2
0.00 29.92 0.5 0.1 1.2 8.9 7.2
1.12 25.53 0.6 0.2 0.9 6.7 7.5
3.53 22.94 0.3 0.2 1.1 8.5 7.7

Please see additional important disclosures at the end of this report. 137
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 8 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
FUNBC 1999-C4 F - BBB- 1.31 0.00 2.50 0.00 1.21
PMCF 2001-ROCK G Baa3 BBB- 0.00 0.00 0.00 0.00 0.00
PMAC 1999-C1 E Baa3 BBB- 0.33 0.00 0.84 1.63 1.19
BSCMS 2001-TOP4 F Baa3 - 0.00 0.23 0.26 0.00 0.00
MSDWC 2000-LIFE F - BBB- 0.00 0.00 1.55 0.00 0.00
HFCMC 2000-PH1 F Baa3 BBB- 3.47 0.10 0.72 0.00 0.29
GSMS 1999-C1 E Baa3 - 1.09 2.21 2.68 0.51 0.65
GMACC 1999-C3 F Baa3 BBB- 5.88 0.22 1.34 0.00 1.32
FUNBC 2001-C2 J Baa3 - 0.00 0.00 0.22 0.00 0.32
BACM 2000-2 H Baa3 - 0.00 0.00 0.00 0.00 0.17
BSCMS 2000-WF2 F - BBB- 0.00 0.00 2.01 0.00 0.00
LBUBS 2001-C2 G Baa3 BBB- 0.17 0.00 0.53 0.00 0.00
PNCMA 2000-C1 F Baa3 BBB- 1.31 1.43 1.27 0.00 0.12
JPMC 2000-C10 F Baa3 BBB- 1.05 0.55 0.55 0.38 0.00
MSC 1999-FNV1 F - BBB- 3.07 0.00 0.36 1.58 2.59
FUNBC 2000-C1 F - BBB- 0.24 0.00 0.00 0.00 0.00
SBM7 2000-C1 G Baa3 - 1.68 0.00 1.82 0.00 0.64
BSCMS 1999-C1 E Baa3 - 0.00 0.00 1.37 0.00 0.00
CCMSC 2000-3 F - BBB- 0.00 0.35 1.43 0.50 0.00
DLJMA 1997-CF1 A3 - A 0.00 0.26 4.38 1.93 1.00
LBCMT 1999-C2 F Baa3 BBB- 0.00 0.00 0.35 2.06 0.00
LBUBS 2000-C4 G Baa3 - 0.00 0.84 0.18 0.08 0.52
LBCMT 1999-C1 E Baa3 BBB- 0.41 0.00 0.24 0.00 0.00
CSFB 1997-C2 E Baa3 - 0.94 5.98 0.00 0.00 1.25
MSC 1998-HF2 F - BBB- 0.00 0.00 0.82 0.00 0.48
MSC 1998-CF1 C A2 - 0.98 2.82 0.74 3.91 4.25
DLJCM 2000-CF1 B2 - BBB- 3.35 1.98 0.43 0.00 0.12
NLFC 1998-2 E - BBB- 0.39 0.00 1.32 0.00 0.58
PNCMA 1999-CM1 B2 - BBB 0.17 0.00 0.00 0.00 0.00
BSCMS 1999-WF2 F Baa3 BBB- 0.00 0.00 1.68 0.00 0.49
CSFB 2001-CK6 H Baa3 - 0.02 0.00 0.07 0.00 0.00
GMACC 2001-C2 H - BBB- 0.00 0.00 0.56 0.00 0.00
GMACC 1999-C2 G Baa3 - 0.00 0.00 5.66 0.00 0.00
CSFB 1998-C2 E Baa1 BBB- 0.00 0.00 0.00 0.85 0.00
GMACC 1999-C1 E - BBB 0.23 0.00 2.62 0.00 0.00

Source: Morgan Stanley, Trepp

138
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and Current BBB-
or Performing Exp. Loss for Subordination Ratio of BBB-
Perf. Specially Historical Current (or lowest Subordination
Spec. Serviced Cumulative Delinquency investment to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of grade class Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) subordination) Loss
2.18 23.17 1.1 0.0 1.3 10.4 7.9
0.49 5.56 0.1 0.4 1.0 8.0 8.1
1.58 17.47 1.1 0.9 1.4 11.8 8.2
0.00 10.07 0.1 0.0 0.6 5.2 8.3
0.33 15.90 0.4 0.4 1.0 8.1 8.4
1.86 18.35 0.5 0.5 1.2 10.8 9.1
0.31 25.07 1.2 0.8 1.4 13.1 9.6
0.00 16.49 1.0 0.7 1.1 10.5 9.8
0.75 27.91 0.4 0.0 0.8 8.0 9.8
0.00 35.16 0.3 0.1 1.0 9.8 9.9
0.49 12.49 0.5 0.0 0.6 5.7 10.2
0.00 30.31 0.3 0.0 0.7 7.6 10.3
0.70 20.83 0.6 0.2 0.9 9.5 10.4
1.38 10.43 0.4 0.3 0.9 9.6 10.6
0.00 21.24 1.6 0.1 1.1 12.6 11.0
1.86 33.46 0.3 0.4 0.9 10.1 11.4
0.81 16.40 0.7 0.0 0.9 10.5 12.1
0.00 14.10 0.3 0.6 0.7 8.1 12.4
0.65 25.74 0.7 0.0 0.8 9.9 12.6
2.91 0.00 1.2 8.1 1.5 18.7 12.6
0.00 22.15 0.9 0.0 0.6 7.4 12.6
0.75 25.33 0.5 0.0 0.6 8.0 13.1
2.11 33.21 0.3 0.4 0.5 6.6 13.2
0.82 18.98 1.0 2.1 0.8 11.2 13.3
4.14 27.21 0.5 0.5 0.7 10.0 13.5
3.63 19.52 2.8 2.5 1.5 20.5 13.6
2.59 20.83 0.6 0.0 0.7 10.0 13.8
1.01 8.22 0.5 0.8 0.9 12.4 13.8
1.09 16.95 0.2 0.5 0.8 11.0 13.9
0.00 4.96 0.5 0.4 0.6 8.0 14.0
0.70 14.07 0.1 0.0 0.6 8.4 14.3
0.00 25.68 0.3 0.0 0.7 9.4 14.3
0.00 12.30 1.1 0.0 0.7 10.6 14.3
4.11 21.05 0.5 0.8 0.9 12.3 14.4
0.11 21.46 0.6 0.8 0.9 13.7 14.7

Please see additional important disclosures at the end of this report. 139
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 8 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
CSFB 2001-CK1 G Baa3 BBB- 0.12 0.00 0.00 0.00 0.21
MSDWC 2001-TOP5 F Baa3 - 0.00 0.00 0.00 0.00 0.00
FUNCM 1999-C2 F Baa3 BBB- 0.00 0.00 1.33 0.00 0.00
BSCMS 2000-WF1 F - BBB- 0.00 0.00 0.45 0.00 0.46
GECMC 2001-1 G Baa3 BBB- 0.00 0.00 0.20 0.00 0.00
JPMCC 2001-CIB2 F - BBB- 0.00 0.00 0.51 0.00 0.00
DLJCM 1999-CG1 B2 Baa3 BBB- 0.00 0.94 0.00 0.00 1.22
LBUBS 2001-C7 H Baa3 - 0.28 0.00 0.10 0.00 0.00
CSFB 2001-CK3 G1 Baa3 BBB- 0.00 0.10 0.00 0.00 0.00
CMAT 1999-C1 E Baa3 - 0.00 0.96 1.41 0.00 1.10
DLJCM 1999-CG2 B2 Baa3 BBB- 1.35 0.00 0.72 0.00 1.84
CMAT 1999-C2 F Baa3 BBB- 0.00 0.00 0.67 0.00 0.00
FUNBC 2001-C3 H - BBB- 0.16 0.00 0.18 0.00 0.00
COMM 1999-1 F Baa3 BBB- 0.00 0.00 0.33 1.25 1.19
MSDWC 2000-LIF2 F Baa3 BBB- 0.00 0.00 0.00 0.00 0.00
MLMI 1998-C2 E Baa3 - 0.56 0.00 1.34 0.00 1.52
MSDWC 2001-TOP3 F Baa3 BBB- 0.27 0.00 0.41 0.00 0.00
MSC 1999-LIFE1 G - BBB- 0.00 0.00 0.00 1.76 0.00
MCFI 1998-MC3 E Baa3 - 1.06 0.00 0.30 0.00 1.39
CSFB 1998-C1 E - BBB- 0.00 0.00 1.27 0.95 0.97
CCMSC 1999-2 F - BBB- 2.65 0.00 0.00 0.00 0.00
PSSF 1999-C2 F Baa3 - 0.00 0.00 0.00 0.93 0.57
DLJCM 1998-CF2 B-2 Baa3 BBB- 0.00 0.00 0.77 0.00 0.00
LBUBS 2001-C3 G - BBB- 0.00 0.00 0.00 0.00 0.00
GMACC 1997-C2 D Baa1 BBB+ 0.00 0.00 2.04 0.68 3.73
CSFB 2001-CP4 G - BBB- 0.00 0.00 0.00 0.00 0.00
PSSF 1999-NRF1 E Baa3 BBB 0.00 0.00 0.00 0.48 0.00
FUCMT 1999-C1 E Baa3 - 0.00 0.14 0.00 0.24 0.33
DLJCM 1999-CG3 B2 Baa3 BBB- 0.79 0.00 0.37 1.10 0.00
MCFI 1998-MC2 E - BBB- 0.00 0.00 0.00 0.00 0.47
DMARC 1998-C1 E Baa3 BBB- 0.48 0.00 0.40 1.61 4.53
GSMS 1998-C1 E - BBB- 0.00 0.63 1.33 1.15 1.50
CCMSC 2000-2 F Baa3 - 0.86 0.00 0.00 0.00 0.00
BACM 2000-1 F Baa3 - 3.19 0.00 0.97 0.00 0.00
CCMSC 1998-2 E - BBB- 0.00 0.00 0.69 0.00 0.00

Source: Morgan Stanley, Trepp

140
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and Current BBB-
or Performing Exp. Loss for Subordination Ratio of BBB-
Perf. Specially Historical Current (or lowest Subordination
Spec. Serviced Cumulative Delinquency investment to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of grade class Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) subordination) Loss
0.15 27.57 0.3 0.0 0.6 9.5 14.9
0.00 10.01 0.1 0.0 0.3 5.2 15.0
0.64 32.57 0.5 0.6 0.7 11.0 15.1
1.52 8.74 0.3 0.1 0.5 7.4 15.3
1.42 26.57 0.3 0.0 0.6 9.0 15.4
0.62 15.05 0.2 0.0 0.5 8.5 15.6
0.26 0.00 0.5 0.6 0.7 10.8 15.8
0.00 6.40 0.1 0.0 0.3 5.5 16.5
0.76 24.75 0.2 0.0 0.5 8.0 16.7
1.13 15.61 0.8 0.2 0.7 11.5 17.0
0.62 26.24 1.0 0.1 0.7 11.5 17.1
0.30 10.07 0.2 0.4 0.7 11.5 17.2
1.36 24.65 0.3 0.0 0.6 9.6 17.3
3.17 26.77 1.1 0.0 0.7 13.0 17.4
0.00 19.88 0.2 0.0 0.3 6.2 18.0
2.90 0.00 0.6 1.5 0.6 11.7 18.1
0.00 6.60 0.1 0.0 0.3 5.3 18.4
0.00 9.56 0.6 0.0 0.4 7.9 18.9
0.15 26.88 0.7 0.3 0.7 12.8 19.0
5.21 31.63 1.1 1.2 0.6 11.7 19.2
6.92 31.85 0.5 0.0 0.5 10.6 19.5
0.00 21.36 0.6 0.3 0.6 12.4 19.7
1.34 27.45 0.4 0.5 0.6 11.9 19.8
0.00 18.08 0.2 0.0 0.3 6.3 20.1
2.95 32.86 1.7 1.5 1.0 19.7 20.1
2.17 14.03 0.2 0.0 0.4 8.2 20.3
0.21 21.65 0.3 0.5 0.6 12.3 20.4
1.59 19.83 0.4 0.5 0.6 11.5 20.5
2.61 31.39 0.7 0.1 0.5 10.9 20.7
0.80 25.57 0.3 1.2 0.4 8.9 20.7
5.08 16.14 2.0 0.6 0.7 15.2 20.7
0.58 17.22 1.2 0.9 0.6 12.3 21.2
0.00 43.17 0.4 0.0 0.4 9.5 21.2
2.37 8.68 0.4 0.1 0.5 11.6 21.9
0.00 17.37 0.3 0.4 0.5 10.3 21.9

Please see additional important disclosures at the end of this report. 141
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 8 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
AMC 1998-C1 E Baa3 BBB 0.00 0.00 1.24 0.00 0.96
PNCMA 2000-C2 G Baa3 - 0.00 0.00 0.19 0.00 0.00
FULBA 1998-C2 F Ba1 BBB-* 0.56 0.00 0.00 0.66 0.74
CASC 1998-D7 A-5 Baa3 BBB- 0.27 0.00 1.20 2.30 0.48
MLMI 1997-C2 E Baa3 - 0.71 0.40 3.11 1.15 0.00
FULB 1997-C2 E Baa3 BBB 1.16 0.00 1.39 0.18 1.92
MCFI 1998-MC1 G - BBB 0.00 0.00 1.80 0.00 0.00
NLFC 1999-1 E Baa3 - 0.00 0.00 0.00 0.45 0.00
HFCMC 1999-PH1 G Baa3 BBB- 0.00 0.14 1.68 0.00 0.00
JPMC 1998-C6 E - BBB- 0.76 0.00 8.09 0.00 0.00
MSC 1999-RM1 F - BBB 0.54 0.00 0.00 0.00 0.56
LBCMT 1998-C4 E Baa3 - 0.00 0.51 0.13 0.35 0.70
NLFC 1998-1 E Baa3 - 0.75 0.00 3.98 0.00 0.00
LBCMT 1998-C1 E Baa1 BBB- 0.76 1.07 0.64 0.00 0.15
SBM7 1999-C1 F Baa3 BBB- 0.00 0.00 2.64 0.00 0.00
JPMCC 2001-CIB3 F - BBB- 0.00 0.00 0.00 0.00 0.00
JPMC 1999-C7 E - BBB- 0.00 0.00 0.00 0.00 1.11
CCMSC 1997-2 E - A- 0.56 0.00 4.11 0.00 0.00
MSC 1998-HF1 E - BBB+ 0.00 1.02 0.20 0.00 0.00
JPMC 1997-C5 E Baa3 - 1.04 1.45 1.73 0.00 0.00
MLMI 1997-C1 E Baa3 - 0.00 1.12 11.91 0.77 1.97
PNCMA 2001-C1 G Baa3 - 0.00 0.00 0.00 0.00 0.00
SBM7 2001-MMA E1-E8 Baa2 - 0.00 0.00 0.00 0.00 0.00
CMFUN 1999-1 F - BBB- 0.00 0.00 0.22 0.25 0.00
MSC 1997-C1 G Ba3 BBB 0.00 0.00 0.00 0.00 3.87
MSC 1998-WF1 E - BBB 0.00 0.00 4.41 0.00 0.00
GMACC 1998-C1 F - BBB- 0.00 0.00 1.18 0.00 0.00
DLJMA 1997-CF2 B2 Baa3 - 0.00 0.00 15.24 0.00 0.00
GMACC 1997-C1 F Baa3 BBB+ 0.00 0.00 0.22 0.00 0.80
CCMSC 1998-1 E Baa3 - 0.00 0.00 0.00 0.00 0.00
PSSF 1998-C1 F Baa3 - 0.00 0.00 0.24 0.22 0.00
CMAC 1998-C2 E - BBB- 0.84 0.16 3.13 0.00 0.35
MCFI 1997-MC1 E Baa3 - 0.00 3.68 3.62 0.00 1.94
FULB 1997-C1 F - BBB 0.87 0.23 1.58 1.32 0.69
BSCMS 1998-C1 E Baa3 BBB- 0.00 0.00 0.49 0.00 1.31

Source: Morgan Stanley, Trepp


* S&P Rating

142
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and Current BBB-
or Performing Exp. Loss for Subordination Ratio of BBB-
Perf. Specially Historical Current (or lowest Subordination
Spec. Serviced Cumulative Delinquency investment to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of grade class Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) subordination) Loss
0.27 22.13 0.6 1.4 0.6 14.2 23.2
0.00 20.03 0.2 0.0 0.4 10.1 24.1
5.53 18.54 0.6 0.7 0.4 9.1 24.2
0.13 12.26 1.1 0.6 0.5 11.7 24.7
1.69 31.49 1.1 0.7 0.5 12.6 24.7
2.76 20.40 0.9 0.8 0.6 13.7 24.8
0.00 26.50 0.5 1.3 0.5 12.7 27.2
0.75 26.10 0.3 0.3 0.5 13.2 27.2
1.47 18.41 0.5 0.1 0.4 11.3 28.2
0.00 18.96 1.5 0.0 0.4 11.5 28.9
0.00 19.60 0.3 0.3 0.4 12.2 29.4
0.90 16.37 0.5 0.0 0.4 10.5 29.6
0.63 16.89 0.7 0.8 0.5 14.3 31.1
0.53 32.99 0.5 1.0 0.4 13.7 31.6
0.00 16.88 0.6 0.0 0.4 12.8 33.0
0.00 6.54 0.1 0.0 0.2 7.4 33.2
0.00 27.41 0.5 0.0 0.4 13.1 35.2
0.95 23.29 0.7 0.5 0.4 14.2 36.5
0.91 15.48 0.2 1.0 0.3 12.6 36.7
0.00 20.57 0.4 2.0 0.4 14.7 37.1
0.00 28.57 1.8 0.9 0.5 20.7 38.2
0.84 8.68 0.1 0.0 0.2 7.6 38.6
0.00 13.76 0.1 0.0 0.2 9.3 39.0
0.00 18.61 0.3 0.2 0.3 10.6 39.1
0.00 26.25 0.8 0.8 0.3 12.3 39.3
0.27 26.28 0.8 0.2 0.3 12.3 39.6
17.21 32.87 0.7 0.3 0.3 11.1 40.7
0.94 21.47 2.4 0.2 0.3 14.1 41.1
2.86 24.29 0.4 1.8 0.3 13.9 43.1
0.00 24.60 0.2 0.7 0.3 11.0 43.2
0.50 14.07 0.2 0.6 0.2 10.5 43.4
1.08 11.93 0.8 0.3 0.3 12.9 46.4
2.11 36.31 1.4 0.7 0.3 15.7 50.6
2.53 25.84 0.8 0.2 0.2 9.0 52.1
1.46 17.87 0.7 0.0 0.2 9.0 52.1

Please see additional important disclosures at the end of this report. 143
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 8 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
DLJCM 1998-CG1 B3 - BBB 0.00 0.44 0.44 0.00 0.39
GMACC 1998-C2 E Baa1 BBB- 0.78 0.49 1.02 0.09 0.00
ACMF 1997-C1 G - BBB- 0.00 0.00 6.74 0.00 0.00
CSFB 1997-C1 E Baa3 - 0.00 0.00 3.28 0.18 0.00
CCMSC 1997-1 E - BBB+ 0.00 0.00 0.96 0.00 4.15
ASC 1997-D5 A2 Baa3 AA 0.12 0.21 0.00 2.86 1.70
ASC 1997-D4 B-1 - BBB- 0.16 0.00 2.98 0.00 0.00
MCFI 1997-MC2 E Baa3 - 0.60 0.42 0.98 0.00 0.00
CMAC 1998-C1 E Baa2 BBB-* 0.64 0.00 0.36 0.00 0.00
MSC 1997-HF1 F - BBB- 1.96 0.00 1.44 0.00 0.00
NLFC 1999-2 E - A- 0.00 0.00 0.00 0.00 0.00
CMAC 1999-C1 G Baa3 - 0.41 0.88 0.00 0.00 0.00
DLJCM 1998-CF1 B2 Baa3 - 0.00 0.72 0.00 0.00 0.00
NASC 1998-D6 A-5 Baa3 BBB+ 0.06 0.05 1.33 0.00 0.00
MSC 1999-WF1 G Ba1 BBB 0.53 0.00 0.00 0.00 0.00
MSC 1998-WF2 G - BBB- 0.00 0.00 0.00 0.00 0.00
JPMC 1997-C4 F - BBB-* 0.00 0.00 0.43 0.00 0.00
MSC 1997-WF1 E A2 - 0.00 0.00 0.00 0.00 0.00
IFUND 2001-A D - BBB* 0.00 0.00 0.00 0.00 0.00

Source: Morgan Stanley, Trepp


* S&P Rating

144
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and Current BBB-
or Performing Exp. Loss for Subordination Ratio of BBB-
Perf. Specially Historical Current (or lowest Subordination
Spec. Serviced Cumulative Delinquency investment to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of grade class Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) subordination) Loss
1.90 25.98 0.4 0.3 0.2 10.8 52.3
0.21 21.97 0.4 0.3 0.2 11.3 56.8
2.74 33.56 0.9 0.0 0.2 9.3 57.0
8.78 19.64 0.7 0.9 0.2 13.4 59.0
0.00 14.91 1.2 0.4 0.2 14.4 60.2
0.61 15.00 1.5 1.3 0.3 20.2 60.8
9.61 7.56 0.6 0.6 0.2 10.0 61.5
2.20 14.33 0.3 0.4 0.2 13.5 63.4
0.16 20.31 0.2 0.5 0.2 12.9 63.5
0.00 25.93 0.3 0.4 0.1 8.6 66.5
1.44 18.44 0.1 0.0 0.2 14.4 70.2
1.49 15.67 0.2 0.0 0.2 10.8 71.4
0.93 16.98 0.2 0.3 0.1 11.6 90.9
1.29 16.44 0.4 0.1 0.1 11.3 97.1
0.00 2.13 0.0 0.1 0.1 7.9 116.5
0.00 11.18 0.1 0.0 0.0 6.1 271.9
0.00 0.00 0.0 0.0 0.0 13.1 1581.4
2.11 5.17 0.1 0.0 0.0 17.0 2072.7
0.00 0.00 0.0 0.0 0.0 12.5 NA

Please see additional important disclosures at the end of this report. 145
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

Section II: Projecting Losses on BB CMBS


In Section I, we ranked BBB- CMBS bonds based on their level of principal
protection from losses. In this section, we apply the same methodology from
Part I to rank the universe of BB conduit CMBS. We measure the level of prin-
cipal protection on a bond by comparing the future expected losses for the deal’s
collateral to the current credit support for the bond. The rankings by subordina-
tion to expected loss ratio are provided in Exhibit 13 of this section.
RATIOS A ND R ANKINGS
We believe that the bonds at the bottom of the list (with the highest ratios) have
the highest level of principal protection and the greatest chance for rating
agency upgrade. Likewise, we believe that the bonds at the top of the list (with
the lowest ratios) have a higher chance of default and downgrade.
A ratio that is less than 1 means that we expect the class to default before matu-
rity; a ratio of greater than 1 means we expect no default. Depending on the
severity assumption and timing curve used to project future losses, between 2
and 15 bonds have subordination-to-loss ratios of less than 1 (See Exhibit 9).
Between 9 and 21 bonds have a ratio between 1 and 2. We believe that classes
with a ratio between 1 and 2 may be vulnerable to a downgrade.

exhibit 9 BB SUBORDINATION-TO-EXPECTED-LOSS RATIOS


FOR 1997-2001 CONDUITS

Ranges for BB Average Default Average Default


Subordination to Timing Curve; Timing Curve;
Expected Loss Ratio 34% Severity 43% Severity
# of Deals % of Deals # of Deals % of Deals
0-1 2 1.3 2 1.3
1-2 9 6.0 12 7.9
2-3 8 5.3 11 7.3
3-4 13 8.6 10 6.6
4-5 4 2.6 12 7.9
5-6 13 8.6 13 8.6
6-7 10 6.6 7 4.6
7-8 7 4.6 12 7.9
>8 85 56.3 72 47.7

Source: Morgan Stanley, Trepp, Bloomberg

146
SCOPE O F T HE S TUDY
This study analyzes and ranks bonds based on the level of principal protection
from losses. Our analysis does not assess the risk of potential downgrades that
may occur for other reasons, such as interest shortfalls.
For example, while ASC 1997-D5 A5 has a high subordination to expected loss
ratio,2 this class was downgraded by Fitch in September 2003 to BB from BBB.
The downgrade was prompted by interest shortfalls caused by servicer reim-
bursements of non-recoverable advances. S&P also downgraded this tranche to
D from BBB.
PROJECTING L OSSES - M AY 2 003
In order to assess the strength of this study as a predictor of rating actions, we
reviewed rating changes on the 112 BB bonds from the prior version of this study.3
Over the course of a year, we would expect the bonds with the lowest subordi-
nation-to-loss ratios to experience the greatest number of downgrades.
Likewise, we would expect the bonds with the highest subordination-to-loss
ratios to experience the greatest number of upgrades.

1986 Default 1986 Default


Timing Curve; Timing Curve;
34% Severity 43% Severity
# of Deals % of Deals # of Deals % of Deals
12 7.9 15 9.9
18 11.9 21 13.9
16 10.6 20 13.2
15 9.9 16 10.6
13 8.6 9 6.0
5 3.3 3 2.0
6 4.0 3 2.0
1 0.7 3 2.0
65 43.0 61 40.4

2
Ratio of 35.8, assuming average default timing curve from Esaki study and 34% severity rate.
3
See Projecting Losses: Are BBs Safe? May 2003.

Please see additional important disclosures at the end of this report. 147
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

We found this to be true when we compared the number of rating actions on


the top half of the ranked list of bonds to the rating actions on the bottom half
of the ranked list. The 56 bonds with the highest ratios experienced 13
upgrades and 5 downgrades, while the 56 bonds with the lowest ratios experi-
enced 13 downgrades and 1 upgrade.
We also found that the rating actions were concentrated at the extremes of the
list. The 20 bonds with the highest subordination-to-loss ratios experienced the
majority of the upgrades (8), and the 20 bonds with the lowest subordination-to-
loss ratios experienced half of the downgrades (9).
METHODOLOGY
In this section, we analyze non-investment grade classes of 151 conduit transac-
tions tracked by Trepp. Each conduit transaction was issued between January
1997 and December 2001. 142 of 151 classes are currently rated BB by
Moody’s, Fitch or S&P; the other 9 classes are rated BB+ or BB-.
For each transaction, we calculate a future expected loss rate based on historical
losses and losses implied by the current level of 30, 60, and 90-day delinquencies,

exhibit 10 PROJECTING LOSSES STUDY - MAY 2003


# OF UPGRADES AND DOWNGRADES ON 112 BB BONDS1

# of Classes # of Classes
Rankings2 Upgraded Downgraded
1-56 13 5
57-112 1 13

1
Since May 2003.
2
Highest Ratio: Rank of 1; Lowest Ratio: Rank of 112
Source: Morgan Stanley, Trepp, Bloomberg

REO, foreclosures, performing specially serviced loans and servicer watchlisted


loans. We do not account for the impact of defeased collateral within the deals.
We begin by assigning a probability of liquidation for each delinquency category,
based on results from Esaki’s commercial mortgage default study.

3
See Projecting Losses: Are BBs Safe? May 2003.

148
Assumptions for Probabilities of Liquidation
In Esaki’s study, about 55% of loans that became more than 90 days delinquent
were ultimately liquidated. For this section, we borrow the results from the
Esaki study and assume that 55% of 90+ day delinquent loans will be liquidated.
We then assume that 60-day delinquent loans will have a 25% liquidation rate,
and 30-day delinquent loans will have a 10% liquidation rate.
To be conservative, we assume that all foreclosed and REO loans will be liqui-
dated. We assign a 2.5% liquidation rate to servicer watchlisted loans and a 5%
liquidation rate to performing specially serviced loans. We assume a low proba-
bility of liquidation for the performing specially serviced loans because these
loans could have been transferred to the special servicer for technical rather than
monetary defaults.
Calculating Loan Losses: Average Timing of Defaults
We then multiply the projected liquidated loan total by a severity rate to compute
each deal’s expected loss rate for the year. For our analysis, we consider two loss
severity rates: 34% and 43%.
The first severity rate that we assume is 34%. Liquidated life insurance company
loans in the Commercial Mortgage Default Study: 1972-2000, by Howard Esaki, expe-
rienced a 34% severity rate. The average severity rate on liquidated CMBS loans
is higher, at 43%4. The calculated loss rates for the year are then used in con-
junction with historical losses to project future loss rates.
Since the calculated losses are based on current delinquency levels, we assume
that the resulting losses will occur within one year from today.
For example, with a 34% severity rate assumption, DLJCM 2000-CKP1, is
expected to have a 0.3% loss rate based on current levels of delinquencies, spe-
cially serviced loans and watchlisted loans. This transaction has seasoned for 4
years, so we assume losses will occur in year 5. The projected loss based on cur-
rent delinquencies (0.3%) is then added to the deal’s historical losses of 2.5%.
To project future losses, we assume that the timing of CMBS loan losses in this
study mirrors the average timing of defaults on the life insurance company loans
from Esaki’s study.
According to the timing of defaults presented in Esaki’s study, about 47% of
loans default by the end of year 5. The DLJCM 2000-CKP1 transaction is
expected to have a 2.8% loss rate by year 5, based on historical losses and pro-
jected losses of currently delinquent loans. If we apply the results of Esaki’s
study, this 2.8% loss rate should correspond to 47% of total loan losses.
Therefore, we conclude that this transaction may suffer from a 3.2% loss rate
(based on original balances) during its remaining lifetime, since 53% of loan loss-
es have yet to occur. (2.8%*(1-47%)¸47%=3.2% loss rate) A 3.2% loss rate based
on original balances corresponds to a 3.5% loss rate, based on current balances.

4
See Special Servicer Severities, February 6, 2004.

Please see additional important disclosures at the end of this report. 149
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 11 AVERAGE TIMING OF DEFAULTS FROM ESAKI’S


COMMERCIAL MORTGAGE DEFAULT STUDY1

Total Cumulative
Default Rates from Defaults That Occur Level of Defaults
Year Esaki’s Study (%) Each Year (%) Through Time (%)
1 0.2 1.5 1.5
2 1.0 6.9 8.4
3 1.7 11.5 19.9
4 2.0 13.1 33.0
5 2.1 13.9 46.9
6 2.3 15.2 62.1
7 2.8 18.9 81.0
8 1.5 9.7 90.7
9 0.9 5.7 96.4
10 0.5 3.6 100.0
1
Real Estate Finance, Commercial Mortgage Defaults: 1972-2000, by Howard Esaki, Winter 2002 Edition.
Source: Morgan Stanley

The timing of defaults presented in Exhibit 11 is fairly evenly distributed, with


47% of loan losses occurring in the first five years after loan origination, and the
remaining 53% of losses occurring in years 6 through 10. If the timing of
defaults in CMBS deviates from this average, it is possible that our analysis
would yield different results.
We repeated our analysis, applying the default timing curve experienced by life
insurance company loans that were originated in 1986. The 1986 origination
cohort experienced the highest default rate of any origination year between 1972
and 1995. For the purposes of this analysis, we do not focus on the absolute
level of defaults, but we apply the 1986 default timing curve as a proxy for the
timing of CMBS loan losses in a real estate downturn. Life insurance company
loans originated in 1986 experienced 70% of all defaults in years 6 through 10
after origination.
Since most of the CMBS transactions in our study have seasoned for less than 6
years, the 1986 default timing curve assumes that the majority of losses have not
yet occurred. Using this back-loaded timing curve, the projected future losses
for these CMBS transactions are higher than in our initial analysis, resulting in
lower subordination-to-loss ratios.

150
exhibit 12 TIMING OF DEFAULTS FOR 1986 COHORT FROM
ESAKI’S COMMERCIAL MORTGAGE DEFAULT STUDY1

Total Cumulative
Default Rates from Defaults That Occur Level of Defaults
Year Esaki’s Study (%) Each Year (%) Through Time (%)
1 0.0 0.0 0.0
2 0.9 3.2 3.2
3 2.3 7.9 11.1
4 2.1 7.5 18.6
5 3.3 11.3 29.9
6 5.8 20.2 50.2
7 10.3 35.8 86.0
8 2.5 8.6 94.6
9 1.3 4.6 99.2
10 0.2 0.8 100.0
1
Real Estate Finance, Commercial Mortgage Defaults: 1972-2000, by Howard Esaki, Winter 2002 Edition
Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 151
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 13 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
DLJCM 2000-CKP1 B5 B3 BB 0.00 0.00 0.10 0.25 0.20
JPMCC 2001-C1 J - BB 0.10 0.00 0.54 0.00 3.10
JPMC 2000-C9 H B1 BB 0.00 0.00 0.46 0.56 0.00
SBM7 2000-C3 J Ba3 BB* 2.43 2.14 0.00 0.00 1.63
SBM7 2000-C2 J Ba2 BB 0.00 0.00 2.14 4.01 1.93
BACM 2001-1 K Ba2 BB 0.35 0.00 4.66 0.11 1.05
SBM7 2001-C1 J Ba2 - 0.40 0.00 3.62 0.00 1.77
GECMC 2000-1 H Ba2 BB- 0.00 1.37 2.41 0.00 0.00
FUNBC 2001-C4 L Ba2 - 0.00 0.00 0.00 1.51 0.33
MSDWC 2001-TOP1 H - BB 0.00 0.36 2.50 0.00 0.00
GMACC 2001-C1 J - BB 1.20 0.00 5.32 0.00 0.00
GMACC 2000-C2 G - BB* 5.02 0.00 3.16 0.00 0.00
GMACC 2000-C3 J Ba2 BB 0.17 0.00 0.86 0.00 0.54
BSCMS 2001-TOP2 H - BB 0.00 0.00 2.67 0.00 0.00
CSFB 2001-CF2 J Ba2 BB 0.07 0.07 1.08 0.00 0.21
BACM 2001-PB1 L Ba2 - 0.00 0.00 0.00 0.00 0.00
KEY 2000-C1 J Ba2 - 0.00 0.00 1.11 0.74 3.09
PNCMA 2001-C1 J Ba2 - 0.00 0.00 0.00 0.00 0.00
BAFU 2001-3 L - BB 0.00 0.00 0.54 0.00 0.00
GMACC 2000-C1 H Ba2 BB 0.00 1.46 5.18 0.00 0.50
LBUBS 2000-C5 H Ba1 BB* 0.00 0.00 2.40 0.00 0.47
FUBOA 2001-C1 L Ba2 BB 0.29 0.17 0.69 0.00 0.00
COMM 2000-C1 G - BB 0.00 0.00 0.00 0.98 0.00
GMACC 1999-C3 G Ba2 - 0.35 0.00 7.18 0.00 0.00
LBUBS 2000-C3 J Ba2 BB 0.00 0.00 0.44 0.16 0.92
FUNBC 1999-C4 H - BB 0.00 0.00 0.17 1.46 1.25
JPMC 1999-C8 G Ba3 BB+ 0.64 0.00 1.69 0.00 0.30
GECMC 2001-2 I Ba2 BB 0.00 0.00 0.50 0.00 0.50
PMCF 2001-ROCK J Ba2 BB 0.00 0.00 0.00 0.00 0.00
CSFB 2000-C1 H - BB 0.19 0.00 1.33 0.00 2.05
MSDWC 2000-LIFE J - BB 0.60 0.00 0.38 0.00 1.19
JPMCC 2001-CIBC H - BB 0.67 0.00 1.31 0.00 0.57
PNCMA 2000-C1 H Ba2 BB 0.29 0.85 2.69 0.00 0.36
MSC 1998-CF1 D Ba2 - 1.37 0.10 0.92 4.07 0.26
CSFB 1999-C1 H - BB 0.13 1.51 0.10 0.58 2.91

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

152
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of BB
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current BB to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.00 23.89 0.3 2.5 3.5 2.2 0.6
0.00 12.79 1.2 0.0 5.1 4.6 0.9
0.66 35.79 0.5 2.0 3.3 4.1 1.3
0.00 11.36 0.9 0.6 3.2 4.1 1.3
1.97 25.19 2.4 0.6 3.7 5.0 1.3
0.85 28.86 1.5 0.1 3.4 4.7 1.4
4.57 15.74 1.5 0.1 3.3 4.8 1.5
1.69 29.03 0.8 0.5 2.8 4.7 1.7
0.09 19.70 0.8 0.0 3.2 5.5 1.7
1.49 23.71 0.7 0.0 1.5 2.8 1.9
0.00 29.06 1.2 0.0 2.6 5.0 1.9
0.00 24.86 0.9 1.0 2.3 4.5 2.0
0.00 33.43 0.6 0.2 1.7 3.8 2.3
1.72 12.96 0.6 0.0 1.3 3.0 2.3
0.01 0.00 0.3 0.5 1.7 3.9 2.3
1.24 12.22 0.1 0.6 1.6 4.3 2.7
0.00 17.31 1.6 0.2 2.1 6.0 2.9
0.84 12.75 0.1 0.5 1.4 4.0 2.9
0.00 15.60 0.2 0.6 1.7 5.1 3.0
1.20 21.17 1.4 0.0 1.7 5.5 3.3
0.65 19.95 0.7 0.0 1.6 5.3 3.3
3.53 26.32 0.4 0.2 1.4 4.7 3.3
0.36 44.34 0.7 0.7 1.6 5.5 3.4
0.00 19.70 1.4 0.7 1.4 4.7 3.4
1.12 32.68 0.7 0.2 1.1 3.7 3.4
1.02 22.95 1.1 0.1 1.5 5.2 3.5
0.67 18.81 0.5 2.5 2.1 7.3 3.5
0.00 25.26 0.5 0.1 1.2 4.8 3.8
0.25 5.57 0.0 0.4 1.0 3.8 3.8
0.56 20.04 1.1 0.0 1.3 5.1 3.9
0.00 16.04 0.6 0.4 1.2 4.7 3.9
6.50 0.00 0.6 0.1 1.3 5.1 3.9
0.83 23.23 0.9 0.2 1.2 5.5 4.4
6.11 21.83 1.6 5.7 2.2 10.3 4.7
7.00 17.35 1.5 0.4 1.2 5.8 4.7

Please see additional important disclosures at the end of this report. 153
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 13 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
GSMS 1999-C1 F Ba2 - 0.23 0.00 4.91 0.52 0.25
LBUBS 2000-C4 J Ba2 - 0.00 0.00 0.08 0.00 1.55
CSFB 2001-CK6 K Ba2 - 0.19 0.97 0.01 0.00 0.00
SBM7 2001-C2 K Ba2 - 1.67 0.79 0.00 0.00 0.00
DLJCM 2000-CF1 B4 - BB 0.30 6.34 0.22 0.00 0.23
FUNBC 2001-C2 L Ba2 - 0.00 0.00 0.00 0.22 0.32
HFCMC 2000-PH1 H Ba2 - 1.31 0.10 0.72 0.00 0.29
CSFB 2001-CKN5 K Ba2 - 0.00 0.00 0.00 0.50 0.00
MLMI 1999-C1 F - BB* 1.14 0.00 2.92 4.82 3.15
GECMC 2001-3 I - BB 0.00 0.00 0.00 0.85 0.00
JPMC 2000-C10 H Ba2 BB 0.00 0.00 1.10 0.00 0.38
MSC 1999-FNV1 H - BB 0.27 0.00 3.08 1.58 2.58
BSCMS 2000-WF2 H - BB* 2.04 0.00 2.01 0.00 0.00
FUNBC 2000-C1 H - BB 0.00 0.00 0.00 0.00 0.00
BSCMS 1999-C1 G Ba2 - 0.81 0.00 1.37 0.00 0.00
DLJCM 1999-CG1 B4 - BB 0.93 0.00 0.95 0.00 1.22
LBCMT 1999-C1 G Ba2 - 0.00 0.00 0.67 0.00 0.00
BSCMS 2000-WF1 H - BB 0.00 0.64 0.00 0.00 0.46
DMARC 1998-C1 F - BB+ 0.10 0.00 0.00 2.17 1.02
CSFB 2001-CK1 J Ba2 BB 0.15 0.12 0.00 0.00 0.21
LBCMT 1999-C2 H Ba2 - 0.00 0.00 0.36 0.98 1.10
SBM7 2000-C1 J Ba2 - 0.55 0.00 1.83 0.00 0.64
CCMSC 2000-3 H - BB* 0.35 0.00 1.43 0.50 0.00
LBUBS 2001-C2 J Ba2 BB 0.00 0.20 0.33 0.00 0.00
JPMCC 2001-CIB2 H - BB 0.00 0.00 0.00 0.00 0.51
GMACC 1999-C2 H Ba2 - 0.00 0.00 5.66 0.00 0.00
GMACC 2001-C2 K - BB 0.00 0.00 0.56 0.00 0.00
GECMC 2001-1 I Ba2 BB 0.86 0.00 0.20 0.00 0.00
DLJCM 1999-CG2 B4 Ba2 BB 0.07 0.00 1.88 0.13 1.67
BSCMS 1999-WF2 H - BB 0.00 0.00 1.01 0.00 0.49
FUNCM 1999-C2 H Ba2 BB 0.00 0.00 1.33 0.00 0.00
FUNBC 2000-C2 H - BB 0.34 0.00 0.00 1.21 0.07
GMACC 1999-C1 F - BB 0.00 0.00 2.47 0.00 0.00
BSCMS 2001-TOP4 H Ba2 - 0.00 0.00 0.49 0.00 0.00
FUNBC 2001-C3 K - BB 0.00 0.00 0.18 0.00 0.00

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

154
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of BB
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current BB to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.38 28.35 1.3 0.9 1.5 7.2 4.8
3.46 19.85 0.7 0.0 0.9 4.4 5.0
0.70 15.07 0.2 0.0 0.9 4.7 5.0
0.00 12.43 0.2 0.0 0.9 4.8 5.1
2.26 23.10 0.9 0.0 1.0 5.4 5.2
0.75 25.88 0.4 0.0 0.8 4.4 5.2
0.91 21.30 0.4 0.5 1.1 5.7 5.2
0.00 19.13 0.3 0.1 0.9 4.7 5.3
0.18 18.95 3.1 0.0 2.1 11.2 5.3
0.00 24.70 0.5 0.0 1.0 5.4 5.3
2.19 12.83 0.4 0.3 1.0 5.3 5.5
0.36 18.54 2.0 0.1 1.4 7.7 5.6
0.00 13.53 0.5 0.0 0.6 3.7 5.8
2.11 33.34 0.3 0.4 0.9 5.1 5.8
0.00 13.92 0.4 0.6 0.7 4.0 6.0
0.26 32.28 0.8 0.6 0.9 5.7 6.1
1.76 29.61 0.4 0.4 0.5 3.3 6.3
1.07 7.50 0.3 0.2 0.6 3.8 6.3
1.74 23.83 1.0 3.5 1.4 9.0 6.6
0.00 31.82 0.3 0.0 0.7 4.9 6.7
0.00 22.92 0.9 0.0 0.6 4.0 6.7
2.12 16.74 0.7 0.0 0.9 5.8 6.8
0.65 24.90 0.7 0.0 0.8 5.2 6.8
0.17 29.40 0.3 0.0 0.7 4.6 6.8
0.62 15.11 0.3 0.0 0.7 5.0 7.1
0.00 15.12 1.1 0.0 0.8 5.4 7.2
0.00 30.04 0.4 0.0 0.7 5.4 7.4
1.42 27.03 0.3 0.0 0.7 5.0 7.7
0.60 28.22 1.1 0.2 0.8 6.6 7.8
0.00 6.62 0.4 0.4 0.5 4.0 7.8
0.63 33.13 0.5 0.6 0.7 5.9 7.9
0.53 21.55 0.6 0.0 0.7 5.8 8.1
1.72 0.00 0.4 0.8 0.8 6.7 8.3
0.00 10.81 0.2 0.0 0.4 3.1 8.3
1.37 27.50 0.3 0.0 0.6 5.4 9.0

Please see additional important disclosures at the end of this report. 155
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 13 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
CSFB 2001-CK3 J Ba2 BB 0.00 0.00 0.10 0.00 0.00
MSDWC 2001-TOP5 H Ba2 - 0.00 0.00 0.00 0.00 0.00
JPMCC 2001-CIB3 H - BB 0.00 0.00 0.00 0.00 0.00
MCFI 1998-MC2 G - BB 0.00 0.00 0.00 0.00 0.48
MSDWC 2001-TOP3 H Ba2 BB 0.00 0.00 0.50 0.00 0.00
BACM 2000-2 K Ba2 - 0.00 0.00 0.00 0.00 0.17
COMM 1999-1 G - BB 0.00 0.00 0.33 1.25 1.19
CSFB 2001-CP4 J - BB 0.00 0.00 0.00 0.00 0.00
MSC 1999-LIFE1 J - BB 0.00 0.00 0.00 1.75 0.00
LBUBS 2001-C3 J - BB 0.00 0.00 0.00 0.00 0.00
GSMS 1998-C1 F - BB+* 0.07 0.00 1.52 1.15 1.50
PSSF 1999-NRF1 G Ba2 BB 0.00 0.00 0.00 0.48 0.00
PSSF 1999-C2 J - BB* 0.00 0.00 0.00 0.93 0.57
DLJCM 1999-CG3 B4 Ba2 BB 0.95 0.00 1.17 0.30 0.37
LBUBS 2001-C7 K Ba2 - 0.00 0.00 0.10 0.00 0.00
BACM 2000-1 H Ba2 - 0.00 0.00 1.68 0.00 0.00
FUCMT 1999-C1 F Ba2 - 0.00 0.00 0.00 0.24 0.32
MLMI 1998-C3 E Ba1 BBB-* 0.00 2.51 0.00 0.00 0.00
MLMI 1997-C2 F - BB 0.74 0.00 2.65 1.02 0.22
CSFB 1997-C2 F - BB 0.56 0.00 5.98 0.00 1.25
CCMSC 2000-2 H Ba2 - 0.00 0.86 0.00 0.00 0.00
GMACC 1997-C2 E Ba1 Ba1 0.00 0.00 1.55 0.00 3.86
AMC 1998-C1 F Ba2 BB 0.00 0.00 1.24 0.00 0.97
CASC 1998-D7 B-2 - BB 0.00 0.13 1.20 2.30 0.48
HFCMC 1999-PH1 J - BB 0.38 0.00 1.69 0.00 0.00
PNCMA 1999-CM1 B4 - BB* 0.54 0.17 0.00 0.00 0.00
JPMC 1998-C6 F - BB 0.00 0.63 8.23 0.00 0.00
FULBA 1998-C2 G Ba2 - 0.43 0.57 0.00 0.20 1.09
MCFI 1998-MC3 F Ba1 BB* 0.32 0.23 0.29 0.00 1.39
MSC 1998-HF1 G - BB* 0.00 0.00 1.23 0.00 0.00
JPMC 1997-C5 F - BB 0.00 0.71 2.96 0.00 0.00
LBCMT 1998-C1 G - BB 0.15 0.23 1.71 0.00 0.16
MCFI 1998-MC1 H - BB+* 0.76 0.00 1.25 0.48 0.07
NLFC 1999-1 F Ba2 - 0.00 0.00 0.00 0.45 0.00
MSDWC 2000-LIF2 J Ba2 BB 0.00 0.00 0.00 0.00 0.00

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

156
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of BB
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current BB to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.76 23.92 0.2 0.0 0.5 4.5 9.2
0.00 9.77 0.1 0.0 0.3 3.1 9.3
0.00 14.56 0.1 0.0 0.5 4.6 9.3
0.80 26.08 0.3 1.3 0.5 4.3 9.3
0.00 7.88 0.2 0.0 0.3 3.0 9.3
0.00 34.89 0.3 0.1 0.5 5.1 9.5
2.74 31.76 1.1 0.0 0.8 7.3 9.5
3.27 15.48 0.2 0.0 0.5 4.6 9.8
0.00 22.61 0.7 0.0 0.5 4.7 9.8
1.01 18.90 0.2 0.0 0.4 3.6 9.9
0.94 17.17 1.2 1.4 0.7 7.0 10.1
0.21 23.83 0.3 0.5 0.6 6.4 10.5
0.00 22.47 0.6 0.3 0.6 7.1 11.1
0.92 36.30 0.8 0.1 0.5 6.1 11.2
0.00 6.31 0.1 0.0 0.3 3.3 11.4
4.88 8.70 0.4 0.1 0.6 7.0 11.5
1.73 21.73 0.4 0.5 0.6 6.6 11.7
0.00 28.53 0.4 2.8 0.9 11.1 12.0
1.71 31.03 1.0 0.7 0.5 6.0 12.1
1.13 20.39 1.5 2.1 0.4 5.4 12.4
0.00 34.33 0.4 0.0 0.4 5.2 12.4
3.05 35.75 1.5 1.9 1.1 13.2 12.5
0.00 23.48 0.6 1.4 0.6 8.3 13.4
0.00 11.08 1.1 0.6 0.5 6.4 13.5
0.43 17.49 0.4 0.1 0.4 5.4 13.8
0.90 15.41 0.2 0.5 0.4 6.2 14.1
0.00 18.99 1.5 0.0 0.4 5.9 14.3
5.37 17.25 0.6 0.7 0.4 5.6 14.9
0.66 26.23 0.7 0.3 0.7 10.2 15.2
0.91 16.57 0.3 1.0 0.4 5.8 15.6
0.40 22.67 0.5 2.0 0.4 6.7 16.0
1.46 31.78 0.6 1.1 0.5 7.6 16.3
0.00 26.40 0.6 1.3 0.5 8.2 16.6
0.75 25.83 0.3 0.3 0.5 8.1 16.7
0.00 20.34 0.2 0.0 0.2 3.3 16.8

Please see additional important disclosures at the end of this report. 157
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 13 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
NLFC 1998-2 F - BB* 0.52 0.07 1.33 0.00 0.58
NLFC 1998-1 F - BB 0.25 0.37 3.66 0.00 0.00
CSFB 1998-C2 F Ba2 BB 0.53 0.00 0.00 0.86 0.00
SBM7 1999-C1 H - BB 0.00 0.00 2.64 0.00 0.00
CMAC 1998-C2 G - BB 0.78 0.00 3.15 0.00 0.00
CMFUN 1999-1 H - BB* 0.00 0.00 0.22 0.00 0.25
JPMC 1999-C7 F - BB 0.12 0.00 0.00 0.00 1.11
GMACC 1997-C1 G - BB+ 2.11 0.00 0.22 0.00 0.82
CMAT 1999-C2 J Ba2 - 0.00 0.00 0.67 0.00 0.00
CCMSC 1997-1 F - BB* 0.00 0.00 0.96 0.00 4.15
MCFI 1997-MC1 F - BB 0.00 0.00 7.88 0.00 2.09
PNCMA 2000-C2 J Ba2 - 0.00 0.00 0.19 0.00 0.00
DLJMA 1997-CF2 B3TB B1 BB* 0.00 0.00 3.69 10.73 0.00
DLJCM 1998-CG1 B4 - BB 0.66 0.81 0.44 0.00 0.00
CCMSC 1998-1 F Ba2 - 0.00 0.00 0.00 0.00 0.00
CMAT 1999-C1 G Ba2 - 0.66 0.00 2.20 0.00 1.28
CCMSC 1999-2 H - BB 2.65 0.00 0.00 0.00 0.00
GMACC 1998-C2 G - BB 0.11 0.78 1.41 0.00 0.00
MSC 1998-WF1 G - BB 0.00 0.00 0.39 1.70 0.00
DLJCM 1998-CF2 B-3 - BB 0.08 0.00 0.00 0.77 0.00
MSC 1999-RM1 H Ba2 BB+ 0.00 0.00 0.00 0.00 0.56
FULB 1997-C2 G - BB* 1.17 0.18 1.40 0.00 1.93
PSSF 1998-C1 H Ba2 - 0.00 0.00 0.24 0.22 0.00
ASC 1997-D4 B-2 - BB 0.91 0.00 3.14 0.00 2.20
CMAC 1998-C1 G - BB* 0.24 0.00 0.36 0.00 0.00
BSCMS 1998-C1 G Ba2 - 0.95 0.00 0.49 0.00 1.31
MSC 1998-HF2 G - BB 0.00 0.00 0.83 0.00 0.48
CCMSC 1998-2 F - BB 0.00 0.00 0.69 0.00 0.00
CSFB 1997-C1 F - BB 0.00 0.00 2.67 0.19 0.00
LBCMT 1998-C4 G Ba2 - 0.51 0.00 0.13 0.87 0.17
CCMSC 1997-2 F - BB 0.56 0.00 4.11 0.00 0.00
ASC 1997-D5 A5 - BB 0.00 0.00 0.00 2.90 0.88
GMACC 1998-C1 H - BB 0.00 0.31 0.18 0.00 0.00
NASC 1998-D6 B-2 - BB 0.12 0.00 1.38 0.43 0.00
CMAC 1999-C1 J Ba2 - 0.96 0.89 0.00 0.00 0.00

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

158
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of BB
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current BB to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
1.07 6.11 0.5 0.8 0.3 6.0 17.6
1.15 15.17 0.7 0.8 0.5 8.1 17.9
3.38 20.39 0.5 0.9 0.4 6.3 17.9
0.00 19.05 0.6 0.0 0.4 7.6 18.8
0.98 11.93 0.6 0.7 0.4 6.8 19.4
0.00 18.87 0.3 0.2 0.3 5.4 19.7
0.00 30.16 0.6 0.0 0.4 7.7 19.8
0.85 23.45 0.4 1.9 0.3 6.8 19.9
0.30 0.00 0.1 0.4 0.3 6.2 20.2
0.00 15.47 1.2 1.0 0.3 6.6 20.5
2.28 30.85 1.6 0.7 0.4 7.6 20.5
0.00 22.49 0.2 0.0 0.3 5.3 20.6
0.00 21.29 3.5 0.3 0.5 11.2 21.9
1.91 26.87 0.4 0.5 0.3 5.6 22.0
0.00 25.45 0.2 0.7 0.3 5.7 22.1
0.63 15.31 1.0 0.2 0.3 6.5 22.1
2.45 34.80 0.4 0.0 0.3 5.9 22.6
1.09 23.40 0.5 0.3 0.2 5.2 23.3
2.61 24.22 0.7 0.2 0.3 6.5 23.8
0.00 37.73 0.5 0.5 0.3 6.6 24.7
0.00 0.00 0.2 0.3 0.3 7.8 25.4
2.59 20.51 0.9 0.9 0.2 6.6 26.7
0.50 13.85 0.2 0.6 0.2 6.6 27.1
7.41 6.60 1.2 0.6 0.2 6.9 28.4
0.49 27.78 0.3 0.5 0.2 6.2 28.5
0.52 19.03 0.7 0.0 0.2 5.2 29.0
3.16 23.68 0.5 0.5 0.3 8.1 29.4
0.00 17.37 0.3 0.4 0.2 5.4 31.9
9.08 18.31 0.6 0.9 0.2 7.3 33.2
0.90 29.33 0.6 0.0 0.2 5.3 33.9
0.96 23.76 0.7 0.5 0.2 6.1 35.7
0.82 16.78 1.2 1.6 0.3 12.1 35.8
18.01 0.00 0.3 0.3 0.2 6.3 36.4
0.79 14.66 0.5 0.1 0.1 5.6 38.4
0.55 16.22 0.2 0.0 0.2 6.0 38.6

Please see additional important disclosures at the end of this report. 159
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 13 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
DLJCM 1998-CF1 B4 - BB 0.00 0.00 0.72 0.00 0.00
ACMF 1997-C1 G - BB* 9.58 0.00 6.74 0.00 0.00
FULB 1997-C1 F - BB* 0.00 0.74 1.35 1.40 0.73
NLFC 1999-2 G - BB* 0.00 0.00 0.00 0.00 0.00
MCFI 1997-MC2 F - BB 0.00 0.00 1.41 0.00 0.00
MSC 1997-C1 F Ba2 BBB+ 0.00 0.00 0.00 0.00 2.00
MSC 1997-HF1 G - BB+ 0.00 1.17 1.52 0.00 0.00
MSC 1999-WF1 H Ba2 BB+ 0.00 0.00 0.00 0.00 0.00
MSC 1998-WF2 H - BB 0.00 0.00 0.00 0.00 0.00
JPMC 1997-C4 G - BB- 0.00 0.00 0.43 0.00 0.00
MSC 1997-WF1 G - BB 0.00 0.00 0.00 0.00 0.00

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

160
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of BB
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current BB to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.93 20.71 0.3 0.3 0.2 6.7 44.1
0.00 32.57 1.1 0.0 0.2 9.4 48.9
2.69 23.65 0.8 0.3 0.2 9.5 52.4
1.45 19.41 0.1 0.0 0.1 6.6 56.8
2.21 19.53 0.4 0.6 0.1 7.4 59.3
1.92 23.76 0.5 0.8 0.3 15.9 63.1
0.00 0.00 0.2 0.4 0.1 7.6 65.3
0.00 2.90 0.0 0.1 0.1 5.7 91.4
1.18 11.26 0.1 0.0 0.0 5.0 182.6
0.00 0.00 0.0 0.0 0.0 5.6 678.9
2.12 6.03 0.1 0.0 0.0 6.2 694.4

Please see additional important disclosures at the end of this report. 161
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

Section III: Projecting Losses on


Single-B CMBS
In Sections I and II, we ranked BBB- and BB CMBS bonds based on their level
of principal protection from losses. In this section, we complete our Projecting
Losses trilogy on subordinate CMBS by ranking the universe of single-B conduit
bonds. We measure the level of principal protection on a bond by comparing the
future expected losses for the deal’s collateral to the current credit support for
the bond. The rankings by subordination to expected loss ratio are provided in
Exhibit 17 of this section.
RATIOS A ND R ANKINGS
We believe that the bonds at the top of the list (with the lowest ratios) have the
highest chance of default and downgrade. Likewise, we believe that the bonds at
the bottom of the list (with the highest ratios) have a higher level of principal
protection and a lower chance for rating agency downgrade.

exhibit 14 SINGLE-B SUBORDINATION TO EXPECTED LOSS RATIOS


FOR 1997-2001 CONDUITS

Ranges for Single B Average Default Average Default


Subordination to Timing Curve; Timing Curve;
Expected Loss Ratio 34% Severity 43% Severity
# of Deals % of Deals # of Deals % of Deals
0-1 12 7.9 17 11.2
1-2 20 13.2 24 15.8
2-3 20 13.2 24 15.8
3-4 18 11.8 10 6.6
4-5 10 6.6 14 9.2
5-6 11 7.2 9 5.9
6-7 10 6.6 8 5.3
7-8 7 4.6 7 4.6
>8 44 28.9 39 25.7

Source: Morgan Stanley, Trepp, Bloomberg

162
A ratio that is less than 1 means that we expect the class to default before matu-
rity; a ratio of greater than 1 means we expect no default. Depending on the
severity assumption and timing curve used to project future losses, between 12
and 39 bonds have subordination to loss ratios of less than 1 (See Exhibit 14).
Between 20 and 32 bonds have a ratio between 1 and 2. We believe that classes
with a ratio between 1 and 2 may be vulnerable to a downgrade.
SCOPE O F T HE S TUDY
This study analyzes and ranks bonds based on the level of principal protection
from losses. Our analysis does not assess the risk of potential downgrades that
may occur for other reasons, such as interest shortfalls.
For example, while ASC 1997-D5 A6 has a high subordination to expected loss
ratio2, this class was downgraded by Fitch in September 2003 to B from BB+.
The downgrade was prompted by interest shortfalls caused by servicer reim-
bursements of non-recoverable advances. S&P also downgraded this tranche to
D from BBB-.

1986 Default 1986 Default


Timing Curve; Timing Curve;
34% Severity 43% Severity
# of Deals % of Deals # of Deals % of Deals
33 21.7 39 25.7
32 21.1 32 21.1
16 10.5 16 10.5
7 4.6 3 2.0
3 2.0 5 3.3
4 2.6 4 2.6
6 3.9 4 2.6
3 2.0 4 2.6
48 31.6 45 29.6

2
Ratio of 27.2, assuming average default timing curve from Esaki study and 34% severity rate; Ratio of 44.0,
assuming 1986 default timing curve and 43% severity rate.

Please see additional important disclosures at the end of this report. 163
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

Projecting Losses - June 2003


In order to assess the strength of this study as a predictor of rating actions, we
reviewed rating changes on the 117 single-B bonds from the prior version of
this study.
Over the course of a year, we would expect the bonds with the lowest subordi-
nation to loss ratios to experience the greatest number of downgrades. We
found that 13 of the 20 single-B classes with the lowest ratios were downgraded
during the past year. The number of downgraded classes declined as ratios
increased, with only 4 of the next 20 ranked bonds being downgraded.
Likewise, we would expect the bonds with the highest subordination to loss
ratios to experience the fewest downgrades and/or the most upgrades. Of the
20 bonds with the highest ratios, we found that 2 were downgraded during the
past year, while 2 were upgraded. The number of upgraded classes declined as
ratios decreased, with only 1 of the next 20 ranked bonds experiencing an
upgrade. No other classes were upgraded since the prior version of the study.
METHODOLOGY
In this section, we analyze single-B classes of 152 conduit transactions tracked
by Trepp. Each conduit transaction was issued between January 1997 and
December 2001. 126 of the 152 classes are currently rated single-B by Moody’s,
Fitch or S&P; the other 26 classes are rated B+ or B-.
For each transaction, we calculate a future expected loss rate based on histori-
cal losses and losses implied by the current level of 30, 60, and 90-day delin-
quencies, REO, foreclosures, performing specially serviced loans and servicer
watchlisted loans. We do not account for the impact of defeased collateral
within the deals.
We begin by assigning a probability of liquidation for each delinquency category,
based on results from Esaki’s commercial mortgage default study.
Assumptions for Probabilities of Liquidation
In Esaki’s study, about 55% of loans that became more than 90 days delinquent
were ultimately liquidated. For this section, we borrow the results from the
Esaki study and assume that 55% of 90+ day delinquent loans will be liquidated.
We then assume that 60-day delinquent loans will have a 25% liquidation rate,
and 30-day delinquent loans will have a 10% liquidation rate.
To be conservative, we assume that all foreclosed and REO loans will be liqui-
dated. We assign a 2.5% liquidation rate to servicer watchlisted loans and a 5%
liquidation rate to performing specially serviced loans. We assume a low proba-
bility of liquidation for the performing specially serviced loans because these
loans could have been transferred to the special servicer for technical rather than
monetary defaults.

164
Calculating Loan Losses: Average Timing of Defaults
We then multiply the projected liquidated loan total by a severity rate to compute
each deal’s expected loss rate for the year. For our analysis, we consider two loss
severity rates: 34% and 43%.
The first severity rate that we assume is 34%. Liquidated life insurance company
loans in the Commercial Mortgage Default Study: 1972-2000, by Howard Esaki,
experienced a 34% severity rate. The average severity rate on liquidated CMBS
loans is higher, at 43%3. The calculated loss rates for the year are then used in
conjunction with historical losses to project future loss rates.
Since the calculated losses are based on current delinquency levels, we assume
that the resulting losses will occur within one year from today.
For example, with a 34% severity rate assumption, DLJCM 2000-CKP1, is
expected to have a 0.3% loss rate based on current levels of delinquencies, spe-
cially serviced loans and watchlisted loans. This transaction has seasoned for 4
years, so we assume losses will occur in year 5. The projected loss based on cur-
rent delinquencies (0.3%) is then added to the deal’s historical losses of 2.5%.
To project future losses, we assume that the timing of CMBS loan losses in this
study mirrors the average timing of defaults on the life insurance company loans
from Esaki’s study.
According to the timing of defaults presented in Esaki’s study, about 47% of
loans default by the end of year 5. The DLJCM 2000-CKP1 transaction is
expected to have a 2.8% loss rate by year 5, based on historical losses and pro-
jected losses of currently delinquent loans. If we apply the results of Esaki’s
study, this 2.8% loss rate should correspond to 47% of total loan losses.
Therefore, we conclude that this transaction may suffer a 3.2% loss rate (based
on original balances) during its remaining lifetime, since 53% of loan losses have
yet to occur. (2.8%*(1-47%)¸47%=3.2% loss rate) A 3.2% loss rate based on
original balances corresponds to a 3.5% loss rate, based on current balances.

3
See Special Servicer Severities, February 6, 2004.

Please see additional important disclosures at the end of this report. 165
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 15 AVERAGE TIMING OF DEFAULTS FROM ESAKI’S


COMMERCIAL MORTGAGE DEFAULT STUDY1

Total Defaults Cumulative


Default Rates from That Occur Level of Defaults
Year Esaki’s Study (%) Each Year (%) Through Time (%)
1 0.2 1.5 1.5
2 1.0 6.9 8.4
3 1.7 11.5 19.9
4 2.0 13.1 33.0
5 2.1 13.9 46.9
6 2.3 15.2 62.1
7 2.8 18.9 81.0
8 1.5 9.7 90.7
9 0.9 5.7 96.4
10 0.5 3.6 100.0
1
Real Estate Finance, Commercial Mortgage Defaults: 1972-2000, by Howard Esaki, Winter 2002 Edition.
Source: Morgan Stanley

The timing of defaults presented in Exhibit 15 is fairly evenly distributed, with


47% of loan losses occurring in the first five years after loan origination, and the
remaining 53% of losses occurring in years 6 through 10. If the timing of
defaults in CMBS deviates from this average, it is possible that our analysis
would yield different results.
We repeated our analysis, applying the default timing curve experienced by life
insurance company loans that were originated in 1986. The 1986 origination
cohort experienced the highest default rate of any origination year between 1972
and 1995. For the purposes of this analysis, we do not focus on the absolute
level of defaults, but we apply the 1986 default timing curve as a proxy for the
timing of CMBS loan losses in a real estate downturn. Life insurance company
loans originated in 1986 experienced 70% of all defaults in years 6 through 10
after origination.
Since most of the CMBS transactions in our study have seasoned for less than
six years, the 1986 default timing curve assumes that the majority of losses have
not yet occurred. Using this back-loaded timing curve, the projected future loss-
es for these CMBS transactions are higher than in our initial analysis, resulting in
lower subordination to loss ratios.

166
exhibit 16 TIMING OF DEFAULTS FOR 1986 COHORT FROM
ESAKI’S COMMERCIAL MORTGAGE DEFAULT STUDY1

Total Defaults Cumulative


Default Rates from That Occur Level of Defaults
Year Esaki’s Study (%) Each Year (%) Through Time (%)
1 0.0 0.0 0.0
2 0.9 3.2 3.2
3 2.3 7.9 11.1
4 2.1 7.5 18.6
5 3.3 11.3 29.9
6 5.8 20.2 50.2
7 10.3 35.8 86.0
8 2.5 8.6 94.6
9 1.3 4.6 99.2
10 0.2 0.8 100.0
1
Real Estate Finance, Commercial Mortgage Defaults: 1972-2000, by Howard Esaki, Winter 2002 Edition.
Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 167
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 17 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
DLJCM 2000-CKP1 B6 Caa1 B+ 0.00 0.00 0.10 0.25 0.20
JPMCC 2001-C1 M - B 0.10 0.00 0.54 0.00 3.10
GECMC 2000-1 K - B 0.00 1.37 2.41 0.00 0.00
SBM7 2000-C3 L B3 B* 2.43 2.14 0.00 0.00 1.63
MSDWC 2001-TOP1 L - B 0.00 0.36 2.50 0.00 0.00
SBM7 2001-C1 M B2 - 0.40 0.00 3.62 0.00 1.77
CSFB 2001-CF2 M B2 B 0.07 0.07 1.08 0.00 0.21
GMACC 2000-C3 M B2 B 0.17 0.00 0.86 0.00 0.54
GMACC 2001-C1 M - B 1.20 0.00 5.32 0.00 0.00
SBM7 2000-C2 L B2 B 0.00 0.00 2.14 4.01 1.93
BACM 2001-1 N B2 B 0.35 0.00 4.66 0.11 1.05
FUNBC 2001-C4 O B2 - 0.00 0.00 0.00 1.51 0.33
BSCMS 2001-TOP2 L - B 0.00 0.00 2.67 0.00 0.00
CCMSC 2000-1 H - B* 0.00 0.84 9.59 1.21 7.45
GMACC 1999-C3 K B2 - 0.35 0.00 7.18 0.00 0.00
LBUBS 2000-C3 M B2 - 0.00 0.00 0.44 0.16 0.92
KEY 2000-C1 M B2 - 0.00 0.00 1.11 0.74 3.09
JPMC 2000-C9 H B1 BB 0.00 0.00 0.46 0.56 0.00
PNCMA 2001-C1 M B2 - 0.00 0.00 0.00 0.00 0.00
GMACC 2000-C2 J - B+* 5.02 0.00 3.16 0.00 0.00
GMACC 2000-C1 L B2 B 0.00 1.46 5.18 0.00 0.50
PMCF 2001-ROCK M B2 B 0.00 0.00 0.00 0.00 0.00
BSCMS 1999-C1 I B2 - 0.81 0.00 1.37 0.00 0.00
MSDWC 2000-LIFE L - B 0.60 0.00 0.38 0.00 1.19
BAFU 2001-3 O - B 0.00 0.00 0.54 0.00 0.00
COMM 2000-C1 K - B* 0.00 0.00 0.00 0.98 0.00
FUBOA 2001-C1 O B2 B 0.29 0.17 0.69 0.00 0.00
CSFB 2000-C1 L - B 0.19 0.00 1.33 0.00 2.05
GECMC 2001-2 L B2 B 0.00 0.00 0.50 0.00 0.50
LBCMT 1999-C1 J B2 - 0.00 0.00 0.67 0.00 0.00
PNCMA 2000-C1 L B2 B 0.29 0.85 2.69 0.00 0.36
JPMCC 2001-CIBC L - B 0.67 0.00 1.31 0.00 0.57
JPMC 1999-C8 H B3 BB- 0.64 0.00 1.69 0.00 0.30
FUNBC 1999-C4 L - B 0.00 0.00 0.17 1.46 1.25
LBUBS 2000-C4 M B2 - 0.00 0.00 0.08 0.00 1.55

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

168
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of B
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current B to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.00 23.89 0.3 2.5 3.5 1.4 0.4
0.00 12.79 1.2 0.0 5.1 2.5 0.5
1.69 29.03 0.8 0.5 2.8 2.0 0.7
0.00 11.36 0.9 0.6 3.2 2.3 0.7
1.49 23.71 0.7 0.0 1.5 1.1 0.7
4.57 15.74 1.5 0.1 3.3 2.5 0.8
0.01 0.00 0.3 0.5 1.7 1.3 0.8
0.00 33.43 0.6 0.2 1.7 1.4 0.8
0.00 29.06 1.2 0.0 2.6 2.2 0.8
1.97 25.19 2.4 0.6 3.7 3.3 0.9
0.85 28.86 1.5 0.1 3.4 3.0 0.9
0.09 19.70 0.8 0.0 3.2 3.2 1.0
1.72 12.96 0.6 0.0 1.3 1.3 1.0
0.00 44.17 5.0 0.0 5.9 6.0 1.0
0.00 19.70 1.4 0.7 1.4 1.4 1.0
1.12 32.68 0.7 0.2 1.1 1.2 1.1
0.00 17.31 1.6 0.2 2.1 2.2 1.1
0.66 35.79 0.5 2.0 3.3 4.1 1.3
0.84 12.75 0.1 0.5 1.4 1.8 1.3
0.00 24.86 0.9 1.0 2.3 2.9 1.3
1.20 21.17 1.4 0.0 1.7 2.3 1.4
0.25 5.57 0.0 0.4 1.0 1.4 1.4
0.00 13.92 0.4 0.6 0.7 1.0 1.4
0.00 16.04 0.6 0.4 1.2 1.7 1.5
0.00 15.60 0.2 0.6 1.7 2.5 1.5
0.36 44.34 0.7 0.7 1.6 2.7 1.6
3.53 26.32 0.4 0.2 1.4 2.3 1.7
0.56 20.04 1.1 0.0 1.3 2.2 1.7
0.00 25.26 0.5 0.1 1.2 2.2 1.7
1.76 29.61 0.4 0.4 0.5 1.0 1.9
0.83 23.23 0.9 0.2 1.2 2.4 1.9
6.50 0.00 0.6 0.1 1.3 2.5 1.9
0.67 18.81 0.5 2.5 2.1 4.2 2.0
1.02 22.95 1.1 0.1 1.5 3.1 2.1
3.46 19.85 0.7 0.0 0.9 1.8 2.1

Please see additional important disclosures at the end of this report. 169
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 17 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
BSCMS 2000-WF1 K - B 0.00 0.64 0.00 0.00 0.46
BSCMS 2000-WF2 L - B 2.04 0.00 2.01 0.00 0.00
CSFB 2001-CKN5 N B2 - 0.00 0.00 0.00 0.50 0.00
LBUBS 2000-C5 K B1 B* 0.00 0.00 2.40 0.00 0.47
LBCMT 1999-C2 L B2 - 0.00 0.00 0.36 0.98 1.10
GSMS 1999-C1 G B3 - 0.23 0.00 4.91 0.52 0.25
JPMC 2000-C10 L B2 B 0.00 0.00 1.10 0.00 0.38
CSFB 2001-CK1 M B2 - 0.15 0.12 0.00 0.00 0.21
HFCMC 2000-PH1 L B2 B 1.31 0.10 0.72 0.00 0.29
CSFB 2001-CK6 N B2 - 0.19 0.97 0.01 0.00 0.00
LBUBS 2001-C2 M B2 B 0.00 0.20 0.33 0.00 0.00
SBM7 2001-C2 N B2 - 1.67 0.79 0.00 0.00 0.00
GECMC 2001-3 L - B 0.00 0.00 0.00 0.85 0.00
DLJCM 1999-CG1 B7 - B 0.93 0.00 0.95 0.00 1.22
CMAT 1999-C1 K B2 - 0.66 0.00 2.20 0.00 1.28
GECMC 2001-1 L B2 - 0.86 0.00 0.20 0.00 0.00
CSFB 1999-C1 K - B 0.13 1.51 0.10 0.58 2.91
FUNBC 2001-C2 O B2 - 0.00 0.00 0.00 0.22 0.32
FUNBC 2000-C1 L - B 0.00 0.00 0.00 0.00 0.00
DLJCM 2000-CF1 B7 - B 0.30 6.34 0.22 0.00 0.23
MLMI 1999-C1 G - B 1.14 0.00 2.92 4.82 3.15
GMACC 1999-C2 K B2 - 0.00 0.00 5.66 0.00 0.00
MCFI 1998-MC2 J - B- 0.00 0.00 0.00 0.00 0.48
CSFB 2001-CK3 M - B- 0.00 0.00 0.10 0.00 0.00
FUNCM 1999-C2 L B2 B 0.00 0.00 1.33 0.00 0.00
PSSF 1999-NRF1 K B2 - 0.00 0.00 0.00 0.48 0.00
CCMSC 2000-3 K - B* 0.35 0.00 1.43 0.50 0.00
MSC 1999-FNV1 K - B 0.27 0.00 3.08 1.58 2.58
JPMCC 2001-CIB2 L - B 0.00 0.00 0.00 0.00 0.51
BSCMS 2001-TOP4 L B2 - 0.00 0.00 0.49 0.00 0.00
GMACC 2001-C2 N - B 0.00 0.00 0.56 0.00 0.00
DLJCM 1999-CG2 B7 - B 0.07 0.00 1.88 0.13 1.67
MSDWC 2001-TOP3 L B2 B 0.00 0.00 0.50 0.00 0.00
MSDWC 2001-TOP5 L B2 - 0.00 0.00 0.00 0.00 0.00
SBM7 2000-C1 M B2 - 0.55 0.00 1.83 0.00 0.64

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

170
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of B
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current B to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
1.07 7.50 0.3 0.2 0.6 1.2 2.1
0.00 13.53 0.5 0.0 0.6 1.3 2.1
0.00 19.13 0.3 0.1 0.9 2.0 2.2
0.65 19.95 0.7 0.0 1.6 3.7 2.3
0.00 22.92 0.9 0.0 0.6 1.4 2.3
0.38 28.35 1.3 0.9 1.5 3.5 2.3
2.19 12.83 0.4 0.3 1.0 2.3 2.4
0.00 31.82 0.3 0.0 0.7 1.8 2.5
0.91 21.30 0.4 0.5 1.1 2.8 2.5
0.70 15.07 0.2 0.0 0.9 2.5 2.7
0.17 29.40 0.3 0.0 0.7 1.8 2.7
0.00 12.43 0.2 0.0 0.9 2.6 2.8
0.00 24.70 0.5 0.0 1.0 2.8 2.8
0.26 32.28 0.8 0.6 0.9 2.7 2.9
0.63 15.31 1.0 0.2 0.8 2.3 3.0
1.42 27.03 0.3 0.0 0.7 1.9 3.0
7.00 17.35 1.5 0.4 1.2 3.6 3.0
0.75 25.88 0.4 0.0 0.8 2.6 3.1
2.11 33.34 0.3 0.4 0.9 2.8 3.1
2.26 23.10 0.9 0.0 1.0 3.3 3.2
0.18 18.95 3.1 0.0 2.1 6.8 3.2
0.00 15.12 1.1 0.0 0.8 2.4 3.2
0.80 26.08 0.3 1.3 0.5 1.5 3.2
0.76 23.92 0.2 0.0 0.5 1.6 3.2
0.63 33.13 0.5 0.6 0.7 2.5 3.3
0.21 23.83 0.3 0.5 0.6 2.1 3.4
0.65 24.90 0.7 0.0 0.8 2.6 3.4
0.36 18.54 2.0 0.1 1.4 4.8 3.4
0.62 15.11 0.3 0.0 0.7 2.4 3.4
0.00 10.81 0.2 0.0 0.4 1.3 3.5
0.00 30.04 0.4 0.0 0.7 2.6 3.5
0.60 28.22 1.1 0.2 0.8 3.1 3.6
0.00 7.88 0.2 0.0 0.3 1.2 3.7
0.00 9.77 0.1 0.0 0.3 1.3 3.9
2.12 16.74 0.7 0.0 0.9 3.4 4.0

Please see additional important disclosures at the end of this report. 171
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 17 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
BSCMS 1999-WF2 J - B+ 0.00 0.00 1.01 0.00 0.49
GMACC 1999-C1 H - B 0.00 0.00 2.47 0.00 0.00
PMAC 1999-C1 F B3 - 0.00 0.00 0.51 1.64 1.20
DMARC 1998-C1 G - B 0.10 0.00 0.00 2.17 1.02
MSC 1999-LIFE1 M - B 0.00 0.00 0.00 1.75 0.00
MLMI 1998-C3 F - B+* 0.00 2.51 0.00 0.00 0.00
MSC 1998-CF1 D Ba2 B* 1.37 0.10 0.92 4.07 0.26
DLJCM 1999-CG3 B7 B2 B 0.95 0.00 1.17 0.30 0.37
CSFB 2001-CP4 M - B 0.00 0.00 0.00 0.00 0.00
JPMCC 2001-CIB3 L - B 0.00 0.00 0.00 0.00 0.00
COMM 1999-1 J - B 0.00 0.00 0.33 1.25 1.19
PSSF 1999-C2 M - B* 0.00 0.00 0.00 0.93 0.57
MLMI 1997-C2 H - B 0.74 0.00 2.65 1.02 0.22
MLMI 1998-C2 F - B* 0.29 0.27 1.34 0.00 1.53
FUCMT 1999-C1 G B3 B* 0.00 0.00 0.00 0.24 0.32
MSC 1998-HF1 J - B* 0.00 0.00 1.23 0.00 0.00
FUNBC 2001-C3 N - B 0.00 0.00 0.18 0.00 0.00
CCMSC 2000-2 K B2 - 0.00 0.86 0.00 0.00 0.00
CASC 1998-D7 B4 - B- 0.00 0.13 1.20 2.30 0.48
LBUBS 2001-C3 M - B 0.00 0.00 0.00 0.00 0.00
FUNBC 2000-C2 K - B* 0.34 0.00 0.00 1.21 0.07
CSFB 1998-C1 G - B* 1.85 0.78 1.18 1.05 0.97
BACM 2000-2 N B2 - 0.00 0.00 0.00 0.00 0.17
PNCMA 1999-CM1 B7 - B* 0.54 0.17 0.00 0.00 0.00
LBUBS 2001-C7 N B2 - 0.00 0.00 0.10 0.00 0.00
MCFI 1998-MC1 L - B* 0.76 0.00 1.25 0.48 0.07
BACM 2000-1 L B2 - 0.00 0.00 1.68 0.00 0.00
CSFB 1998-C2 H B2 B 0.53 0.00 0.00 0.86 0.00
AMC 1998-C1 G - B 0.00 0.00 1.24 0.00 0.97
MSDWC 2000-LIF2 M B2 B 0.00 0.00 0.00 0.00 0.00
GMACC 1997-C2 F B2 - 0.00 0.00 1.55 0.00 3.86
CCMSC 1998-1 H B3 - 0.00 0.00 0.00 0.00 0.00
JPMC 1998-C6 G - B- 0.00 0.63 8.23 0.00 0.00
CMAC 1998-C2 J - B 0.78 0.00 3.15 0.00 0.00
LBCMT 1998-C1 J - B 0.15 0.23 1.71 0.00 0.16

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

172
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of B
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current B to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.00 6.62 0.4 0.4 0.5 2.1 4.1
1.72 0.00 0.4 0.8 0.8 3.4 4.1
2.21 21.36 1.1 1.0 1.5 6.1 4.2
1.74 23.83 1.0 3.5 1.4 5.8 4.2
0.00 22.61 0.7 0.0 0.5 2.1 4.4
0.00 28.53 0.4 2.8 0.9 4.3 4.6
6.11 21.83 1.6 5.7 2.2 10.4 4.8
0.92 36.30 0.8 0.1 0.5 2.6 4.8
3.27 15.48 0.2 0.0 0.5 2.3 4.9
0.00 14.56 0.1 0.0 0.5 2.4 4.9
2.74 31.76 1.1 0.0 0.8 4.0 5.3
0.00 22.47 0.6 0.3 0.6 3.4 5.3
1.71 31.03 1.0 0.7 0.5 2.6 5.3
1.91 0.00 0.6 2.1 0.8 4.5 5.4
1.73 21.73 0.4 0.5 0.6 3.1 5.4
0.91 16.57 0.3 1.0 0.4 2.0 5.5
1.37 27.50 0.3 0.0 0.6 3.4 5.5
0.00 34.33 0.4 0.0 0.4 2.3 5.6
0.00 11.08 1.1 0.6 0.5 2.7 5.7
1.01 18.90 0.2 0.0 0.4 2.1 5.7
0.53 21.55 0.6 0.0 0.7 4.3 5.9
2.61 29.66 1.2 1.3 0.7 4.1 6.1
0.00 34.89 0.3 0.1 0.5 3.3 6.1
0.90 15.41 0.2 0.5 0.4 2.7 6.2
0.00 6.31 0.1 0.0 0.3 1.8 6.2
0.00 26.40 0.6 1.3 0.5 3.1 6.3
4.88 8.70 0.4 0.1 0.6 4.0 6.7
3.38 20.39 0.5 0.9 0.4 2.4 6.8
0.00 23.48 0.6 1.4 0.6 4.2 6.8
0.00 20.34 0.2 0.0 0.2 1.4 6.9
3.05 35.75 1.5 1.9 1.1 7.3 6.9
0.00 25.45 0.2 0.7 0.3 1.8 7.1
0.00 18.99 1.5 0.0 0.4 2.9 7.1
0.98 11.93 0.6 0.7 0.4 2.5 7.2
1.46 31.78 0.6 1.1 0.5 3.4 7.2

Please see additional important disclosures at the end of this report. 173
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 17 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
HFCMC 1999-PH1 L B2 B 0.38 0.00 1.69 0.00 0.00
NLFC 1998-1 H - B 0.25 0.37 3.66 0.00 0.00
GSMS 1998-C1 G - B+ 0.07 0.00 1.52 1.15 1.50
CMAT 1999-C2 M B2 - 0.00 0.00 0.67 0.00 0.00
NLFC 1998-2 H - B-* 0.52 0.07 1.33 0.00 0.58
NLFC 1999-1 H B2 B 0.00 0.00 0.00 0.45 0.00
CMFUN 1999-1 K - B* 0.00 0.00 0.22 0.00 0.25
SBM7 1999-C1 K - B 0.00 0.00 2.64 0.00 0.00
DLJCM 1998-CG1 B6 - B 0.66 0.81 0.44 0.00 0.00
MCFI 1998-MC3 H B2 - 0.32 0.23 0.29 0.00 1.39
JPMC 1999-C7 G - B 0.12 0.00 0.00 0.00 1.11
PNCMA 2000-C2 M B2 - 0.00 0.00 0.19 0.00 0.00
FULBA 1998-C2 J B1 - 0.43 0.57 0.00 0.20 1.09
MSC 1998-WF1 J - B* 0.00 0.00 0.39 1.70 0.00
FULB 1997-C2 J - B-* 1.17 0.18 1.40 0.00 1.93
CCMSC 1999-2 K - B 2.65 0.00 0.00 0.00 0.00
GMACC 1998-C2 K - B 0.11 0.78 1.41 0.00 0.00
DLJCM 1998-CF2 B-5 - B 0.08 0.00 0.00 0.77 0.00
CCMSC 1997-1 H - B-* 0.00 0.00 0.96 0.00 4.15
MSC 1998-HF2 K - B 0.00 0.00 0.83 0.00 0.48
CMAC 1998-C1 K - B* 0.24 0.00 0.36 0.00 0.00
MSC 1999-RM1 L B2 B 0.00 0.00 0.00 0.00 0.56
CCMSC 1998-2 H - B 0.00 0.00 0.69 0.00 0.00
NASC 1998-D6 B-5 - B 0.12 0.00 1.38 0.43 0.00
PSSF 1998-C1 K - B+ 0.00 0.00 0.24 0.22 0.00
JPMC 1997-C5 F - B+* 0.00 0.71 2.96 0.00 0.00
CMAC 1999-C1 M B2 - 0.96 0.89 0.00 0.00 0.00
LBCMT 1998-C4 K B2 - 0.51 0.00 0.13 0.87 0.17
DLJCM 1998-CF1 B6 - B* 0.00 0.00 0.72 0.00 0.00
CCMSC 1997-2 H - B 0.56 0.00 4.11 0.00 0.00
GMACC 1997-C1 G - B+* 2.11 0.00 0.22 0.00 0.82
MLMI 1997-C1 F - B* 0.00 0.00 5.97 0.75 1.68
DLJMA 1997-CF2 B3TB B1 - 0.00 0.00 3.69 10.73 0.00
ASC 1997-D4 B3 - B+* 0.91 0.00 3.14 0.00 2.20
MSC 1997-C1 H B3 B+ 0.00 0.00 0.00 0.00 2.00

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

174
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of B
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current B to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
0.43 17.49 0.4 0.1 0.4 2.9 7.4
1.15 15.17 0.7 0.8 0.5 3.6 7.9
0.94 17.17 1.2 1.4 0.7 5.6 8.0
0.30 0.00 0.1 0.4 0.3 2.5 8.2
1.07 6.11 0.5 0.8 0.3 2.8 8.3
0.75 25.83 0.3 0.3 0.5 4.1 8.5
0.00 18.87 0.3 0.2 0.3 2.5 9.1
0.00 19.05 0.6 0.0 0.4 3.6 9.1
1.91 26.87 0.4 0.5 0.3 2.3 9.1
0.66 26.23 0.7 0.3 0.7 6.7 10.0
0.00 30.16 0.6 0.0 0.4 4.0 10.3
0.00 22.49 0.2 0.0 0.3 2.7 10.3
5.37 17.25 0.6 0.7 0.4 3.9 10.3
2.61 24.22 0.7 0.2 0.3 3.0 10.8
2.59 20.51 0.9 0.9 0.2 2.8 11.2
2.45 34.80 0.4 0.0 0.3 2.9 11.2
1.09 23.40 0.5 0.3 0.2 2.5 11.4
0.00 37.73 0.5 0.5 0.3 3.2 11.9
0.00 15.47 1.2 0.4 0.2 3.0 12.4
3.16 23.68 0.5 0.5 0.3 3.5 12.5
0.49 27.78 0.3 0.5 0.2 2.8 12.9
0.00 0.00 0.2 0.3 0.3 4.0 13.1
0.00 17.37 0.3 0.4 0.2 2.3 13.9
0.79 14.66 0.5 0.1 0.1 2.1 14.2
0.50 13.85 0.2 0.6 0.2 3.5 14.6
0.40 22.67 0.5 2.0 0.4 6.7 16.0
0.55 16.22 0.2 0.0 0.2 2.7 17.5
0.90 29.33 0.6 0.0 0.2 2.8 17.9
0.93 20.71 0.3 0.3 0.2 2.8 18.0
0.96 23.76 0.7 0.5 0.2 3.1 18.3
0.85 23.45 0.4 1.9 0.3 6.6 19.3
7.13 29.11 1.2 1.0 0.4 8.8 20.3
0.00 21.29 3.5 0.3 0.5 11.4 22.3
7.41 6.60 1.2 0.6 0.2 5.6 23.1
1.92 23.76 0.5 0.8 0.3 6.2 24.6

Please see additional important disclosures at the end of this report. 175
Transforming Real Estate Finance
chapter 9 CMBS Conduit Subordination Levels

exhibit 17 1997-2001 CONDUIT DEALS


RANKED BY SUBORDINATION-TO-LOSS RATIO
(34% SEVERITY; AVERAGE DEFAULT TIMING CURVE)
(CONTINUED)

Current Current
Moody’s Fitch 30 Days 60 Days 90 Days FOR. REO
Deal Name Class Rating Rating Del (%) Del (%) Del (%) (%) (%)
FULB 1997-C1 H - B-* 0.00 0.74 1.35 1.40 0.73
ACMF 1997-C1 J - B 9.58 0.00 6.74 0.00 0.00
MCFI 1997-MC2 H - B 0.00 0.00 1.41 0.00 0.00
ASC 1997-D5 A6 - B 0.00 0.00 0.00 2.90 0.88
CSFB 1997-C1 G - B* 0.00 0.00 2.67 0.19 0.00
GMACC 1998-C1 J - B 0.00 0.31 0.18 0.00 0.00
MSC 1997-HF1 H - B 0.00 1.17 1.52 0.00 0.00
MSC 1999-WF1 L B2 - 0.00 0.00 0.00 0.00 0.00
NLFC 1999-2 H - B* 0.00 0.00 0.00 0.00 0.00
MSC 1998-WF2 K - B+ 0.00 0.00 0.00 0.00 0.00
MSC 1997-WF1 H - B* 0.00 0.00 0.00 0.00 0.00
JPMC 1997-C4 G - B* 0.00 0.00 0.43 0.00 0.00

Source: Morgan Stanley, Trepp, Bloomberg


* S&P Rating

176
Future
Expected Loss Expected
for Currently Losses, Based
Delinquent, on Historical
Watchlisted Losses and
or Performing Exp. Loss for Ratio of B
Perf. Specially Historical Current Subordination
Spec. Serviced Cumulative Delinquency Current B to Future
Serv. Watchlist Loans (% of Loss (% of Levels (% of Subordination Expected
(%) (%) orig. bal.) orig. bal.) curr. bal.) (%) Loss
2.69 23.65 0.8 0.3 0.2 4.5 25.0
0.00 32.57 1.1 0.0 0.2 5.1 26.6
2.21 19.53 0.4 0.6 0.1 3.4 27.1
0.82 16.78 1.2 1.6 0.3 9.2 27.2
9.08 18.31 0.6 0.9 0.2 6.0 27.4
18.01 0.00 0.3 0.3 0.2 5.1 29.4
0.00 0.00 0.2 0.4 0.1 3.9 33.9
0.00 2.90 0.0 0.1 0.1 2.2 35.8
1.45 19.41 0.1 0.0 0.0 3.8 85.9
1.18 11.26 0.1 0.0 0.0 3.2 118.2
2.12 6.03 0.1 0.0 0.0 3.9 434.0
0.00 0.00 0.0 0.0 0.0 5.6 678.9

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178
Chapter 10

Transforming Real Estate Finance


Multifamily MBS

Please see additional important disclosures at the end of this report. 179
Transforming Real Estate Finance
chapter 10 Multifamily MBS

FANNIE M AE
In addition to “private-label” CMBS, the CMBS market also encompasses multi-
family agency securities, issued by Fannie Mae, Ginnie Mae and Freddie Mac.
The single largest issuer of multifamily MBS is Fannie Mae.
The main Fannie Mae program is Delegated Underwriting and Servicing (DUS).
THE F ANNIE M AE D US P ROGRAM
Fannie Mae created the DUS program in 1988 to streamline the underwriting
process and help fulfill its commitment to multifamily housing. Under the pro-
gram, specially approved lenders may underwrite, close, service and sell mort-
gages to Fannie Mae without prior review by Fannie Mae. DUS lenders benefit
from this special relationship because they have greater autonomy in underwrit-
ing and servicing and can also be more competitive given that DUS loan rates
are lower than in the prior approval program. Before this program, the process
was lengthier given that the agency had to underwrite and approve the transac-
tion in advance of purchase.
CHARACTERISTICS O F D US L OANS
Loans originated under the DUS program are generally either fixed-rate balloon
mortgages with 5-, 7-, 10-, or 15-year terms or fixed-rate fully amortizing loans
with 25- or 30-year terms. Variations, such as 20-year fully amortizing loans, are
also permissible. The loans are secured by mortgages on income-producing, mul-
tifamily rental or cooperative buildings with at least five units and with occupan-
cy rates of at least 90%. The buildings may be existing or recently completed
and may require moderate rehabilitation.
Loan amounts are $1 million to $50 million. There is always a loss sharing agree-
ment between Fannie Mae and DUS lenders in case of default. Loans must have
been originated within 6 months of Fannie Mae’s purchase.
PREPAYMENT P ROTECTION
One of the main advantages of multifamily securities over residential MBS is the
prepayment protection on multifamily loans. Most DUS loans have yield mainte-
nance premiums in the event of an early prepayment. The premium is usually
yield maintenance calculated at the relevant treasury rate, or “Treasuries flat.”
Common yield maintenance terms are:
• Balloon Term (years) Yield Maintenance Term (years)
5 3 or 4.5
7 5 or 6.5
10 7 or 9.5
15 10
30 10

180
After the yield maintenance period ends, the borrower is still required to pay a
1% premium on prepayment which is retained by Fannie Mae. This premium is
waived during the last 90 days of the loan term to facilitate refinancing.
Curtailments are not allowed and, consequently, the borrower is faced with the
choice of either prepaying the entire loan balance or not at all.
Prepayment fees are passed through to the investor by Fannie Mae only to the
extent they are received from the borrower. Fannie Mae’s obligation extends only
to the outstanding principal balance of the security, i.e., if an MBS DUS defaults
as a premium security, the investor receives a minimum of par but may lose
some or all of the premium.
Most DUS loans can be assumed by a new, and creditworthy, borrower on pay-
ment of a 1% assumption fee that is not passed through to the investor. Given
that the pricing speed assumption of DUS is usually 0% CPR, the assumability
option does not add any negative convexity to the security.
The prepayment fee actually due from the borrower is calculated by substituting
the note rate for the coupon in the above calculation. The difference between the
fee received and the fee paid to the investor is shared by FNMA and the lender.
UNDERWRITING
DUS lenders have strong incentives to underwrite high quality loans. First and
foremost, Fannie Mae monitors the performance of their DUS lenders. In addi-
tion, when a DUS loan defaults, losses up to the first 5% of the UPB are borne
solely by the lender and losses in excess of 5% are shared by Fannie Mae and the
lender according to a formula. The lender’s share of the loss is limited to 20-40%
of the UPB. The yield maintenance premium is also part of the loss computation
giving the lender a vested interest in enforcing payment of the premium.
For pricing and underwriting purposes, Fannie Mae categorizes DUS loans into
one of four credit “tiers” based on debt service coverage and loan-to-value
ratios. Tier 4 loans have the highest credit quality, while Tier 1 loans have the
lowest. Most DUS loans tend to fall into the middle two tiers. Tier 1 loans are
extremely rare. Fannie Mae may also designate loans with a ‘+’ in each category,
based on subjective criteria such as property location and management. A ‘+’
reduces the guarantee fee by about 10 bp.

exhibit 1 DUS UNDERWRITING TIERS

Minimum Debt Maximum


Service Coverage Ratio Loan-to-Value Ratio
Tier 1 1.15 80%
Tier 2 1.25 80%
Tier 3 1.35 65%
Tier 4 1.55 55%

Note: Most DUS loans are in Tier 2 or Tier 3.


Source: Fannie Mae

Please see additional important disclosures at the end of this report. 181
Transforming Real Estate Finance
chapter 10 Multifamily MBS

FANNIE M AE D MBS
In 1996, Fannie Mae began issuing discount MBS (DMBS) as a means of selling
multifamily loans in the secondary mortgage market. Fannie Mae started routine-
ly securitizing multifamily loans on a programmatic basis in 1994, but these secu-
rities did not possess the characteristics of DMBS.
DMBS C HARACTERISTICS
DMBS are Fannie Mae’s only short-term, non-interest bearing securities that are
collateralized by mortgages. Since DMBS are non-interest bearing securities, they
are sold to investors at a discount and repaid at par upon maturity.
DMBS maturities generally range between three and nine months, with occasional
exceptions.

exhibit 2

DMBS ISSUANCE

Notes: 1As of February 1, 2002.


Issuance volumes prior to 2000 only represent DMBS with 3-month maturities.
Source: Fannie Mae

To date, almost all DMBS issuance has consisted of three-month securities. Since
DMBS were first issued in 1996, more than $18 billion securities have been sold.
During 2001, DMBS issuance totaled $8.6 billion, a 38% increase over issuance
in 2000. Despite low interest rates, many borrowers chose to maintain financial
flexibility by using short term financing. For 2002, Fannie Mae projects DMBS
issuance to be close to 2001 levels. As of February 1st, 2002, Fannie Mae issued
$681 million of DMBS.
FANNIE M AE G UARANTEE
DMBS, like all other Fannie Mae securities, carry Fannie Mae’s guarantee of full
and timely payment of principal. DMBS are not rated by the rating agencies but
are equivalent to agency credits. In the event of a principal shortfall, payments
on DMBS are pari passu with other senior debt of Fannie Mae.

182
LOAN C HARACTERISTICS
While single-asset executions are available, DMBS are most often secured by
a pool of cross-collateralized, cross-defaulted, first-lien mortgages on income-
producing residential properties with at least 5 units. These multifamily mort-
gages are typically underwritten to conform to the Fannie Mae Delegated
Underwriting and Servicing (DUS) requirements.
DMBS loans tend to be more conservative than multifamily loans in conduit
transactions, in terms of loan-to-value (LTV) ratios and debt service coverage
ratios (DSCR). LTVs on DMBS collateral range between 50% and 75%, while
DSCRs typically range between 1.65X and 1.30X. In typical CMBS conduit
transactions, multifamily loans tend to have 1.25X DSCR and 75% LTVs.
The loans supporting DMBS are extended to borrowers, such as REITs and pen-
sion funds, under a credit facility agreement. The credit facility provides borrow-
ers with short-term advances that are funded by the sale of DMBS. Borrowers
receive proceeds from DMBS issuance, which are determined by market dis-
count. These loans mimic variable-rate financing, as they may be “rolled” every
few months when the DMBS mature. The facility term may be 5, 7 or 10 years
in length.
In Exhibit 3, we have illustrated an example where a borrower requests a short-
term advance of $100 million, with $200 million of multifamily properties as
collateral. Fannie Mae issues $100 million of DMBS, and the market discount of
0.5% on the securities results in the borrower receiving $99.5 million.

exhibit 3

MULTIFAMILY
CREDIT FACILITY

1
Assumes $99.5MM discounted proceeds from sale of DMBS.
Source: Fannie Mae

Please see additional important disclosures at the end of this report. 183
Transforming Real Estate Finance
chapter 10 Multifamily MBS

At maturity, the investor will receive $100 million, via proceeds from new DMBS
issuance, or a payoff by the borrower.
PREPAYMENTS A ND D EFAULTS
DMBS are locked out from prepayments for their entire term and, therefore,
have no prepayment risk. Default risk is also non-existent to DMBS investors, as
Fannie Mae guarantees payments of principal when due. To date, there have
been no defaults, but in the case of default, Fannie Mae would pay DMBS
investors par at maturity.
TRADING L EVELS
Discounts on new issue three-month DMBS may be converted to annualized
yields or spreads to LIBOR. Historically, three-month DMBS have yielded
LIBOR less 15-16 bp. During the first few weeks of 2002, three-month DMBS
have been issued with average yields of LIBOR – 6 bp.
In the secondary market, Morgan Stanley traded nearly $5 billion of DMBS in
2001, and $700 million in 2002 YTD. We estimate that Morgan Stanley is
involved in 20-25% of DMBS trades in the secondary market.

exhibit 4

DMBS TRADES:
THREE-MONTH
MATURITY

Source: Fannie Mae

INVESTOR B ASE
DMBS are purchased primarily by money market investors who view these secu-
rities as an attractive alternative to Treasury Bills.
Fannie Mae DMBS are similar to Treasuries, in that they are permitted invest-
ments for federally supervised institutions and for trusts and funds invested
under the authority of the U.S. DMBS can also be purchased in unlimited
amounts by national banks, federally chartered credit unions and federal savings
and loans associations.

184
GINNIE M AE/FHA
Within the agency multifamily market, the second largest issuer in the agency
market is the Government National Mortgage Association (GNMA). Project
loans may be made under a number of Housing and Urban Development
Department (HUD) programs, including:
• 221(d)4: Construction or permanent financing
• 223(f): Refinancing
• 223(a)7: Accelerated refinancing
• 232: Nursing home/assisted living
• 241(f): Equity take-out second mortgage
All Ginnie Mae securities are backed by loans originated by the Federal Housing
Administration (FHA) and are either permanent loan certificates (PLCs) or con-
struction loan certificates (CLCs).
PLCs are usually 35-year fully amortizing fixed-rate mortgages. Prepayment pro-
tection is either (1) a 5-year lockout followed by declining penalty points (5, 4, 3,
2, 1) over the next five years or (2) a 10-year lockout. Many PLCs begin as CLCs
and are converted to PLCs upon completion of the construction project. CLCs
trade at wider spreads than PLCs because of liquidity and uncertainty associated
with funding a construction loan.
Exhibit 5 shows some of the major differences between Ginnie Mae and FHA
project loans:

CHARACTERISTICS OF GINNIE MAE AND FHA


exhibit 5 PROJECT LOANS
Ginnie Mae FHA
Government guarantee Explicit Implicit
Principal payment
in case of default 100% 99%
Delay days 44 54
Delivery PTC Physical
Data on Bloomberg Yes No

Source: Fannie Mae

Effective April 1, 1997, Ginnie Mae reduced pool processing time from 10 days
to 5 days and added other features to streamline its multifamily MBS program.1

1
See inside MBS & ABS, May 1, 1997, p.3.

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Transforming Real Estate Finance
chapter 10 Multifamily MBS

exhibit 6 A PROFILE OF GINNIE MAE MULTIFAMILY MBS


Issuer Ginnie Mae approved mortgage lender
Issue Type GNMA I
Underlying
Mortgages FHA Insured multifamily mortgages
Pool Types Construction Loan Securities
(CL) Security rate remains constant with conversion
to permanent loan
(CS) Security rate changes with conversion to permanent
loan Project Loan Securities
(PL) Level payment permanent securities
(PN) Non-level payment permanent securities
(LM) Securities for Mature Loans. Loans pooled after more
than 24 months of amortization
(LS) Securities for Small Loans. Loans of no more than $1MM
Securities
Interest Rate Fixed; at .25 to .50 percent below the interest rate of the
underlying mortgage(s)
Guaranty Full and timely payment of principal and interest
Guarantor Ginnie Mae (full faith and credit of the United States)
Principal
and Interest Paid monthly to securities holders
Maturity Varies, typically 40 years
Minimum
Certificate Size $25,000 (may be less for aged securities)
Transfer Agent Chase (formerly Chemical Bank)
Source: Reprinted from Ginnie Mae website, www.ginniemae.gov, 1997

FREDDIE M AC
Freddie Mac, a large issuer in the 1980s, reduced its role in the multifamily
securitization market in the 1990s. The agency has recently begun to increase its
multifamily loan production.

186
PROGRAM P LUS
Freddie Mac’s Program Plus is similar to Fannie Mae’s DUS program. Under the
program, Freddie Mac pre-approves multifamily lenders with “local market
expertise.” Since 1993, Freddie Mac has financed $5.3 billion (1,400 properties)
under Program Plus.
To be eligible for Program Plus, loans must be between $5 million and $50 mil-
lion and have the following characteristics:
• Terms of 7, 10, 15, 20, or 25 years
• Amortization period of 20, 25, or 30 years
• Maximum LTV of 75%
• Minimum DSCR of 1.3
The yield maintenance terms of the loans are:
• Term(years)/Yield Maintenance(years)
7/6.5 10/9.5 15/14 20/15

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188
Chapter 11

Transforming Real Estate Finance


Floating Rate Large Loan CMBS

Please see additional important disclosures at the end of this report. 189
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

In this chapter, we examine three aspects of floating rate CMBS. In Section I,


we examine the incidence of extensions in the floating rate large loan universe.
In Section II, we examine whether floating rate CMBS deals are inclined to
experience a negative ratings drift over time. In Section III, we describe the
mechanics of available funds caps in the context of a hypothetical floating rate
CMBS structure.

Section I: Floating Rate Large Loan Extensions


MOTIVATIONS F OR E XTENDING
In this section, we examine the incidence of extensions in the floating rate large
loan universe as well as the motivations for exercising extension options (i.e.,
credit vs. non-credit related reasons). Our main findings are that nearly a quarter
of loans exercised extension options at maturity, and that the majority of exten-
sions were motivated by credit issues.
Floating rate loans within CMBS transactions typically have a substantial princi-
pal balance remaining at the time of maturity. In order to repay this balance, a
borrower may refinance the loan or sell the underlying property. If the loan’s
terms include an extension option, the borrower may instead choose to post-
pone repayment of the loan.
Whereas a borrower’s incentive to prepay a loan in the residential mortgage mar-
ket is heavily dependent on prevailing interest rates, a borrower’s incentive to
extend a loan in the commercial mortgage market is predominantly driven by
credit-related issues.
A borrower’s decision to extend a loan could be a result of credit problems, such
as the property’s weak financial condition or deterioration in the property’s oper-
ating performance.
The borrower may also need to extend for a variety of other reasons, unrelated
to credit. For example, the borrower may find refinancing prior to the loan’s
maturity, but need to extend because the new loan’s closing date is beyond the
original loan’s maturity date. Another possibility is that the borrower believes
that the underlying property’s financial performance could improve over the next
year and allow the borrower to refinance at lower rates than the property cur-
rently allows. Additionally, improved financials could result in higher valuations,
which may result in additional proceeds to the borrower. If commercial lending
is scarce, the borrower may also have a difficult time finding refinancing and
need to extend.

190
There also may be some instances in which the level of interest rates motivates
the borrower to extend. That is, the borrower holds the view that interest rates
will decline in the coming year, allowing the borrower to access cheaper rates in
the future.
23% O F L OANS E XERCISE E XTENSION O PTIONS A T M ATURITY
For our analysis, we examined the universe of floating rate large loan CMBS
issued since January 2000. The majority of loans within this sample were issued
with extension options. Extendable loans account for 69% of the universe, based
on loan count, and 86% of the universe, based on loan balance. To date, about
half of the extendable loan balances have reached maturity. Of the extendable
loan balances that have reached maturity, 23% have extended. Based on loan
count, the results were similar, with 27% of loans exercising extension options.

exhibit 1

LOAN
EXTENSIONS
WITHIN FLOATING
RATE CMBS
(BASED ON
ORIGINAL
BALANCE)

Source: Morgan Stanley, Intex, Trepp

COMPOSITION O F E XTENDED L OANS


In all, we found 112 matured loans that exercised extension options. Office loans
accounted for nearly half of the extended loan pool, while hotel loans accounted
for 16% of the loans, and multifamily loans accounted for 14% of the loans.
Although office loans comprise a large portion of the extended loan pool, they
did not experience the highest extension rate of the major property types.

Please see additional important disclosures at the end of this report. 191
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

exhibit 2

PROPERTY TYPES
OF EXTENDED
LOANS BASED ON
SECURITIZED
LOAN BALANCES

1
Includes industrial, manufactured housing, mixed use, and senior housing loans.
Source: Morgan Stanley, Intex, Trepp

HOTEL L OANS E XPERIENCE H IGHEST E XTENSION R ATE


While we found that on average, 23% of loan balances exercised extension
options, we found that this experience varied depending on collateral type. For
example, based on loan balances, hotel loans exercised 40% of extension options,
while retail loans exercised 8%. (See Exhibit 3)

exhibit 3 EXTENSION RATES BY PROPERTY TYPE


(BASED ON ORIGINAL BALANCE)

Property Type Extension Rate (%)1


Hotel 40
Office 30
Multifamily 18
Retail 8
Other2 13
Total 23
1
Represents percentage of loans that exercised extension options at maturity.
2
Includes industrial, manufactured housing, mixed use, and senior housing loans.
Source: Morgan Stanley, Intex, Trepp

This observation is not surprising since we also determined that the majority of
extended loans (68%) chose to extend for credit-related reasons. Over the past
couple of years, the retail sector has remained healthy, while the hotel sector has
suffered a downturn. As a result, we found the higher incidence of hotel loan
extensions to be linked to deterioration in operating performance and lower occu-
pancy rates.

192
METHODOLOGY
In order to determine the rate at which borrowers exercise extension options on
floating rate large loans, we examined floating rate large loan CMBS transactions
that were issued since January 2000. We identified 76 floating rate loans within
this universe that were flagged with a CMSA modification code of 1 (maturity
date extension) or CMSA workout code of 4 (extension) in Trepp or Intex.
Unfortunately, the servicer files, which are the source for this extension informa-
tion, do not always flag all of the extended loans. In order to capture extended
loans that were not flagged in the servicer files, we searched for loans that were
still outstanding at least one year after the original maturity date. Using this
methodology, we identified an additional 53 loans.
In total, we were able to identify 129 floating rate loans that extended. We elimi-
nated 17 of the 129 loans, which did not have extension options, and limited our
analysis to the remaining 112 extendable loans.
In order to determine the motivations for exercising extension options on these
112 loans, we examined changes in property performance (DSCR and occupancy)
since loan origination. In addition, we considered servicer commentary in
monthly watchlist files and consulted Realpoint analysts for their opinions. We
found that 75 loans (68%) exercised extension options due to credit problems.

Please see additional important disclosures at the end of this report. 193
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

Section II: A Discussion of Drift


In this section, we examine whether floating rate CMBS deals are inclined to
experience negative ratings drift over time.
Floating rate loans appeal to CMBS borrowers, in part, because they provide
flexibility for prepayment or extension. A borrower can replace floating rate
financing with longer term fixed rate financing, if a property has stabilized prior
to maturity. Likewise, a borrower may exercise an extension option and buy
more time to improve a property’s cash flows. These structural features, howev-
er, seem to imply that floating rate CMBS deals may ultimately be left with a
pool of weak assets, if all of the stabilized assets prepay or pay off as scheduled
on their maturity dates.
We address this topic and examine whether floating rate CMBS deals are inclined
to experience a negative ratings drift over time. We tackle this question by exam-
ining the ratings history of floating rate CMBS deals issued in 2000. We choose
to examine the 2000 vintage, as we specifically want to focus on the perform-
ance of transactions after significant loan paydowns have occurred. Floating
rate CMBS tend to be short transactions (~3 years). Therefore, the 2000 vintage
should have experienced significant paydowns, as these deals have seasoned for
3-4 years.
OUR F INDINGS
For our analysis, we examined the ratings drift of 224 classes. Since issuance,
these 224 classes have experienced 118 downgrades by the rating agencies. With
the exception of four downgrades on GSMS 2000-GSFL, which were related to
inadequate terrorism insurance, all downgrades resulted from the deterioration
of remaining loans. This seems to support the observation that floating rate
CMBS ratings deteriorate over time as loans pay down. We found, however, that
these paydowns also increase credit enhancement on many classes. In the case
of the 2000 floating rate cohort, paydowns resulted in 1401 upgrades.
Over time, the 2000 floating rate vintage experienced a positive upgrade/down-
grade ratio of 1.2 to 1. A positive ratio does not necessarily imply a positive rat-
ings drift across all classes.
In order to determine which classes have positive and negative ratings drift, we
examined the rating actions on non-rake floating rate tranches issued in 2000.
We did not to include rake classes, which are tied to the performance of a single
loan. Almost all rating actions on rake classes have been downgrades (29 tranch-
es downgraded and 1 tranche upgraded).

1
The 224 classes experienced a total of 144 upgrades (140 due to increased credit enhancement; 4 due to
improved terms of terrorism insurance in GSMS 2000-GSFL).

194
exhibit 4 AVERAGE NOTCH DRIFTS FOR 2000 FLOATING RATE CMBS1

Original Rating Average Notch Drift1


AAA 0.0
AA+ 1.0
AA 1.7
AA- 2.0
A+ 0.8
A 0.8
A- -3.7
BBB+ 3.3
BBB 3.1
BBB- 3.6
BB+ 4.5
BB 1.2
BB- 3.3
B+ 3.0
B 1.9
B- 0.3
CCC+ NA
CCC 3.0
CCC- NA
Total 1.6
1
Data set only includes non-rake tranches that have been upgraded/downgraded by at least one rating agency.
Source: Morgan Stanley, Moody’s, S&P, Fitch

We began by aggregating non-rake tranches into buckets, based on their original


ratings. We then calculated the average notch drift of the tranches in each of
these original rating buckets. If a tranche was upgraded/downgraded by more
than one rating agency, we used the lowest ratings drift to get the most conser-
vative result. Therefore, if a class was upgraded 2 notches by Moody’s and 3
notches by S&P, we used the 2 notch drift. Likewise, if a class was downgraded
2 notches by Moody’s and 3 notches by S&P, we used the -3 notch drift.
CONCLUSION
We found that each category, with the exception of A-, experienced a positive
average ratings drift since issuance. (see Exhibit 4)

Please see additional important disclosures at the end of this report. 195
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

The downward drift of the A- category was driven by downgrades on MSDWC


2000-XLF D, COMM 2000-FL2 F and COMM 2000-FL3 D. The latter two
classes were the lowest rated non-rake tranches in those structures.
We also found that although the ratings drift for floating rate CMBS classes has
been positive as a whole, the ratings drift pattern differs at each rating agency.
As shown in Exhibit 6, classes that were originally rated lower than BBB+ by
S&P exhibit a negative ratings drift. Fitch rating actions, on the other hand,
have resulted in positive ratings drift across almost every original rating category.

exhibit 5 NUMBER OF TRANCHES UPGRADED/


DOWNGRADED BY EACH RATING AGENCY1

Moody’s S&P
Upgrades Downgrades Upgrades
Full Rating # of % of # of % of # of % of
Category2 Tranches Tranches Tranches Tranches Tranches Tranches
AAA 0 0% 0 0% 0 0%
AA 9 28% 0 0% 7 39%
A 8 25% 6 46% 7 39%
BBB 9 28% 3 23% 3 17%
BB 5 16% 2 15% 1 6%
B 1 3% 2 15% 0 0%
CCC 0 0% 0 0% 0 0%
Total 32 100% 13 100% 18 100%
1
Does not include upgrades/downgrades on rake tranches.
2
Includes plus and minus designations at each rating level.
Source: Morgan Stanley, Moody’s, S&P, Fitch

196
exhibit 6 AVERAGE NOTCH DRIFTS FOR 2000 FLOATING RATE CMBS1
BY RATING AGENCY

Original Rating Moody’s S&P Fitch


AAA 0.0 NA NA
AA+ NA 1.0 1.0
AA 1.6 1.8 2.0
AA- 2.0 3.0 2.0
A+ -2.0 2.0 2.3
A 0.3 0.3 3.1
A- -4.7 -2.6 -0.3
BBB+ 4.5 1.0 7.0
BBB 0.0 -4.0 7.7
BBB- 5.0 -0.5 6.5
BB+ 7.0 -1.0 10.0
BB 1.0 -1.3 3.6
BB- 3.0 -2.0 2.5
B+ NA -3.0 3.5
B 2.0 -2.0 2.2
B- -1.0 -2.0 1.5
CCC+ NA NA NA
CCC NA -1.0 7.0
CCC- NA NA NA
Total 1.1 -0.7 3.5
1
Data set only includes non-rake tranches that have been upgraded/downgraded by at least one rating agency.
Source: Morgan Stanley, Moody’s, S&P, Fitch

S&P Fitch
Downgrades Upgrades Downgrades
# of % of # of % of # of % of
Tranches Tranches Tranches Tranches Tranches Tranches
0 0% 0 0% 0 0%
0 0% 14 28% 0 0%
5 29% 11 22% 2 20%
3 18% 12 24% 1 10%
4 24% 7 14% 3 30%
4 24% 5 10% 4 40%
1 6% 1 2% 0 0%
17 100% 50 100% 10 100%

Please see additional important disclosures at the end of this report. 197
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

exhibit 7 2000 FLOATING RATE CMBS RATING ACTIONS SINCE ISSUANCE


Moody’s
Old New Date of
CMBS Transactions Class Rating Action Rating Rating Action
Chase Commercial Mortgage Securities Corp, 2000-FL1
Chase Commercial Mortgage Securities Corp, 2000-FL1
Chase Commercial Mortgage Securities Corp, 2000-FL1
Chase Commercial Mortgage Securities Corp, 2000-FL1
Chase Commercial Mortgage Securities Corp, 2000-FL1
Chase Commercial Mortgage Securities Corp, 2000-FL1

COMM 2000-FL1 B Aa2 Upgrade Aaa 12/13/2001


COMM 2000-FL1 C Aa2 Upgrade Aaa 12/13/2001
COMM 2000-FL1 D A2 Upgrade Aa2 12/13/2001
COMM 2000-FL1 E A2 Upgrade Aa2 12/13/2001
COMM 2000-FL1 F Baa1 Upgrade A2 12/13/2001
COMM 2000-FL1 G A3 Upgrade Aaa 10/24/2002
COMM 2000-FL1 G Baa3 Upgrade A3 12/13/2001
COMM 2000-FL1 H Aa2 Upgrade Aaa 4/7/2003
COMM 2000-FL1 H Baa2 Upgrade Aa2 10/24/2002
COMM 2000-FL1 H Baa3 Upgrade Baa2 12/13/2001
COMM 2000-FL1 J A2 Upgrade Aa3 4/7/2003
COMM 2000-FL1 J Baa3 Upgrade A2 10/24/2002
COMM 2000-FL1 J Ba1 Upgrade Baa3 12/13/2001
COMM 2000-FL1 K Ba2 Upgrade Ba1 12/13/2001

COMM 2000-FL2 B Aa2 Upgrade Aaa 9/11/2003


COMM 2000-FL2 D A1 Downgrade A3 10/24/2002
COMM 2000-FL2 E Baa2 Downgrade Ba1 9/11/2003
COMM 2000-FL2 E A2 Downgrade Baa2 10/24/2002
COMM 2000-FL2 F Baa3 Downgrade Ba3 9/11/2003
COMM 2000-FL2 F A3 Downgrade Baa3 10/24/2002
COMM 2000-FL2 GCO Baa1 Downgrade Baa2 10/24/2002
COMM 2000-FL2 GHM Baa1 Downgrade Baa3 10/24/2002
COMM 2000-FL2 GLP Baa1 Downgrade Ba1 10/24/2002
COMM 2000-FL2 GNS Ba3 Downgrade B1 9/11/2003
COMM 2000-FL2 GNS Ba1 Downgrade Ba3 6/18/2003
COMM 2000-FL2 GNS Baa1 Downgrade Ba1 10/24/2002
COMM 2000-FL2 GWH Baa1 Downgrade Ba3 10/24/2002
COMM 2000-FL2 HCO Baa2 Downgrade Baa3 10/24/2002
COMM 2000-FL2 HHM Baa2 Downgrade Ba1 10/24/2002
COMM 2000-FL2 HLP Baa2 Downgrade Ba2 10/24/2002
COMM 2000-FL2 HNS B1 Downgrade B2 9/11/2003
COMM 2000-FL2 HNS Ba2 Downgrade B1 6/18/2003
COMM 2000-FL2 HNS Baa2 Downgrade Ba2 10/24/2002
COMM 2000-FL2 HWH Baa2 Downgrade B1 10/24/2002
COMM 2000-FL2 JCO Baa3 Downgrade Ba1 10/24/2002
COMM 2000-FL2 JHM Baa3 Downgrade Ba2 10/24/2002
COMM 2000-FL2 JLP Baa3 Downgrade Ba3 10/24/2002
COMM 2000-FL2 JNS B2 Downgrade B3 9/11/2003
COMM 2000-FL2 JNS Ba3 Downgrade B2 6/18/2003
COMM 2000-FL2 JNS Baa3 Downgrade Ba3 10/24/2002
COMM 2000-FL2 JWH Baa3 Downgrade B2 10/24/2002
COMM 2000-FL3 KQA Baa1 Downgrade Ba1 5/30/2003
COMM 2000-FL3 KSR Baa1 Downgrade Ba2 5/30/2003
COMM 2000-FL3 KWC Baa1 Downgrade B1 5/30/2003
COMM 2000-FL3 KWS Baa1 Downgrade Ba1 5/30/2003
COMM 2000-FL3 LQA Baa2 Downgrade Ba2 5/30/2003
COMM 2000-FL3 LSR Baa2 Downgrade Ba3 5/30/2003
COMM 2000-FL3 LWS Baa2 Downgrade Ba2 5/30/2003
COMM 2000-FL3
COMM 2000-FL3
COMM 2000-FL3
COMM 2000-FL3
COMM 2000-FL3
COMM 2000-FL3

DLJ Commercial Mortgage Corp, 2000-STF1 B4 Ba2 Upgrade Baa2 9/11/2003


DLJ Commercial Mortgage Corp, 2000-STF1 B5 Ba3 Upgrade Baa3 9/11/2003
DLJ Commercial Mortgage Corp, 2000-STF1
DLJ Commercial Mortgage Corp, 2000-STF1
DLJ Commercial Mortgage Corp, 2000-STF1
DLJ Commercial Mortgage Corp, 2000-STF1
DLJ Commercial Mortgage Corp, 2000-STF1

GMAC Commercial Mortgage Asset Corp, 2000-FL-A C Aa2 Upgrade Aaa 9/3/2003

Source: Moody’s, S&P, Fitch, Intex

198
S&P Fitch
Old New Date of Old New Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action
C A Downgrade BBB+ 11/13/2003
D A- Downgrade BBB 11/13/2003
E BBB Downgrade BB 11/13/2003
F BBB- Downgrade BB- 11/13/2003
G BB Downgrade B 11/13/2003
H B Downgrade B- 11/13/2003

B AA Upgrade AAA 10/16/2001


C AA+ Upgrade AAA 12/14/2001
C AA- Upgrade AA+ 10/16/2001
D A Upgrade AA 10/16/2001
F A Upgrade AAA 8/16/2002
G A- Upgrade AAA 8/16/2002
H BBB Upgrade A+ 8/16/2002
J BBB- Upgrade BBB+ 8/16/2002
K BB Upgrade BB+ 8/16/2002

B AA Upgrade AAA 10/14/2003


C A Upgrade AA 10/14/2003
C A+ Downgrade A 1/15/2003
D A Downgrade BBB+ 1/15/2003
GCO BBB+ Downgrade BB+ 1/15/2003
GWH BB+ Downgrade B+ 1/15/2003
GWH BBB+ Downgrade BB+ 4/12/2002
HCO BBB Downgrade BB 1/15/2003
HWH BB Downgrade B 1/15/2003
HWH BBB Downgrade BB 4/12/2002
JCO BBB- Downgrade BB- 1/15/2003
JWH BB- Downgrade B- 1/15/2003
JWH BBB- Downgrade BB- 4/12/2002

B AA Upgrade AAA 5/19/2003 B AA Upgrade AAA 10/16/2003


D A- Downgrade BBB- 5/19/2003 D BB Downgrade BB- 4/2/2004
KHS BBB+ Downgrade BB+ 5/19/2003 D BBB- Downgrade BB 10/16/2003
KWC BBB+ Downgrade B+ 5/19/2003 D A- Downgrade BBB- 4/22/2003
LHS BBB- Downgrade BB- 5/19/2003 KHS BBB- Downgrade BB 10/16/2003
KQA BBB+ Downgrade BB+ 10/16/2003
KSR BBB Downgrade B 4/2/2004
KSR BBB+ Downgrade BBB 10/16/2003
LHS BBB Downgrade BB 10/16/2003
LQA BBB Downgrade BB 10/16/2003
LSR BBB- Downgrade B- 4/2/2004
LSR BBB Downgrade BBB- 10/16/2003
MHS BBB- Downgrade BB- 10/16/2003

A2 AA Upgrade AAA 8/14/2003


A3 A Upgrade AAA 8/14/2003
B1 BBB Upgrade AAA 8/14/2003
B2 BBB- Upgrade AAA 8/14/2003
B4 BB Upgrade A 8/14/2003
B5 BB- Upgrade BBB 8/14/2003
B6 B Upgrade BB- 8/14/2003

B AA Upgrade AA+ 5/27/2003 B AA+ Upgrade AAA 9/3/2002

Please see additional important disclosures at the end of this report. 199
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

exhibit 7 2000 FLOATING RATE CMBS RATING ACTIONS SINCE ISSUANCE


(CONTINUED)
Moody’s
Old New Date of
CMBS Transactions Class Rating Action Rating Rating Action
GMAC Commercial Mortgage Asset Corp, 2000-FL-A D A2 Upgrade A1 9/3/2003

GMAC Commercial Mortgage Asset Corp, 2000-FL-B


GMAC Commercial Mortgage Asset Corp, 2000-FL-B
GMAC Commercial Mortgage Asset Corp, 2000-FL-B
GMAC Commercial Mortgage Asset Corp, 2000-FL-B
GMAC Commercial Mortgage Asset Corp, 2000-FL-B
GMAC Commercial Mortgage Asset Corp, 2000-FL-B

GMAC Commercial Mortgage Asset Corp, 2000-FL-F B Aa2 Upgrade Aa1 4/14/2003
GMAC Commercial Mortgage Asset Corp, 2000-FL-F C A2 Upgrade A1 4/14/2003
GMAC Commercial Mortgage Asset Corp, 2000-FL-F
GMAC Commercial Mortgage Asset Corp, 2000-FL-F
GMAC Commercial Mortgage Asset Corp, 2000-FL-F
GMAC Commercial Mortgage Asset Corp, 2000-FL-F
GMAC Commercial Mortgage Asset Corp, 2000-FL-F

GMAC Commercial Mortgage Securities, 2000-FL1 C A2 Downgrade Baa1 1/26/2004


GMAC Commercial Mortgage Securities, 2000-FL1 D Baa2 Downgrade Ba1 1/26/2004
GMAC Commercial Mortgage Securities, 2000-FL1 E Baa3 Downgrade Ba2 1/26/2004
GMAC Commercial Mortgage Securities, 2000-FL1 F Ba2 Downgrade B2 1/26/2004

GS Mortgage Securities Corp II, 2000-GSFL III A Aa1 Upgrade Aaa 10/29/2003
GS Mortgage Securities Corp II, 2000-GSFL III A Aaa Downgrade Aa1 9/27/2002
GS Mortgage Securities Corp II, 2000-GSFL III F Baa2 Upgrade Baa1 10/29/2003
GS Mortgage Securities Corp II, 2000-GSFL III G3 Baa3 Upgrade Baa1 10/29/2003
GS Mortgage Securities Corp II, 2000-GSFL III X0 Aa1 Upgrade Aaa 10/29/2003
GS Mortgage Securities Corp II, 2000-GSFL III X0 Aaa Downgrade Aa1 9/27/2002
GS Mortgage Securities Corp II, 2000-GSFL III X1 Aa1 Upgrade Aaa 10/29/2003
GS Mortgage Securities Corp II, 2000-GSFL III X1 Aaa Downgrade Aa1 9/27/2002
GS Mortgage Securities Corp II, 2000-GSFL III X2 Aa1 Upgrade Aaa 10/29/2003
GS Mortgage Securities Corp II, 2000-GSFL III X2 Aaa Downgrade Aa1 9/27/2002

JP Morgan Commercial Mortgage Finance Corp, 2000-FL1 B Aa2 Upgrade Aa1 1/7/2003
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1 C A2 Upgrade A1 1/7/2003
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1 G Ba2 Downgrade Ba3 1/7/2003
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1 H B2 Downgrade B3 1/7/2003
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1 J B3 Downgrade Caa1 1/7/2003
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1
JP Morgan Commercial Mortgage Finance Corp, 2000-FL1

Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7


Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7
Lehman Brothers Floating Rate Commercial Mortgage Trust, 2000-LLF C7

Morgan Stanley Dean Witter Capital I, 2000-XLF B A2 Upgrade Aa2 9/11/2003


Morgan Stanley Dean Witter Capital I, 2000-XLF B Aa2 Downgrade A2 6/5/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF C Baa2 Downgrade Ba2 6/5/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF C A3 Downgrade Baa2 1/27/2003

Source: Moody’s, S&P, Fitch, Intex

200
S&P Fitch
Old New Date of Old New Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action
C A Upgrade A+ 5/27/2003 B AA Upgrade AA+ 2/6/2002

B A Upgrade AAA 10/17/2002


C BBB Upgrade AAA 10/17/2002
D BBB- Upgrade AAA 10/17/2002
E AA Upgrade AAA 7/30/2003
E BB Upgrade AA 10/17/2002
F B Upgrade BB+ 10/17/2002

B AA+ Upgrade AAA 2/25/2004


B AA Upgrade AA+ 9/10/2002
C A+ Upgrade AAA 2/25/2004
C A Upgrade A+ 9/10/2002
D BBB Upgrade AA 2/25/2004
E BBB- Upgrade A 2/25/2004
F BB Upgrade BBB- 2/25/2004

B AA+ Upgrade AAA 5/16/2003


B AA Upgrade AA+ 8/28/2002
C AA+ Upgrade AAA 3/17/2004
C AA Upgrade AA+ 2/10/2004
C A+ Upgrade AA 5/16/2003
C A Upgrade A+ 8/28/2002
D A- Upgrade AAA 3/17/2004
D BBB+ Upgrade A- 2/10/2004
D BBB Upgrade BBB+ 8/28/2002
E BBB Upgrade AAA 3/17/2004
E BBB- Upgrade BBB 8/28/2002
F BBB- Upgrade AAA 3/17/2004
F BB+ Upgrade BBB- 8/28/2002
G BB Upgrade BBB 3/17/2004
H B Downgrade CCC 5/16/2003
J B- Downgrade CC 5/16/2003

B AA+ Upgrade AAA 3/31/2003 B AA+ Upgrade AAA 8/20/2003


C AA Upgrade AAA 3/31/2003 C AA Upgrade AAA 8/20/2003
D AA- Upgrade AAA 3/31/2003 D AA- Upgrade AAA 8/20/2003
E A+ Upgrade AA 3/31/2003 E A+ Upgrade AAA 8/20/2003
F A Upgrade A+ 3/31/2003 F A Upgrade AA 8/20/2003
G A- Upgrade A 3/31/2003 G A- Upgrade AA- 8/20/2003
H BBB+ Upgrade A- 3/31/2003 H A- Upgrade A+ 8/20/2003
JBO BBB+ Downgrade BB- 3/31/2003 L BBB- Downgrade BB+ 3/10/2003
KBO BBB Downgrade B+ 3/31/2003 M BB- Downgrade B+ 3/10/2003
LBO BBB- Downgrade B 3/31/2003 N BB Downgrade B+ 12/2/2002
M BB+ Downgrade BB 3/31/2003 P BB- Downgrade B 12/2/2002
N BB Downgrade B+ 3/31/2003 Q B+ Downgrade B- 12/2/2002
P BB- Downgrade B 3/31/2003 S B Downgrade B- 12/2/2002
Q B+ Downgrade CCC+ 3/31/2003
S B Downgrade CCC 3/31/2003
T B- Downgrade CCC 3/31/2003
U CCC Downgrade CCC- 3/31/2003

C BBB Downgrade BB 7/9/2003


C A Downgrade BBB 2/11/2003

Please see additional important disclosures at the end of this report. 201
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

exhibit 7 2000 FLOATING RATE CMBS RATING ACTIONS SINCE ISSUANCE


(CONTINUED)
Moody’s
Old New Date of
CMBS Transactions Class Rating Action Rating Rating Action
Morgan Stanley Dean Witter Capital I, 2000-XLF C A2 Downgrade A3 9/6/2002
Morgan Stanley Dean Witter Capital I, 2000-XLF D B2 Downgrade Caa1 9/11/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF D Ba2 Downgrade B2 6/5/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF D Baa2 Downgrade Ba2 1/27/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF D A3 Downgrade Baa2 9/6/2002
Morgan Stanley Dean Witter Capital I, 2000-XLF E Caa2 Downgrade Ca 9/11/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF E B3 Downgrade Caa2 6/5/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF E Ba3 Downgrade B3 1/27/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF E Baa2 Downgrade Ba3 9/6/2002
Morgan Stanley Dean Witter Capital I, 2000-XLF F1 Caa2 Downgrade Ca 6/5/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF F1 B2 Downgrade Caa2 1/27/2003
Morgan Stanley Dean Witter Capital I, 2000-XLF F1 Baa3 Downgrade B2 9/6/2002

Salomon Brothers Mortgage Securities VII, 2000-FL1 B Aa2 Upgrade Aaa 6/29/2001
Salomon Brothers Mortgage Securities VII, 2000-FL1 C A2 Upgrade Aaa 6/29/2001
Salomon Brothers Mortgage Securities VII, 2000-FL1 D Baa2 Upgrade A1 6/29/2001
Salomon Brothers Mortgage Securities VII, 2000-FL1 E Baa3 Upgrade Baa1 6/29/2001
Salomon Brothers Mortgage Securities VII, 2000-FL1 F Ba1 Upgrade A3 4/30/2002
Salomon Brothers Mortgage Securities VII, 2000-FL1 F Ba2 Upgrade Ba1 6/29/2001
Salomon Brothers Mortgage Securities VII, 2000-FL1 G B2 Upgrade Baa3 4/30/2002

SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 D Aa2 Upgrade Aaa 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 E Aa3 Upgrade Aa1 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 F A2 Upgrade Aa3 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 G A3 Upgrade A1 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 H A2 Upgrade Aaa 10/31/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 H Baa1 Upgrade A2 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 J A3 Upgrade Aaa 10/31/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 J Baa2 Upgrade A3 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 K Baa1 Upgrade Aa2 10/31/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2 K Baa3 Upgrade Baa1 3/1/2002
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2
SASCO Floating Rate Commercial Mortgage Trust, 2000-C2

Source: Moody’s, S&P, Fitch, Intex

202
S&P Fitch
Old New Date of Old New Date of
Class Rating Action Rating Rating Action Class Rating Action Rating Rating Action
D CCC Downgrade D 11/6/2003
D B Downgrade CCC 7/9/2003
D A- Downgrade B 2/11/2003
E CCC Downgrade D 7/9/2003
E BBB Downgrade CCC 2/11/2003
F1 BBB- Downgrade D 2/11/2003

B AA+ Upgrade AAA 10/8/2001


C AA+ Upgrade AAA 7/3/2002
C AA Upgrade AA+ 10/8/2001
D AA Upgrade AAA 7/3/2002
D AA- Upgrade AA 10/8/2001
E AA- Upgrade AA 7/3/2002
E A+ Upgrade AA- 10/8/2001
F A+ Upgrade AA- 7/3/2002
F A Upgrade A+ 10/8/2001
G A Upgrade A+ 7/3/2002
G A- Upgrade A 10/8/2001
H A Upgrade AAA 11/21/2002
H A- Upgrade A 7/3/2002
H BBB+ Upgrade A- 10/8/2001
J A- Upgrade AAA 11/21/2002
J BBB+ Upgrade A- 7/3/2002
J BBB Upgrade BBB+ 10/8/2001
K BBB+ Upgrade AAA 11/21/2002
K BBB Upgrade BBB+ 7/3/2002
K BBB- Upgrade BBB 10/8/2001
L BBB- Upgrade AAA 11/21/2002
L BB+ Upgrade BBB- 7/3/2002
M BB+ Upgrade AA 11/21/2002
M BB Upgrade BB+ 7/3/2002
N BB Upgrade AA- 11/21/2002
N BB- Upgrade BB 7/3/2002
P BB- Upgrade A+ 11/21/2002
P B+ Upgrade BB- 7/3/2002
Q B+ Upgrade A 11/21/2002
Q B Upgrade B+ 7/3/2002
S B- Upgrade BBB 11/21/2002
T CCC Upgrade BB+ 11/21/2002

Please see additional important disclosures at the end of this report. 203
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

Section III: Available Funds Cap Mechanics


Available funds caps are a commonly discussed topic in the home equity world,
as investors are concerned with rising rates and the basis risk between fixed rate
collateral and floating rate bonds. Although CMBS structures are not typically
faced with an interest rate mismatch between collateral and bonds, the concept
of available funds cap does exist in some CMBS deals.
In this section, we will describe the mechanics of available funds cap in the con-
text of a hypothetical floating rate CMBS structure.
HOW D OES A N A VAILABLE F UNDS C AP W ORK?
An available funds cap limits the coupon on specified CMBS bonds to the collat-
eral weighted average coupon (WAC).1 The available funds cap is triggered on a
CMBS class if the bond coupon for that class exceeds the weighted average col-
lateral coupon. When such a scenario occurs, the cap initially limits the coupon
on the affected class to the collateral coupon, but typically, any additional cash
that remains after paying interest on all classes is paid sequentially to each
capped class. This additional cash makes up the difference between the capped

exhibit 8a AVAILABLE FUNDS CAP EXAMPLE:


ASSETS IN MONTH 11

Loan Balance ($MM) Interest Rate2 Interest Payment ($MM)


1 500 LIBOR+70 0.750
2 500 LIBOR+130 1.000
1,000 LIBOR+100 1.750

exhibit 8b AVAILABLE FUNDS CAP EXAMPLE:


LIABILITIES IN MONTH 1

Accrued Accrued Interest


Class Size Pass-Through Interest Capped at
Class ($MM) Rate2 ($MM) WAC ($MM)
A 600 LIBOR+30 0.700 0.700
B 200 LIBOR+60 0.283 0.283
C4 100 LIBOR+90 0.167 0.167
D4 100 LIBOR+120 0.192 0.175
X5 1,000 WAC/IO
1,000 LIBOR+51
1
Interest only loans, 36-month term, 24-month lockout period.
2
1-Month LIBOR=1.10%
3
Difference between bond’s stated coupon and collateral WAC.
4
Subject to WAC Cap
5
Notional Amount
Source: Morgan Stanley
1
The available funds cap is also referred to as a WAC cap.

204
coupon payment and the original specified coupon payment. Any remaining
cash after paying all of the coupons is passed to the IO.
To illustrate this concept, consider a simple, hypothetical floating rate CMBS
deal that is backed by two loans. These two loans have a weighted average
coupon of LIBOR+100 bp. The liabilities consist of four classes and an IO.
The very senior classes of a CMBS deal are typically not subject to a WAC cap,
but the mezzanine classes may be. In our example, classes C and D have speci-
fied coupons of LIBOR+90 bp and LIBOR+120 bp and are subject to an avail-
able funds cap.
In this hypothetical transaction, the collateral WAC in month 1 will pay the stat-
ed coupons on classes A, B and C. Class D, however, will be capped at the col-
lateral WAC of LIBOR+100 bp, since its stated coupon (LIBOR+120 bp)
exceeds the collateral WAC.
After paying the full coupons on classes A through C and the capped coupon on
class D, $0.425 million in collateral interest is still available for distribution. This
is enough cash to pay class D an additional $0.017 million, such that it receives
its full coupon payment. The remaining $0.408 million is distributed to the IO.
The available funds cap may also be triggered in a scenario where the higher
coupon loans pay off, leaving the lower coupon loans in the pool.

Additional
WAC Cap Interest Interest Interest
Shortfall3 Amount Payment Shortfall
($MM) ($MM) ($MM) ($MM)
- - 0.700 -
- - 0.283 -
- - 0.167 -
0.017 0.017 0.192 -
0.408
1.750

Please see additional important disclosures at the end of this report. 205
Transforming Real Estate Finance
chapter 11 Floating Rate Large Loan CMBS

In Exhibits 9a & 9b, we revisit the same structure but assume that one of the
loans pays off, leaving a single loan with a coupon of LIBOR+70 bp. In this
scenario, class C as well as class D triggers the available funds cap. After paying
the capped coupons, there is enough cash to pay the full class C coupon. Class
D, however, does not receive its full coupon of $0.192 million and only receives
$0.183 million. Therefore, this class experiences an interest shortfall of $0.009
million. The IO in this case does not receive any interest.

exhibit 9a AVAILABLE FUNDS CAP EXAMPLE: MONTH 26


ASSETS1

Loan Balance ($MM) Interest Rate2 Interest Payment ($MM)


1 500 LIBOR+70 0.750
2 - LIBOR+130 -
500 LIBOR+70 0.750

exhibit 9b AVAILABLE FUNDS CAP EXAMPLE: MONTH 26


LIABILITIES

Accrued Accrued Interest


Class Size Pass-Through Interest Capped at
Class ($MM) Rate2 ($MM) WAC ($MM)
A 100 LIBOR+30 0.117 0.117
B 200 LIBOR+60 0.283 0.283
C4 100 LIBOR+90 0.167 0.150
D4 100 LIBOR+120 0.192 0.150
X5 500 WAC/IO
500 LIBOR+72
1
Interest only loans, 36-month term, 24 month lockout period.
2
1-Month LIBOR=1.10%
3
Difference between bond’s stated coupon and collateral WAC.
4
Subject to WAC Cap
5
Notional Amount
Source: Morgan Stanley

206
Additional
WAC Cap Interest Interest Interest
Shortfall3 Amount Payment Shortfall
($MM) ($MM) ($MM) ($MM)
- - 0.117 -
- - 0.283 -
0.017 0.017 0.167 -
0.042 0.033 0.183 0.009
-
0.750

Please see additional important disclosures at the end of this report. 207
This Page Intentionally Left Blank

208
Chapter 12

Transforming Real Estate Finance


Commercial Mortgage Defaults

Please see additional important disclosures at the end of this report. 209
Transforming Real Estate Finance
Chapter 12 Commercial Mortgage Defaults

This chapter contains our commercial mortgage default study which covers the
time period 1972-2002. Our main conclusion is that most investment grade
CMBS (with the exception of BBBs from more recent vintages) are well protected
against the most severe real estate downturn of the last 30 years.
The addition of two years of new data alters the original conclusion only slightly.
In the past, all investment-grade CMBS were protected from the magnitude of
losses experienced by life insurance company loans. With continued reductions
in subordination levels, a greater proportion of recently rated BBB classes would
now be vulnerable to a downturn of the magnitude of the late 1980s and early
1990s.
In our updated study:
• We added 1,383 new loans, increasing the total to nearly 18,000.
• The average lifetime cumulative default rate (based on loan balances) for
cohorts with at least 10 years of seasoning decreased from 20.5% to 19.6%
over the last two years.
• 1986 remained the worst origination year, with nearly 32% of the total bal-
ance eventually defaulting.
• The average severity on liquidated loans was about 33%.
• Of the cohorts with at least 10 years of seasoning, the 1991 and 1992 origi-
nation years had the lowest cumulative default rates.
• For a given cohort, on average, the peak years for defaults were years 3-7
after origination.
• About 55% of the defaulted loans were liquidated.
BACKGROUND
Mark Snyderman authored two pioneering studies in 1991 and 1994 on cumula-
tive lifetime default rates on commercial mortgages held by life insurance com-
panies. His 1994 article tracked defaults (90+ day delinquent loans) on eight
large insurance companies through 1991. The studies were the first to track com-
mercial mortgage credit through several complete real estate cycles. Snyderman
was able to follow the performance of loans originated in a given year (cohort)
until all of the loans had either matured, prepaid, or defaulted.
In 1999, Snyderman, L’Heureux, and Esaki (ELS) used the same insurance com-
panies and data sources as the original studies to update the default data through
1997. The period of the ELS extension included the final years of the worst real
estate downturn since the Great Depression of the 1930s. One of the findings of
the study was that the 1986 cohort of originations was the worst in the past 30
years, with a cumulative default rate of 28%. Investment-grade CMBS from the
average conduit deal issued at that time, however, would not have lost principal if
subjected to the default and loss rates experienced by the 1986 cohort.
Two years ago (2002), Esaki updated the study, adding three years of data. The
main finding was that declining subordination levels would put some BBB
CMBS at risk if the default rates of the worst cohort were repeated.

210
COMPARISON T O P REVIOUS S TUDIES
Our update through 2002 shows little difference from the results of the previous
study with data through 2000. Only 21 loans from the database defaulted during
2001 and 2002. This represents only 0.3% of the total number of loans originat-
ed in the last 10 years of the study.
In the current update, we examined the credit performance of 17,978 individual
loans, an increase of about 1,400 loans from the 2002 study. The average life-
time cumulative default rate for origination cohorts with at least ten years of his-
tory was 19.6%, slightly lower than the 20.5% in the prior default study pub-
lished by Esaki in 2002. On average, about 91% of defaults occurred within the
first 10 years of origination. The cumulative default rate of almost 32% for
originations in 1986 was again the highest for any cohort.
NUMBER O F L OANS B Y O RIGINATOR A ND O RIGINATION Y EAR
In the current study, we tracked commercial mortgage default rates from life
insurance company annual statements for 2001 and 2002. We then aggregated
our data with the two previous Snyderman studies, the ELS findings, and the
Esaki (2002) report. As in the earlier studies, we chose to include cohorts with a
minimum of five years of seasoning. Of the 17,978 total loans originated, about
2,700 (15.3%), had defaulted by 2002.
SIZE O F L OANS
The median loan size was about $4.2 million, and the average loan size was
about $8.5 million. Average loan size has trended up over time, increasing from
$3 million in 1972 to $14 million in 1997. Over 70% of the loans were less than
$8 million.
The less-than-$2 million loan category had the lowest default rate, while the $4-8
million category had the highest default rate. This is the same as previous studies.
GEOGRAPHIC D ISTRIBUTION
As in earlier studies, the loans are geographically well diversified, with the largest
percentages in the West (23%) and Northeast (22%). The highest default rates
were in the South Central region (25%), with the lowest in the West (10%).
DEFAULTS B Y O RIGINATION C OHORT
The cumulative lifetime default rate (by loan balance) for cohorts with at least 10
years of history ranged from 4.0% for 1992 originations to 31.7% for 1986 orig-
inations. The average lifetime cumulative default rate (based on loan balance)
for cohorts with at least 10 years of seasoning was 19.6%, down from 20.5% in
the previous study. The drop resulted from the addition of 1991 and 1992,
which had the two lowest cumulative default rates of any cohort.

Please see additional important disclosures at the end of this report. 211
Transforming Real Estate Finance
Chapter 12 Commercial Mortgage Defaults

TIMING O F D EFAULTS
On average, the annual default rate was low within the year of loan origination,
but rose to about 1% in the first year following origination, then jumped to a
range of 1.5% to 2.7% for the next six years. Default rates then declined to less
than 1% for the next three years, and tailed off gradually. These results are near-
ly identical to the Esaki (2002) study. As in that study, there is no spike in
defaults at balloon dates. Some research analysts have noted that loan restruc-
tures result in the appearance of low default rates in balloon years, but there is
no evidence to support this in our study.
The default timing pattern for individual cohorts can vary widely from the aver-
age. The timing and total defaults of a cohort are highly dependent on its posi-
tion in the real estate cycle. For almost all cohorts, however, the peak in
defaults is in years three through seven after origination.
LIQUIDATIONS A ND R ECOVERIES
As in previous studies, not all defaulting (90+ days delinquent) loans liquidate. We
found that only about half of the loans we recorded as entering default for the
first time went straight through to liquidation. Another quarter of the loans were
restructured, while the rest became current again. Of the loans becoming current,
about 60% were eventually restructured, and another 30% defaulted again. We
estimate that about 55% of loans entering default are eventually liquidated, 40%
are restructured, 3% become delinquent again, and only 2% fully recover.
Our finding that 20% of loans entering default initially recover is similar to a
Fitch (2001) CMBS default study finding that 22% of defaulted loans in CMBS
return to current status. Our study goes one step further, however, and finds
that only about 9% of these loans remain current. This means that only about
2% (20% x 9%) of loans entering default return permanently to current status.
SEVERITY O F L OSS
The loss severity on liquidated loans for the loans added to the previous study
was about 31%, the same as in the previous study and less than the 36% in the
original Snyderman studies. The severity calculation includes foregone interest
and expenses, as well as lost principal.
In Exhibit 1, we outline the components that are used in the loss severity calcu-
lation. For loans that were liquidated within the last 10 years of the study, fore-
gone interest accounted for a large portion of loss severity. On average, the
loans liquidated within this 10-year time period experienced 24 months between
default and liquidation.

212
exhibit 1

SEVERITY OF LOSS
ON LIQUIDATED
LOANS
(1992-2002)

Source: Morgan Stanley

For the entire 1972-2002 period, the average severity of loss on foreclosed loans
is about 33%. As in earlier studies, the range of severities for individual loans is
large. Some loans had severities of over 100%, while others recorded no loss.

Please see additional important disclosures at the end of this report. 213
Transforming Real Estate Finance
Chapter 12 Commercial Mortgage Defaults

IMPACTS O F D EFAULTS O N C URRENT B OND S TRUCTURES


In the Esaki (2002) study, we found that the average cohort with at least 10 years
of seasoning lost about 5.4% of its original balance through defaults. In this
study, the average cohort with at least 10 years of seasoning lost slightly less,
about 4.9% of its original balance.

exhibit 2 AVERAGE SUBORDINATION FOR CONDUIT/


FUSION TRANSACTIONS

1998 1999 2000 2001 2002 2003 20041


AAA 29% 27% 23% 21% 20% 17% 14%
AA 24% 22% 19% 17% 16% 14% 12%
A 18% 17% 14% 13% 12% 10% 9%
BBB 13% 12% 11% 9% 8% 7% 5%
BB 6% 6% 5% 4% 4% 3% 3%
B 3% 3% 3% 2% 2% 2% 2%

1
As of August 19, 2004.
Source: Commercial Mortgage Alert, Morgan Stanley

This calculation assumes that restructured loans have half of the severity
(16.5%) of liquidated loans. Since the average conduit/fusion transaction today
is being issued with BBB subordination levels of about 5%, most investment-
grade CMBS are still protected against the average loss of origination cohorts of
the last 30 years.
The loss on the worst cohort, 1986, has an estimated loss of 8.1% of its original
balance. This exceeds the average BBB subordination level on conduit and
fusion CMBS transactions being issued today, and would result in the default of
even some single-A classes. It is, however, still below the lowest credit support
levels for AAA CMBS.

exhibit 3 NUMBER OF LOANS BY ORIGINATOR, 1972-1997

Number Percentage Change Total Loan


Originator of Loans from Esaki (2002) Amount ($BN)

Aetna Life Insurance Company 3,042 1.1% 26.6

Connecticut Mutual Life Insurance Company 1,062 15.9% 5.7

Equitable Life Insurance Company 1,838 1.1% 17.2

John Hancock Mutual Life Insurance Company 2,538 13.0% 18.1

New England Mutual Life Insurance Company 1,736 25.0% 11.5

The Northwestern Mutual Life Insurance Company 1,108 21.9% 13.6

The Prudential Insurance Company of America 4,349 7.6% 42.6

The Travelers Insurance Company 2,305 1.7% 17.4

Total 17,978 8.3% 152.8

Source: Morgan Stanley

214
Our loss estimates are based on a number of assumptions. The most important
assumption for loss calculation is that the severity of restructured loans is half
that for liquidated loans. If we assume, as some market participants believe, that
restructured loans have close to 0% severity, the loss for the worst cohort drops
to 6.1%. On the other hand, if we assume that restructured and liquidated loans
have the same severity of 33%, the loss rate estimate rises to 10.6%.
CONCLUSIONS
The results from our update of commercial mortgage defaults through the year
2002 do not significantly change the previous findings on cumulative default and
loss rates, the severity of losses on liquidated loans, or the shape of the loss curve.
REFERENCES
Esaki, Howard. “Commercial Mortgage Defaults: 1972-2000.” Real Estate Finance,
Winter 2002.
Esaki, Howard, Steven L’Heureux, and Mark P. Snyderman. “Commercial
Mortgage Defaults: An Update.” Real Estate Finance, Spring 1999.
Lans, Diane M. and Noel Cain. “Dissecting Defaults and Losses: 2001 CMBS
Conduit Loan Default Study.” Fitch IBCA Special Report, August 2001.
Snyderman, Mark P. “Commercial Mortgages: Default Occurrence and
Estimated Yield Impact.” Journal of Portfolio Management, Fall 1991.
Snyderman, Mark P. “Update on Commercial Mortgage Defaults.” Real Estate
Finance, Summer 1994.

Please see additional important disclosures at the end of this report. 215
Transforming Real Estate Finance
Chapter 12 Commercial Mortgage Defaults

exhibit 4

NUMBER OF
LOANS BY
ORIGINATION YEAR

Source: Morgan Stanley

exhibit 5

AVERAGE
LOAN AMOUNT BY
ORIGINATION YEAR

Source: Morgan Stanley

exhibit 7 LOANS ORIGINATED AND DEFAULT RATES BY REGION

Percentage
Number of Change from Amount of
Loans from Esaki (2002) Loans ($BN)
West Coast 4,120 9.2 37.0
South Central 3,042 7.3 19.6
Northeast 3,891 6.7 40.1
Mid-Central 3,317 8.0 25.4
Southeast 3,069 8.8 27.4
Canada/Other 539 20.9 3.3
Total 17,978 8.3 152.8

Source: Morgan Stanley

216
exhibit 6 LOANS ORIGINATED AND DEFAULT RATES BY
PRINCIPAL AMOUNT
Percentage Percent Loan Count
Loan Amount Loans Change from of Default Rate
($MM) Originated Esaki (2002) Total (%)
1-2MM 4,083 3.3% 22.7% 12.9%
2-4 MM 4,473 5.2% 24.9% 15.6%
4-8 MM 4,326 9.8% 24.1% 16.7%
>8MM 5,096 14.5% 28.3% 15.7%
Total 17,978 8.3% 100.0% 15.3%
Source: Morgan Stanley

By Loan Count By Loan Amount

Percentage
Percent of Change from Default Percent of Percentage Default
Total Esaki (2002) Rate (%) Total Change Rate (%)
22.9 0.2 10.2 24.2 -0.4 11.6
16.9 -0.2 24.6 12.8 0.2 23.7
21.6 -0.3 13.3 26.3 -0.4 13.9
18.5 0.0 15.8 16.7 0.0 16.6
17.1 0.1 15.7 17.9 0.5 14.4
3.0 0.3 9.8 2.1 0.1 15.7
100.0 NA 15.3 100.0 NA 15.2

Please see additional important disclosures at the end of this report. 217
Transforming Real Estate Finance
Chapter 12 Commercial Mortgage Defaults

exhibit 8a

LIFETIME DEFAULT
RATES BY
ORIGINATION
COHORT
(BY PRINCIPAL
BALANCE)

Source: Morgan Stanley

exhibit 8b

LIFETIME DEFAULT
RATES BY
ORIGINATION
COHORT
(BY LOAN COUNT)

Source: Morgan Stanley

exhibit 9a

AVERAGE TIMING
OF DEFAULTS –
LOAN COUNT

Source: Morgan Stanley

218
exhibit 9b

AVERAGE TIMING
OF DEFAULTS –
LOAN AMOUNT

Source: Morgan Stanley

exhibit 10

LIQUIDATED,
RESTRUCTURED,
AND RECOVERED
LOANS

Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 219
220
Chapter 12

appendix A-1 TIMING OF DEFAULTS BY COHORT – LOAN COUNT


10 Year Lifetime % in
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Total Total 10 yrs

AVG 0.33 1.19 1.64 1.71 1.67 1.81 1.66 1.08 0.96 0.72 0.69 0.55 0.51 0.43 0.31 0.43 0.37 0.18 0.14 0.20 0.12 0.04 0.01 0.02 0.00 0.03 0.00 0.00 0.00 0.00 0.00 13.02 15.27 85.25

1972 0.00 2.44 3.75 3.56 3.19 1.31 0.19 0.38 0.00 0.00 0.00 0.19 0.19 0.38 0.75 0.94 0.56 0.19 0.19 0.75 0.38 0.00 0.19 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 14.82 19.51 75.96

1973 0.14 2.99 5.03 3.40 1.49 0.41 0.00 0.14 0.14 0.14 0.14 0.00 0.82 0.95 0.68 0.82 0.68 0.14 0.27 0.82 0.27 0.27 0.00 0.14 0.00 0.00 0.00 0.00 0.00 0.00 13.99 19.84 70.55

1974 0.71 6.23 3.26 1.42 0.57 0.71 0.14 0.14 0.14 0.42 0.00 0.14 0.42 0.71 0.42 0.71 0.71 0.28 0.28 0.14 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 13.74 17.56 78.23

1975 2.33 2.33 1.94 0.58 0.58 0.58 0.39 0.00 0.39 0.39 0.00 1.17 1.36 0.58 0.78 0.78 0.78 0.58 0.39 0.00 0.00 0.00 0.00 0.00 0.00 0.19 0.00 0.00 9.51 16.12 59.04

1976 0.21 0.82 0.41 1.23 0.21 0.00 0.21 0.00 0.00 1.03 0.62 1.23 0.41 0.21 0.21 1.85 0.82 0.41 0.62 0.62 0.21 0.00 0.00 0.00 0.00 0.00 0.00 4.72 11.29 41.82

1977 0.00 0.85 0.14 0.28 0.14 0.28 0.14 0.71 0.56 1.55 0.99 0.56 0.14 0.56 0.42 0.56 0.85 0.00 0.28 0.14 0.00 0.14 0.00 0.00 0.00 0.00 5.65 9.32 60.61

1978 0.28 0.19 0.09 0.00 0.38 0.00 0.09 0.66 1.80 1.14 1.52 0.85 1.42 0.66 0.95 0.95 0.57 0.09 0.00 0.00 0.19 0.00 0.00 0.00 0.00 6.16 11.85 52.00

1979 0.27 0.36 0.09 0.62 0.18 0.36 0.18 2.13 0.98 1.96 1.16 1.16 1.51 1.42 0.80 0.36 0.18 0.36 0.00 0.00 0.00 0.00 0.00 0.00 8.27 14.04 58.86

1980 0.24 0.47 0.24 0.00 0.59 1.30 2.25 1.54 2.01 1.54 2.01 2.01 1.42 0.83 0.12 0.24 0.36 0.24 0.00 0.12 0.24 0.00 0.00 12.20 17.77 68.67

1981 0.75 0.00 1.00 0.50 0.75 2.74 2.00 2.49 2.49 1.25 1.75 2.24 0.75 0.25 0.00 0.50 0.25 0.25 0.00 0.00 0.00 0.00 15.71 19.95 78.75

1982 1.38 0.92 2.29 2.75 5.05 1.83 0.00 1.38 3.67 0.00 0.92 0.92 0.00 0.46 0.00 0.00 0.00 0.46 0.00 0.00 0.00 20.18 22.02 91.67

1983 1.25 0.31 1.10 4.39 2.51 3.29 0.78 0.47 1.88 0.78 1.10 0.16 0.16 0.00 0.00 0.00 0.00 0.00 0.00 0.00 17.87 18.18 98.28

1984 0.00 1.41 3.17 1.94 4.59 2.29 3.70 1.76 2.29 1.59 0.53 0.35 0.00 0.18 0.00 0.00 0.00 0.00 0.00 23.28 23.81 97.78

1985 0.08 2.40 2.08 2.48 2.56 3.60 3.28 1.68 1.12 0.32 0.48 0.08 0.16 0.08 0.00 0.00 0.08 0.00 20.10 20.50 98.05
Transforming Real Estate Finance

1986 0.00 1.18 2.16 2.06 3.44 4.92 8.46 2.26 1.28 0.49 1.08 0.20 0.10 0.10 0.00 0.00 0.00 27.34 27.73 98.58

1987 0.21 0.31 1.77 2.71 4.38 5.63 3.65 2.09 1.04 0.31 0.73 0.42 0.21 0.00 0.00 0.00 22.84 23.46 97.33

1988 0.10 0.29 1.87 4.72 4.13 4.52 2.75 1.28 1.28 0.29 0.10 0.00 0.00 0.10 0.00 21.34 21.44 99.54

1989 0.35 0.93 3.13 3.36 2.55 2.09 2.67 1.74 0.70 0.58 0.23 0.12 0.12 0.00 18.31 18.54 98.75

1990 0.41 3.13 4.63 2.18 2.18 3.00 1.09 0.27 0.00 0.27 0.14 0.27 0.00 17.30 17.57 98.45

1991 0.72 1.20 1.68 1.68 1.20 0.24 0.48 0.48 0.00 0.00 0.24 0.00 7.93 7.93 100.00

1992 0.94 0.31 1.88 1.25 0.00 0.00 0.00 0.00 0.00 0.31 0.00 4.69 4.69 100.00

1993 0.21 0.62 0.00 1.04 0.00 0.62 0.21 0.00 0.00 0.21 2.90 2.90 100.00

1994 0.43 0.00 0.64 0.43 0.21 0.00 0.00 0.21 0.00 1.93 1.93 100.00

1995 0.00 0.36 0.36 0.00 0.00 0.00 0.00 0.71 1.42 1.42 100.00

1996 0.00 0.16 0.00 0.00 0.16 0.32 0.16 0.80 0.80 100.00

1997 0.00 0.00 0.00 0.00 0.00 0.14 0.14 0.14 100.00
Commercial Mortgage Defaults

Source: Life Insurance company annual statements; Morgan Stanley


appendix A-2 TIMING OF DEFAULTS BY COHORT – LOAN SIZE
10 Year Lifetime % in
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 Total Total 10 yrs

AVG 0.19 0.92 1.51 1.72 1.84 2.00 2.68 1.49 0.91 0.61 0.87 0.43 0.30 0.36 0.24 0.23 0.28 0.15 0.14 0.09 0.08 0.05 0.02 0.04 0.00 0.02 0.00 0.00 0.00 0.00 0.00 13.89 15.20 85.81

1972 0.00 1.68 2.52 2.99 10.20 1.25 0.06 0.23 0.00 0.00 0.00 0.22 0.08 0.23 0.69 0.54 0.70 0.14 0.10 0.47 0.16 0.00 0.35 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 18.94 22.63 83.71

1973 0.26 2.24 4.59 2.46 1.06 0.40 0.00 0.05 0.15 0.04 0.11 0.00 0.42 0.80 0.50 0.72 0.49 0.05 0.12 0.36 0.40 0.44 0.00 0.38 0.00 0.00 0.00 0.00 0.00 0.00 11.35 16.03 70.83

1974 0.81 7.10 4.55 1.02 0.74 0.85 0.07 0.12 0.11 0.96 0.00 0.07 0.41 0.42 0.38 0.60 0.52 0.15 0.74 0.27 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 16.33 19.90 82.08

1975 1.91 3.04 1.18 0.54 0.20 0.23 0.15 0.00 0.44 0.67 0.00 1.11 1.58 0.19 0.59 0.25 0.39 0.41 0.36 0.00 0.00 0.00 0.00 0.00 0.00 0.11 0.00 0.00 8.36 13.36 62.55

1976 0.32 1.35 0.15 1.69 0.15 0.00 0.07 0.00 0.00 0.88 0.73 0.72 0.58 0.10 0.07 1.79 0.39 0.35 1.10 0.35 0.11 0.00 0.00 0.00 0.00 0.00 0.00 5.34 10.90 48.98

1977 0.00 1.44 0.04 2.76 0.04 2.83 0.18 3.33 0.40 1.76 0.44 0.53 0.03 0.33 2.22 1.00 0.46 0.00 0.09 0.04 0.00 0.08 0.00 0.00 0.00 0.00 13.21 18.00 73.41

1978 0.14 0.07 0.04 0.00 0.29 0.00 0.03 0.47 1.48 1.64 1.63 0.80 1.13 0.46 0.83 0.61 0.49 0.14 0.00 0.00 0.16 0.00 0.00 0.00 0.00 5.78 10.40 55.64

1979 0.11 0.32 0.97 0.57 0.43 0.28 0.14 2.62 0.98 2.27 0.89 0.90 1.32 3.13 0.42 0.18 0.38 0.55 0.00 0.00 0.00 0.00 0.00 0.00 9.59 16.47 58.21

1980 0.08 0.25 0.16 0.00 0.53 2.16 1.69 1.22 1.22 1.53 2.05 1.54 0.92 1.27 0.80 0.25 0.50 0.11 0.00 0.03 0.08 0.00 0.00 10.89 16.38 66.50

1981 0.69 0.00 0.57 0.50 0.53 2.21 0.83 2.05 3.44 0.92 2.11 0.91 0.48 0.04 0.00 0.43 0.15 0.73 0.00 0.00 0.00 0.00 13.84 16.58 83.48

1982 0.73 1.54 1.77 1.44 2.66 1.31 0.00 0.53 3.19 0.00 4.42 0.68 0.00 2.39 0.00 0.00 0.00 0.15 0.00 0.00 0.00 17.59 20.80 84.53

1983 0.82 0.16 1.09 3.81 2.46 2.99 1.53 0.80 1.84 0.65 0.79 0.14 0.04 0.00 0.00 0.00 0.00 0.00 0.00 0.00 16.95 17.13 98.92

1984 0.00 1.27 1.99 1.22 2.52 1.14 7.76 4.79 2.75 2.27 0.17 1.18 0.00 0.10 0.00 0.00 0.00 0.00 0.00 25.88 27.16 95.28

1985 0.05 2.33 1.83 2.45 2.92 2.90 2.86 2.24 1.30 0.38 0.93 0.07 0.27 0.32 0.00 0.00 0.46 0.00 20.17 21.29 94.75

1986 0.00 0.92 2.28 2.14 3.25 5.82 10.30 2.47 1.31 0.24 2.32 0.23 0.31 0.06 0.00 0.00 0.00 31.05 31.66 98.09

1987 0.13 0.20 1.23 2.86 4.60 4.73 4.63 2.84 0.49 0.18 1.07 0.41 0.10 0.00 0.00 0.00 22.95 23.46 97.82

1988 0.09 0.28 1.85 3.65 3.47 3.43 4.25 1.42 1.16 0.13 0.08 0.00 0.00 0.03 0.00 19.81 19.83 99.87

1989 0.10 1.28 2.38 3.55 1.85 1.84 4.33 1.50 0.49 0.56 0.73 0.49 0.15 0.00 18.60 19.24 96.70

1990 0.09 2.47 5.95 1.80 2.87 3.26 1.02 0.27 0.00 0.10 0.03 0.46 0.00 17.85 18.31 97.49

1991 0.50 1.22 0.85 1.11 1.27 0.37 0.37 0.18 0.00 0.00 0.28 0.00 6.14 6.14 100.00

1992 1.05 0.18 1.39 0.80 0.00 0.00 0.00 0.00 0.00 0.57 0.00 4.00 4.00 100.00

1993 0.27 0.37 0.00 1.81 0.00 0.37 0.10 0.00 0.00 0.11 3.03 3.03 100.00

1994 0.34 0.00 0.69 0.17 0.23 0.00 0.00 0.03 0.00 1.47 1.47 100.00

1995 0.00 0.09 0.34 0.00 0.00 0.00 0.00 0.78 1.20 1.20 100.00

Please see additional important disclosures at the end of this report.


1996 0.00 0.10 0.00 0.00 0.08 0.14 0.13 0.44 0.44 100.00

1997 0.00 0.00 0.00 0.00 0.00 0.11 0.11 0.11 100.00

12.48 14.58 85.60

Source: Life Insurance company annual statements; Morgan Stanley

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222
Chapter 13

Transforming Real Estate Finance


Transaction Monitoring

Please see additional important disclosures at the end of this report. 223
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

In this chapter, we provide samples of transaction monitoring pieces that we


publish regularly. Section I contains an example of our monthly delinquency
article which reports delinquencies for the entire universe as well as for sea-
soned, multiborrower CMBS. Section II contains an excerpt from our conduit
tracking report of specially serviced loans in Morgan Stanley transactions.
Section III includes an excerpt from our retail study analyzing risky tenant expo-
sure in Morgan Stanley deals. Section IV provides an example of our quarterly
tracking of CMBS rating actions. Section V contains our most recent report on
the credit performance of CMBS originators.

Section I. CMBS Delinquency Report


Based on October 2004 remittance reports, delinquencies on all CMBS transactions
declined 4 bp to 1.13% of original balances. Most of the improvement was attrib-
utable to office collateral. Sixty-plus day delinquencies on all CMBS declined 2 bp
to 0.97%.
After peaking at 2.62% in November 2003, seasoned delinquencies have declined
consistently over the past eight months. Based on October remittance reports,
delinquencies on seasoned transactions (aged over one year) declined 10 bp to
1.79%. The liquidation of a $33.4 million loan in MSC 1997-ALIC (Cambridge
Park 2) accounted for 3 bp of the decline. The remaining 7 bp of improvement is
attributable to a large number of small loans. Sixty-plus day delinquencies on
seasoned deals declined 4 bp to 1.55%.

exhibit 1

DELINQUENCIES
IN SEASONED
CMBS DEALS AND
LIFETIME
AVERAGE

Source: Morgan Stanley, Intex

224
exhibit 2 CMBS DELINQUENCIES BY YEAR OF ORIGINATION (IN %)
(AS OF OCTOBER 2004 REMITTANCE REPORTS)

Current Balance 30/60/90+ Forc. & Change From


Year ($BN) Days REO Total Last Month
1990 0.2 19.46 0.00 19.46 0.04
1991 0.1 0.00 0.00 0.00 0.00
1992 0.2 0.00 0.00 0.00 0.00
1993 0.4 1.33 0.95 2.27 0.02
1994 0.7 1.21 3.39 4.60 1.18
1995 3.1 0.89 2.21 3.09 -0.80
1996 9.2 1.01 0.89 1.90 0.13
1997 26.4 1.65 1.46 3.11 -0.35
1998 57.0 0.84 1.04 1.88 -0.07
1999 34.2 1.35 1.01 2.36 -0.19
2000 32.6 0.94 1.22 2.15 0.06
2001 52.3 0.71 0.34 1.04 0.06
2002 48.9 0.24 0.12 0.36 0.04
2003 82.0 0.09 0.00 0.09 0.03
2004 59.0 0.06 0.00 0.06 0.05
Total/Average 406.3 0.60 0.53 1.13 -0.04
Source: Morgan Stanley, Intex

ORIGINATION Y EAR
Of the cohorts with more than $20 billion in collateral outstanding, the
1997 cohort posted the greatest improvement, declining 35 bp to 3.11%.

exhibit 3 CMBS DELINQUENCIES BY PROPERTY TYPE (IN %)


(AS OF OCTOBER 2004 REMITTANCE REPORTS)

Product Current Balance 30/60/90+ Forc. & Change From


Type ($BN) Days REO Total Last Month
Hotel-Motel 29.0 1.06 1.39 2.44 -0.13
Industrial-Warehouse 21.9 0.73 0.83 1.56 -0.01
Mixed 16.3 0.21 0.46 0.67 -0.11
Mobile Home 8.3 0.45 0.13 0.58 0.14
Multifamily 70.4 1.15 0.58 1.73 0.10
Office 100.0 0.46 0.49 0.95 -0.14
Retail 124.7 0.45 0.35 0.80 -0.02
Self-Storage 5.6 0.25 0.03 0.28 0.03
Senior Housing 3.9 1.55 1.06 2.61 -0.65
Other 26.2 0.01 0.36 0.37 0.00
Total/Average 406.3 0.60 0.53 1.13 -0.04

Source: Morgan Stanley, Intex

Please see additional important disclosures at the end of this report. 225
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

The liquidation of the Cambridge Park 2 loan was responsible for 13 bp of


the improvement.
MULTIFAMILY D ELINQUENCIES R ISE
Delinquencies on multifamily collateral rose 10 bp during the month to 1.73%.
Although multifamily fundamentals are showing signs of improvement (vacan-
cies nationwide declined 20 bp in 3Q04) we continue to maintain a cautious view
on the sector.
OFFICE C OLLATERAL P OST 1 4 B P I MPROVEMENT
Office delinquencies declined 14 bp to 0.95% of current balances. Eight basis
points of the decline is attributable to the liquidation of three office properties,
Allen Center in GMACC 1997-C2, the Bell Atlantic Building in CMAC 1998-C2
and Cambridge Park 2 in MSC 1997-ALIC. The weighted average loss severity
on those loans was 28.6%.
CUMULATIVE L OSSES
Cumulative losses for the seasoned universe rose 3 bp to 0.59% of original bal-
ances. MCFI 1997-MC1 experienced the greatest rise in cumulative losses (104
bp) due to the liquidation of the Radisson Hotel & Suites-Buffalo. The loan’s
loss severity was 100%.

exhibit 4 CMBS DELINQUENCIES BY PROPERTY TYPE AND YEAR


(IN %) (AS OF OCTOBER 2004 REMITTANCE REPORTS)

Product Type 1990 1991 1992 1993 1994 1995 1996


Hotel-Motel 0.00 N/A N/A 0.00 1.26 21.59 8.97
Industrial-Warehouse 0.00 0.00 0.00 0.00 12.97 4.53 1.97
Mixed 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Mobile Home N/A N/A 0.00 0.00 0.00 11.46 0.00
Multifamily 0.00 0.00 0.08 1.47 0.00 2.20 2.34
Office 38.92 0.00 0.00 0.00 0.00 0.00 0.37
Retail 0.00 0.00 0.00 9.85 10.11 2.96 0.94
Self-Storage N/A N/A N/A N/A N/A 0.00 0.00
Senior Housing N/A N/A N/A N/A 1.62 12.90 5.93
Other 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Source: Morgan Stanley, Intex

226
exhibit 5 CMBS DELINQUENCIES BY STATE (IN %)
(AS OF OCTOBER 2004 REMITTANCE REPORTS)

Current Balance % Total Change From


State ($BN) Delinq. Last Month
CA 59.3 0.53 -0.06
NY 45.3 0.43 -0.07
TX 25.9 2.79 0.24
FL 23.0 1.70 -0.06
IL 12.6 2.11 -0.10
NJ 12.7 0.76 0.03
VA 12.6 0.14 -0.08
MA 10.5 1.39 -0.49
PA 10.2 1.75 -0.22
MD 9.9 0.27 -0.11
Total/Average 221.9 1.06 -0.06
Source: Morgan Stanley, Intex

1997 1998 1999 2000 2001 2002 2003 2004


7.40 3.64 2.15 1.44 1.52 0.00 0.00 0.00
3.67 3.62 2.24 3.02 0.76 0.25 0.00 0.00
4.43 1.09 2.60 4.20 0.62 0.00 0.00 0.00
0.54 0.86 0.39 0.69 0.33 1.16 0.00 0.00
1.50 1.01 3.66 3.44 3.74 1.19 0.26 0.00
3.92 2.99 3.82 2.41 0.24 0.22 0.04 0.00
3.63 1.42 1.46 1.25 0.53 0.09 0.04 0.00
0.41 0.55 0.66 1.75 0.00 0.00 0.00 0.00
4.55 3.05 2.33 2.33 2.09 0.00 0.00 N/A
6.41 2.59 2.04 0.00 0.00 0.00 0.00 0.00

Please see additional important disclosures at the end of this report. 227
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

Section II. Summer Update


In this summer 2004 issue of our tracking report, we provide details on 73 spe-
cially serviced loans ($447.6 million in current balances) in Morgan Stanley con-
duit transactions.
Loans in this report are either currently in special servicing or are resolved loans
that were covered in our previous report. Conduit transactions issued off
Morgan Stanley’s shelf that do not have any loans in special servicing are not in
this report.
The information provided is based on July 2004 and August 2004 remittance
reports and recent conversations with special servicers.

exhibit 6 MORGAN STANLEY TRANSACTIONS


(JULY 2004 REMITTANCE REPORTS)

Original Current
Balance Balance
Deal Name ($MM) ($MM) Factor
Morgan Stanley Capital I, 1996-C1 340.5 128.3 0.38
Morgan Stanley Capital I, 1996-WF1 605.4 234.2 0.39
Morgan Stanley Capital I, 1997-ALIC 802.7 312.0 0.39
Morgan Stanley Capital I, 1997-C1 640.7 315.6 0.49
Morgan Stanley Capital I, 1997-HF1 622.4 270.7 0.43
Morgan Stanley Capital I, 1997-WF1 559.2 356.7 0.64
Morgan Stanley Capital I, 1998-CF1 1,107.3 850.8 0.77
Morgan Stanley Capital I, 1998-HF1 1,283.7 992.2 0.77
Morgan Stanley Capital I, 1998-HF2 1,066.3 898.2 0.84
Morgan Stanley Capital I, 1998-WF1 1,392.2 1,069.6 0.77
Morgan Stanley Capital I, 1998-WF2 1,062.0 898.1 0.85
Morgan Stanley Capital I, 1999-FNV1 632.1 582.6 0.92
Morgan Stanley Capital I, 1999-LIFE 594.0 559.2 0.94
Morgan Stanley Capital I, 1999-RM1 867.1 739.1 0.85
Morgan Stanley Capital I, 1999-WF1 968.5 798.0 0.82
Morgan Stanley Dean Witter Capital, 2000-LIFE 689.0 641.8 0.93
Morgan Stanley Dean Witter Capital, 2001-TOP1 1,172.2 1,080.2 0.92
Morgan Stanley Dean Witter Capital, 2001-TOP3 1,031.2 989.9 0.96
Morgan Stanley Dean Witter Capital, 2002-TOP7 976.6 931.4 0.95
Morgan Stanley Capital I, 2003-TOP11 1,194.9 1,180.4 0.99
Total/Weighted Average 17,608.0 13,829.0 0.83

Source: Intex, Remittance Reports

228
TRANSACTION S TATISTICS
Based on July remittance reports, delinquencies on the transactions we reviewed
were 2.20% of current balances, 14 bp higher than the average for seasoned
CMBS deals (aged over one year). Cumulative losses on the transactions we cov-
ered were 64 bp, versus 54 bp for seasoned CMBS.
LOAN S TATISTICS
Twelve loans accounting for about $88.5 million in current balances are new spe-
cially serviced loans since our last report. Twelve problem loans accounting for
about $42.7 million in current balances have been resolved since our last report,
either through liquidation, payoff or by being returned to the master servicer.

Delinquency Data (%) Specially Serviced Data


Specially
Serviced or % of Specially
30, 60 Forc. & Cum Resolved Serviced or
& 90+ REO Total Loss Loans ($MM) Resolved Loans
2.65 3.21 5.85 1.02 7.5 1.7
0.00 0.00 0.00 1.32 18.3 4.1
13.62 0.00 13.62 0.39 42.5 9.5
0.00 0.00 0.00 0.81 6.6 1.5
2.94 0.00 2.94 0.36 7.9 1.8
0.00 0.00 0.00 0.00 7.6 1.7
1.26 4.75 6.01 5.70 105.5 23.6
1.27 0.00 1.27 0.96 21.9 4.9
0.83 0.88 1.71 0.52 13.3 3.0
2.93 1.70 4.63 0.21 50.5 11.3
0.00 0.00 0.00 0.00 10.7 2.4
4.49 3.19 7.69 0.10 45.8 10.2
0.00 1.76 1.76 0.00 9.9 2.2
0.55 0.57 1.12 0.27 4.2 0.9
0.00 0.00 0.00 0.06 4.2 0.9
0.00 1.57 1.57 0.39 12.2 2.7
2.15 1.13 3.28 0.01 40.2 9.0
0.50 0.00 0.50 0.06 6.8 1.5
0.00 0.47 0.47 0.00 4.4 1.0
0.00 0.00 0.00 0.00 27.6 6.2
1.26 0.94 2.20 0.64 447.6 100.0

Please see additional important disclosures at the end of this report. 229
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

Based on current balances, office properties accounted for 26.4% of the loans
reviewed, followed by retail (19.6%) and multifamily (15.6%).
In terms of loan count, retail properties had the greatest representation (16
loans), followed by multifamily (15 loans), office (13 loans), industrial-warehouse
(12 loans) and hotel (7 loans).
RATING A CTIONS
Year-to-date through August 25, 2004, tranches on deals covered in this report
experienced a 16.5 to 1 upgrade/downgrade ratio. Over the same period, the
CMBS universe experienced a 3.4 to 1 upgrade/downgrade ratio.

230
exhibit 7 SPECIALLY SERVICED LOANS
IN MORGAN STANLEY TRANSACTIONS
(JULY 2004 REMITTANCE REPORTS)

Specially Serviced % of
or Resolved Specially Serviced or
Property Type Number of Loans Loans ($MM) Resolved Loans
Office 13 118.3 26.4
Retail 16 87.6 19.6
Multifamily 15 69.6 15.6
Industrial-Warehouse 12 68.3 15.3
Hotel 7 64.7 14.5
Health Care 5 29.1 6.5
Mobile Home 3 6.4 1.4
Mixed Use 1 2.6 0.6
Self Storage 1 1.0 0.2
Total 73 447.6 100

Source: Intex, Trepp, Remittance Reports

Please see additional important disclosures at the end of this report. 231
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

Sample Loan Summary:


HILLSIDE MOBILE HOME PARK
• Original Balance: $4,839,717
• Current Balance: $4,115,841
• Percent of Pool Balance: Not Applicable
• Master Servicer: GMAC COMMERCIAL MORTGAGE CORP.
• Special Servicer: LENNAR PARTNERS.
• Trustee: LASALLE NATIONAL BANK

property description valuation information

Status: Discounted Payoff Appraisal Value: $2,650,000


Paid Though Date: Not Applicable Appraisal Date: November 2003
Location: Stillwater, New York Original LTV: 57.6%
Size: 383 Units Original Loan per Unit: $12,636
Year Built: 1971 Current LTV: Not Applicable
Property Type: Mobile Home Current Loan per Unit: Not Applicable
Originator: Morgan Stanley Underwritten DSCR: 1.53
Current DSCR: 0.72 (July 2004)

market data

Closest MSA: Albany, New York - 23 Miles


Market Average Occupancy for Property Type: Not Available
Market Average Rent for Property Type: Not Available

Source: Intex, Trepp, REIS, Special Servicers, Remittance Reports

232
REASON F OR S PECIAL S ERVICING T RANSFER
Payment default.
UPDATE
According to the August 2004 remittance report, there was a discounted payoff
of the loan on August 16, 2004, with a $1,979,805 loss to the trust.
As of July 2004, the DSCR was 0.72. An updated appraisal in November 2003
valued the property at $2,650,000.
PREVIOUS S TATUS O F R ESOLUTION
In our last report, escrows and principal and interest payments were past due.
According to the special servicer, the borrower had fallen behind on principal
and interest payments due to the increase in escrow requirements and its recent
increase in expenditures.
The borrower fell behind in escrow payments when the state required a water
and sewer upgrade. The special servicer had indicated that the borrower was in
the process of funding approximately $150,000 in upgrades to connect the park
to the county sewer system. In addition, there had been a general increase in
estimated taxes and insurance.
According to the special servicer, the DSCR was 1.13 as of July 9, 2003. The
special servicer indicated that a forbearance agreement was being negotiated.
Terms of the agreement stipulated that the borrower would pay $5,000 per
month for the next 10 months to bring the escrows current, and the special ser-
vicer would waive the default interest.
ASSET S UMMARY
The subject property is a 383-unit mobile home park, located in Stillwater, New
York. The mobile home park has several amenities, including a clubhouse and a
swimming pool. The property was approximately 74% occupied as of May 2002.
The special servicer indicated that a 2001 property inspection found the proper-
ty to be in good condition.
MATURITY D ATE
February 1, 2006

Please see additional important disclosures at the end of this report. 233
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

Section III. Retail Detail


In 2001, we published our Retail Detail study, which assessed the exposure of
risky retailers within Morgan Stanley underwritten CMBS. At the time, several
U.S. retailers announced bankruptcies or store closings, and the health of the
retail sector was deteriorating.
Today, the economy is showing signs of improvement and the retail sector as a
whole has weathered the economic downturn well. According to Reis, vacancy
rates for retail properties have remained in a stable range of 6.8% to 7.1% since
the end of 2001. As of the end of 2Q03, the retail vacancy rate was 6.9%.
Although we are less concerned with the retail sector than we are with other
property sectors, we still recognize the importance of monitoring deals for expo-
sure to weak retailers.
In this update of the retail study, we examine 42 Morgan Stanley deals for expo-
sure to 116 risky retail credits. The risky retail credits were identified by the
REIT equity research team using the Z-score methodology. All Morgan Stanley
transactions underwritten prior to July 2003 with outstanding retail loans were
included in this analysis (Exhibit 8). The equity research risky tenant list is based
on 4Q02 financial results (Exhibit 9).
Our main findings are:
• Morgan Stanley CMBS deals have limited exposure to risky tenants. On a
risk-weighted basis, 1.2% of Morgan Stanley CMBS collateral has exposure
to the retailers. Risk-weighting accounts for the portion of a loan that can
be attributed to the retailer, based on its gross leasable area.
• On average, Morgan Stanley deals have 18% total exposure to the risky ten-
ants. Total exposure includes the full balance of all loans with exposure to
any of the 116 risky tenants.
• With the exception of MSC 1997-LB1, all Morgan Stanley deals (with retail
loans) have some exposure to the risky tenants.
• Retail loans within large loan transactions have slightly more risk exposure
than retail loans within conduit deals. On a risk-weighted basis, 3.7% of the
retail loans within the large loan deals had exposure to the risky tenants.
Within conduit deals, the retail loans had 3.4% exposure. While it is some-
what surprising that the risky tenant exposure is slightly higher in large loan
deals, we do not believe that the regional and super-regional malls backing
large loan transactions pose more risk than the strip centers and smaller
shopping centers that are typically found in conduit transactions. This study
only captures risky public companies and does not assess the risk of local,
non-public retailers, which are often found in strip centers.
• MSDWC 2001-PGM had the highest risk-weighted exposure as a percentage
of the entire deal at 5.7%.

234
exhibit 8 MORGAN STANLEY CMBS DEALS

Deal Aug 2003 Total Delinquencies (%)


MSC 1996-C1 2.53
MSC 1996-WF1 2.27
MSC 1997-ALIC 1.53
MSC 1997-C1 1.85
MSC 1997-HF1 0.29
MSC 1997-LB1 0.00
MSC 1997-WF1 2.01
MSC 1997-XL1 0.00
MSC 1998-CF1 11.09
MSC 1998-HF1 1.14
MSC 1998-HF2 2.68
MSC 1998-WF1 2.76
MSC 1998-WF2 0.00
MSC 1998-XL1 0.00
MSC 1998-XL2 0.00
MSC 1999-CAM1 1.51
MSC 1999-FNV1 4.72
MSC 1999-LIFE 1.77
MSC 1999-RM1 1.53
MSC 1999-WF1 0.63
MSC 2000 HG 0.00
MSDWC 2000-LIFE 0.82
MSDWC 2000-LIFE2 0.00
MSDWC 2000-PRIN 0.00
MSDWC 2001-PGMA 0.00
MSDWC 2001-PPM 0.00
MSDWC 2001-TOP1 1.39
MSDWC 2001-TOP3 0.41
MSDWC 2001-TOP5 0.00
MSDWC 2001-FRMA 0.00
MSDWC 2001-SGMA 0.00
MSDWC 2001-DFMA 0.00
MSDWC 2001-IQA 0.00
MSDWC 2001-XLF 0.00
MSDWC 2002-HQ 0.00
MSDWC 2002-IQ2 0.00
MSDWC 2002-IQ3 0.00
MSDWC 2002-XLF 0.00
MSDWC 2002-TOP7 0.00
MSDWC 2003-TOP9 0.00
MSDWC 2003-HQ2 0.00
MSC 2003-IQ4 0.00

Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 235
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

MOTIVATION F OR T HE S TUDY
Store closing announcements and retailer bankruptcies are often followed by a
notification from CMBS data providers detailing the number of CMBS deals
affected by the closing. In order to calculate the deal exposure to a troubled ten-
ant, most CMBS data providers use databases containing the top three tenants
for each loan. While this analysis is informative, we think it falls short in at least
three aspects:
(1) The procedure misses all but the top three tenants within a loan (Some loans
only list the top tenant.).
(2) The tenant information that is used by the data providers is often not updat-
ed after deal issuance.
(3) The analysis does not look at the cumulative risk of all unhealthy tenants.
We were prompted to publish a comprehensive study that addresses the short-
comings listed above.
Using a database from the National Research Bureau, we are able to capture
82% of the loan balances of retail tenants in Morgan Stanley underwritten
CMBS deals. This compares with only 32% covered by a database of the top
three tenants. In addition, we look at the cumulative exposure of a list of risky
retailers, rather than deal exposure to just one retailer.
RETAIL P ROPERTY O VERVIEW
In aggregate, retail properties typically constitute 27%-30% of the collateral in
CMBS transactions and historically have been among the most common proper-
ty types within CMBS. Within retail properties, grocery-anchored community
centers and super-regional malls are considered more desirable than box centers
or mid-market malls. Strong regional malls and grocery-anchored community
centers typically have lower defaults and cash flow volatility than other retail
property types within CMBS.

236
exhibit 9 RISKY TENANTS AND Z-SCORES BASED ON FOURTH
QUARTER 2002 FINANCIAL STATEMENTS

Deal Z-Score Deal Z-Score


A. Hirsch & Son (1.8) Kids ’R Us 2.5
Allied Tires 1.2 Kindy Optical (26.6)
Ames - Kmart 2.4
Babies ’R Us 2.5 Landry’s Seafood House 2.1
Benson Optical (26.6) Levi’s Outlet by Designs 2.2
BestPrice! Fashions 2.7 Maier & Berkele (0.9)
BestPrice! Kids 2.7 Manhattan Bagel 0.4
Big Bear 2.6 Mayor’s Jewelers (0.9)
Big Bear Plus 2.6 Monfried Optical (26.6)
Big Kmart 2.4 Montgomery Ward Optical 2.2
Bi-Lo 2.6 National Vision Centers 1.7
BJ’s Optical 2.2 Nevada Optical (26.6)
Blockbuster Video Stores 1.4 Newport News 0.2
BOGO’s Food and Deals 3.4 Noah’s New York Bagels 0.4
Books and Co 2.3 O’Charleys 2.0
Books-A-Million 2.3 One Price & More! 2.7
Cadilac 2.1 P&C 2.6
Calloway’s Nursery 1.9 Paper Warehouse 1.5
Candies Outlet 2.2 Party Universe 1.5
Carrow’s 0.1 Pearle Vision 2.2
Casual Male Big & Tall 2.2 Pearle Vision Express 2.2
CD Exchange 0.9 Pep Boys 2.2
CD Warehouse 0.9 Perfumania 1.5
Champps Americana 2.1 Quality 2.6
Checkers 1.6 Rainforest Café 2.1
Chesapeake Bagel Bakery 0.4 Rally’s 1.6
Cinema Ride (11.9) Right Start 0.9
Coco’s 0.1 Rite Aid 2.2
Cole Vision Center 2.2 Rite Aid Pharmacy 2.2
dELiA*s 0.5 Samuel’s (1.8)
Denny’s 0.1 Schubach (1.8)
Disc-Go-Round 0.9 Sears Optical 2.2
Dockers Outlet by Designs 2.2 Service Merchandise 0.8
Duling Optical (26.6) Silverman’s (1.8)
Eagle Country Market 3.4 Silversmiths and Mission Jewelers (1.8)
Eagle Discount Foods 3.4 Singer/Specs Discount Vision (26.6)
Ecko Unltd 2.2 Site for Sore Eyes (26.6)
Eddie Bauer 0.2 Sizes Unlimited 2.4
Einstein Bros 0.4 Souplantation 2.3
Elegant Illusions 5.4 Southern Optical (26.6)
Elegant Pretenders (1.4) Spiegel 0.2
FAO Schwartz 0.9 Sterling Optical (26.6)
Florsheim (0.4) Superior Optical (26.6)
Foodco 3.4 Sweet Tomatoes 2.3
Goodyear Auto Service Center 1.2 Target Optical 2.2
Harold’s 0.7 The Avenue 2.4
Harry’s In A Hurry (4.3) The Avenue Plus 2.4
Hatfield Jewelers (1.8) The Crab House 2.1
Hearex Hearing Centers (1.0) Things Remembered 2.2
Hill’s Department Store 0.6 Today’s Man 0.8
Homeland Grocery 3.0 Tommy Hilfiger 2.1
Hometown Auto Retailers 4.0 Toys ’R Us 2.5
Imaginarium 2.5 Vista Optical 1.7
Imposters (1.4) Ward’s Optical 2.2
IPCO Optical (26.6) Wayne Jewelers (1.8)
Jennifer Convertibles 4.7 Wickes Lumber 2.6
Jennifer Leather 4.7 Willie G’s 2.1
Joe Mugg’s Newstand 2.3 Wing Foot 1.2
Joe’s Crab Shack 2.1 Xando Cosi (2.8)
Just Tire 1.2 Zany Brainy 0.9

Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 237
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chapter 13 Transaction Monitoring

Risky Retailers
Risky tenants were determined from the Z-Score methodology, which was devel-
oped by Professor Edward Altman of NYU and implemented by the Morgan
Stanley REIT equity research team. The Z-score methodology is a statistical
technique, which attempts to predict financial distress of corporations using
financial ratios. Altman’s methodology uses multiple discriminant analysis
(MDA) and a sample of 66 firms to derive the best linear combination of the
firms’ financial ratios.
The discriminant function that results from the MDA considers five financial
ratios, which are multiplied by different coefficients to produce a score:
Z-Score:1.2* (Working Capital / Total Assets)+
1.4* (Retained Earnings / Total Assets) +
3.3* (EBIT / Total Assets) +
0.6 * (Market Value of Equity / Liabilities) +
1.0 * (Sales / Total Assets)
Based on Altman’s findings, Morgan Stanley’s equity research REIT group used a
cutoff Z-score of 2.4 to identify unhealthy companies. Any publicly traded com-
pany with a Z-score below 2.4 is included as one of the risky tenants. In addi-
tion, the REIT group also included companies with stock prices below $1.00,
even if their Z-scores were above 2.4. Companies that trade on the NASDAQ
bulletin board or companies that had been delisted because of delinquency in fil-
ings were also included. The resulting 116 risky tenants are listed in Exhibit 10.
For further discussion of the Z-score methodology and the financial ratios,
see Predicting Financial Distress of Companies: Revisiting the Z-score and Zeta Models
by Edward I. Altman.
METHODOLOGY
In order to assess CMBS exposure to the 116 risky retailers, we used the
National Research Bureau Shopping Center Directory to locate risky tenants
within the CMBS deals. The Shopping Center Directory lists all tenants within
40,000 shopping centers nationwide, giving us the ability to locate many tenants
that would be undetected in conventional CMBS tenant searches. The National
Research Bureau Shopping Center Directory is updated semi-annually. This
report was based on data in the first 2003 version released in June. CMBS data
providers and prospectus material typically only list the largest three tenants
within a shopping center. Therefore, the information provided in the directory
allows us to look at smaller tenants within various retail properties.
With both the shopping center directory and S&P Conquest data, we can track
82% of retail balances in Morgan Stanley deals. If this study were performed
using data solely from the S&P Conquest database, only 32% of the retail loan
balances would have complete tenant information.
In total, we had some level of tenant information for 97% of the retail loans
within the transactions that we examined. Sixty-nine percent of the loans were

238
covered through information from the National Research Bureau Shopping
Center Directory, and had complete tenant information for the shopping centers.
Twenty-eight percent of the loans were covered through data obtained from the
S&P Conquest database, which only provided information on one to three ten-
ants per shopping center. Tenant information was not available for about 3% of
the retail loans.
For each deal, we calculated a “weighted-risk” retail exposure (in $). We define
weighted-risk retail exposure as the sum of all weighted-risk retail balances for
each shopping center with risky tenants. The weighted-risk retail balance for
each shopping center is computed in the following way:
[Current balance of shopping center loan with risky tenant exposure]*[Sum of
gross leasable areas (GLA) of risky tenants in the shopping center] / [GLA of
entire shopping center]
We also computed total risk exposure for each deal, which is equal to the sum of
all current shopping center loan balances with risky tenant exposure.
In our previous study, we did not consider the retail risk of any multiproperty
loans. In this publication, we have increased the scope of our study to include
multiproperty loans, most of which are found within the XL deals. To calculate
weighted-risk retail balances for multiproperty loans, we considered each shop-
ping center individually by using allocated loan amounts.
SHORTFALLS/OTHER F ACTORS T O C ONSIDER
As with most studies, there are a few caveats that should be highlighted. Risk-
weighted exposure is not necessarily a true indicator of the riskiness of a shop-
ping center. There are financially distressed retailers that are not captured in this
study, as we only cover publicly traded companies.
Risk-weighted exposure also implies that only a portion of the loan is at risk
when stores become distressed. This may be true if a couple of small retailers
go out of business. However, the entire loan may be at risk if a number of
stores in the shopping center become distressed. We did not account for this in
our study.
For the purposes of this study, we also examined and included all adjacent or
adjoining retailers within a specific shopping center, regardless of whether the
tenant’s space is collateral in the securitization. It is possible that we are includ-
ing out-parcels or portions of shopping centers that are not part of the Morgan
Stanley securitizations. However, inclusion is important since retailers are affect-
ed by the health of the shopping center as a whole.
In addition, we computed risk-weighted exposures based on the size of the retail-
er, rather than by the portion of property cash flows represented by the retailer.
An anchor store, for example, with a large GLA, would be weighted heavily, even
though anchors typically pay lower rents than other smaller tenants within a mall.
For example, within a newly built center, a grocery store anchor may pay rent of
only $10 per square foot but occupy 70% of the GLA, while the in-line tenants
may pay $20 per square foot and only occupy 30% of the GLA.

Please see additional important disclosures at the end of this report. 239
Transforming Real Estate Finance
chapter 13 Transaction Monitoring
SAMPLE DEAL SUMMARY
exhibit 10 MSC 1996-C1

Source: Morgan Stanley

240
Please see additional important disclosures at the end of this report. 241
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

Section IV. CMBS Ratings Actions


• Rating changes at each of the three rating agencies followed similar patterns
during the first three quarters of the year. At least 84% of each agency’s
upgrades were on mezzanine CMBS, while more than 59% of each agency’s
downgrades were on subordinate tranches.1
• Fitch was the most active, accounting for more than half of all rating actions.
Moody’s was the least active but accounted for almost half of the downgrades.
Fitch had the highest upgrade/downgrade ratio (6.4 to 1), while Moody’s had a
more balanced ratio (1.3 to 1) and S&P had a ratio closer to the ratio of the
overall universe (3.8 to 1).

exhibit 11 2004 YTD1 RATING ACTIONS BY RATING AGENCY

Rating Agency Upgrades Downgrades


Moody’s 198 156
S&P 348 91
Fitch 554 87
Total 1,100 334
1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

• As the rating agencies moved in concert, so did the direction of the bonds.
Upgrades outnumbered downgrades on investment-grade CMBS by a ratio of
8.8 to 1, while downgrades outnumbered upgrades on non-investment grade
tranches. The upgrade/downgrade ratio for non-investment grade CMBS was
0.7 to 1. This ratio was lower for non-investment grade floating rate CMBS
(0.2 to 1).

exhibit 12 2004 YTD1 RATING CHANGES BY CREDIT CLASS

Fixed Rate CMBS Floating Rate CMBS All CMBS


Credit Class Upgrades Downgrades Upgrades Downgrades Upgrades Downgrades
Investment Grade 790 44 155 63 945 107
Non-Investment Grade 146 190 9 37 155 227
Total 936 234 164 100 1100 334
1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

1
Mezzanine CMBS includes AA+ through BBB-; Subordinate CMBS includes BB+ and below.

242
• The overall upgrade/downgrade ratio was positive for both fixed and floating
rate CMBS. Fixed rate classes experienced a 4.0 to 1 ratio, while floating rate
classes experienced a lower ratio of 1.6 to 1.
• In total, rating agencies upgraded 1,100 CMBS classes and downgraded 334,
resulting in a 3.3 to 1 ratio. This is an improvement over the 1.8 to 1 ratio for
year-end 2003.

exhibit 13

HISTORICAL CMBS
RATING ACTIONS

1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

• The CMBS upgrade/downgrade ratio remains more favorable than the corpo-
rate bond ratio over the same period. Through the third quarter, corporate
bonds experienced an upgrade/downgrade ratio of 0.9 to 1.

Please see additional important disclosures at the end of this report. 243
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 14

2004 YTD1 RATING


CHANGES BY
COHORT YEAR

1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

• The 2000 cohort persists as the worst performing issuance year in terms of
rating actions, accounting for 24% of all CMBS downgrades (81) in 2004YTD.
In 2003, about 14% of all tranches issued in 2000 were downgraded.
Through 3Q2004, about 8% of tranches issued in 2000 were downgraded.
• While almost half of the downgrades on the 2000 cohort were on floating
rate classes and rake tranches in 2003, over 85% of the downgrades in
2004YTD were due to deteriorating credit fundamentals on fixed rate classes.

exhibit 15 2004 YTD1 DOWNGRADES BY CMBS ISSUANCE YEAR

% of Total Unique
Issuance Year Tranches Downgraded
1998 3.0
1999 4.7
2000 7.9
2001 4.1
2002 3.9
2003 0.2
1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P, Commercial Mortgage Alert

244
This Page Intentionally Left Blank

245
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 16 2004 YTD1 RATING CHANGES MATRIX


FOR ALL CMBS
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB
AAA 0 7 0 0 0 3 0 0 0 0 0 0
AA+ 71 0 1 0 0 1 0 1 0 0 0 0
AA 154 49 0 3 3 2 0 0 1 0 0 0
AA- 19 15 17 0 0 0 0 0 0 1 0 0
A+ 27 13 11 21 1 0 2 1 0 0 1 0
A 31 20 21 29 46 0 4 2 3 0 1 1
A- 12 4 7 2 30 33 0 3 2 2 1 0
BBB+ 11 2 7 3 11 16 22 0 4 3 2 0
BBB 10 5 13 9 9 28 22 43 1 11 6 3
BBB- 4 0 3 2 4 10 16 22 39 0 15 5
BB+ 3 0 2 0 1 2 2 6 11 19 0 7
BB 0 0 2 0 1 3 1 1 4 9 20 0
BB- 0 0 0 0 0 1 2 1 0 0 9 8
B+ 0 0 0 0 0 1 0 1 1 0 1 2
B 0 0 0 0 0 0 1 0 2 0 5 1
B- 0 0 0 0 0 0 0 0 0 0 1 2
CCC+ 0 0 0 0 0 0 0 0 0 1 0 0
CCC 0 0 0 0 0 0 0 0 0 0 2 0
CCC- 0 0 0 0 0 0 0 0 0 0 0 0
CC+ 0 0 0 0 0 0 0 0 0 0 0 0
CC 0 0 0 0 0 0 0 0 0 0 0 0
CC- 0 0 0 0 0 0 0 0 0 0 0 0
C+ 0 0 0 0 0 0 0 0 0 0 0 0
C 0 0 0 0 0 0 0 0 0 0 0 0
C- 0 0 0 0 0 0 0 0 0 0 0 0
D 0 0 0 0 0 0 0 0 0 0 0 0
Total 342 115 84 69 106 100 72 81 68 46 64 29

1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

246
BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- C+ C C- D Total
0 0 0 0 0 0 0 0 0 0 0 0 0 0 10
0 0 0 0 0 0 0 0 0 0 0 0 0 0 74
0 0 0 0 0 0 0 0 0 0 0 0 0 0 212
0 0 0 0 0 0 0 0 0 0 0 0 0 0 52
0 0 0 0 0 0 0 0 0 0 0 0 0 0 77
0 0 0 0 0 0 0 0 0 0 0 0 0 0 158
0 0 0 0 0 0 0 0 0 0 0 0 0 0 96
0 1 0 0 0 0 0 0 0 0 0 0 0 0 82
0 0 2 1 0 0 0 0 0 0 0 0 0 0 163
6 0 0 2 0 0 0 0 0 0 0 0 0 0 128
2 0 0 1 0 1 0 0 0 0 0 0 0 0 57
14 10 4 2 0 3 0 0 0 0 0 0 0 0 74
0 10 6 4 1 0 1 0 0 0 0 0 0 0 43
2 0 12 15 2 1 0 0 1 0 0 0 0 1 40
2 10 0 18 13 9 0 0 1 0 0 0 0 2 64
0 0 3 0 12 28 3 0 4 0 0 0 0 4 57
0 0 0 0 0 0 0 0 1 0 0 0 0 1 3
0 1 2 1 1 0 3 0 13 0 0 2 0 6 31
0 0 0 0 0 0 0 0 1 0 0 0 0 1 2
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 2 0 0 2
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 5 5
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
1 0 0 1 1 1 0 0 0 0 0 0 0 0 4
27 32 29 45 30 43 7 0 21 0 0 4 0 20 1434

Please see additional important disclosures at the end of this report. 247
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 17 2004 YTD1 RATING CHANGES MATRIX


FOR FIXED RATE CMBS TRANCHES
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB
AAA 0 1 0 0 0 3 0 0 0 0 0 0
AA+ 54 0 0 0 0 1 0 1 0 0 0 0
AA 125 42 0 1 1 2 0 0 1 0 0 0
AA- 14 10 12 0 0 0 0 0 0 1 0 0
A+ 22 10 9 17 1 0 2 1 0 0 1 0
A 25 19 17 27 44 0 1 0 2 0 0 1
A- 10 4 5 2 25 32 0 2 1 1 1 0
BBB+ 8 2 4 3 10 15 18 0 2 0 0 0
BBB 6 4 9 8 8 23 20 40 1 5 1 1
BBB- 2 0 1 1 3 8 14 21 35 0 6 1
BB+ 3 0 2 0 1 2 2 6 10 17 0 7
BB 0 0 2 0 1 3 1 1 3 7 20 0
BB- 0 0 0 0 0 1 2 1 0 0 9 8
B+ 0 0 0 0 0 1 0 1 1 0 0 2
B 0 0 0 0 0 0 1 0 2 0 4 1
B- 0 0 0 0 0 0 0 0 0 0 1 1
CCC+ 0 0 0 0 0 0 0 0 0 1 0 0
CCC 0 0 0 0 0 0 0 0 0 0 2 0
CCC- 0 0 0 0 0 0 0 0 0 0 0 0
CC+ 0 0 0 0 0 0 0 0 0 0 0 0
CC 0 0 0 0 0 0 0 0 0 0 0 0
CC- 0 0 0 0 0 0 0 0 0 0 0 0
C+ 0 0 0 0 0 0 0 0 0 0 0 0
C 0 0 0 0 0 0 0 0 0 0 0 0
C- 0 0 0 0 0 0 0 0 0 0 0 0
D 0 0 0 0 0 0 0 0 0 0 0 0
Total 269 92 61 59 94 91 61 74 58 32 45 22

1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

248
BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- C+ C C- D Total
0 0 0 0 0 0 0 0 0 0 0 0 0 0 4
0 0 0 0 0 0 0 0 0 0 0 0 0 0 56
0 0 0 0 0 0 0 0 0 0 0 0 0 0 172
0 0 0 0 0 0 0 0 0 0 0 0 0 0 37
0 0 0 0 0 0 0 0 0 0 0 0 0 0 63
0 0 0 0 0 0 0 0 0 0 0 0 0 0 136
0 0 0 0 0 0 0 0 0 0 0 0 0 0 83
0 1 0 0 0 0 0 0 0 0 0 0 0 0 63
0 0 1 0 0 0 0 0 0 0 0 0 0 0 127
1 0 0 0 0 0 0 0 0 0 0 0 0 0 93
0 0 0 0 0 0 0 0 0 0 0 0 0 0 50
12 6 3 1 0 3 0 0 0 0 0 0 0 0 63
0 9 5 2 0 0 0 0 0 0 0 0 0 0 37
2 0 11 14 1 1 0 0 0 0 0 0 0 0 34
2 10 0 17 11 7 0 0 1 0 0 0 0 1 57
0 0 3 0 12 25 2 0 3 0 0 0 0 2 49
0 0 0 0 0 0 0 0 1 0 0 0 0 1 3
0 1 2 1 1 0 3 0 13 0 0 2 0 6 31
0 0 0 0 0 0 0 0 1 0 0 0 0 1 2
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 1 0 0 1
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 5 5
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
1 0 0 1 1 1 0 0 0 0 0 0 0 0 4
18 27 25 36 26 37 5 0 19 0 0 3 0 16 1170

Please see additional important disclosures at the end of this report. 249
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 18 2004 YTD1 RATING CHANGES MATRIX


FOR FLOATING RATE CMBS TRANCHES
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB
AAA 0 6 0 0 0 0 0 0 0 0 0 0
AA+ 17 0 1 0 0 0 0 0 0 0 0 0
AA 29 7 0 2 2 0 0 0 0 0 0 0
AA- 5 5 5 0 0 0 0 0 0 0 0 0
A+ 5 3 2 4 0 0 0 0 0 0 0 0
A 6 1 4 2 2 0 3 2 1 0 1 0
A- 2 0 2 0 5 1 0 1 1 1 0 0
BBB+ 3 0 3 0 1 1 4 0 2 3 2 0
BBB 4 1 4 1 1 5 2 3 0 6 5 2
BBB- 2 0 2 1 1 2 2 1 4 0 9 4
BB+ 0 0 0 0 0 0 0 0 1 2 0 0
BB 0 0 0 0 0 0 0 0 1 2 0 0
BB- 0 0 0 0 0 0 0 0 0 0 0 0
B+ 0 0 0 0 0 0 0 0 0 0 1 0
B 0 0 0 0 0 0 0 0 0 0 1 0
B- 0 0 0 0 0 0 0 0 0 0 0 1
CCC+ 0 0 0 0 0 0 0 0 0 0 0 0
CCC 0 0 0 0 0 0 0 0 0 0 0 0
CCC- 0 0 0 0 0 0 0 0 0 0 0 0
CC+ 0 0 0 0 0 0 0 0 0 0 0 0
CC 0 0 0 0 0 0 0 0 0 0 0 0
CC- 0 0 0 0 0 0 0 0 0 0 0 0
C+ 0 0 0 0 0 0 0 0 0 0 0 0
C 0 0 0 0 0 0 0 0 0 0 0 0
C- 0 0 0 0 0 0 0 0 0 0 0 0
D 0 0 0 0 0 0 0 0 0 0 0 0
Total 73 23 23 10 12 9 11 7 10 14 19 7

1
Through September 30, 2004.
Source: Morgan Stanley, Fitch, Moody’s, S&P

250
BB- B+ B B- CCC+ CCC CCC- CC+ CC CC- C+ C C- D Total
0 0 0 0 0 0 0 0 0 0 0 0 0 0 6
0 0 0 0 0 0 0 0 0 0 0 0 0 0 18
0 0 0 0 0 0 0 0 0 0 0 0 0 0 40
0 0 0 0 0 0 0 0 0 0 0 0 0 0 15
0 0 0 0 0 0 0 0 0 0 0 0 0 0 14
0 0 0 0 0 0 0 0 0 0 0 0 0 0 22
0 0 0 0 0 0 0 0 0 0 0 0 0 0 13
0 0 0 0 0 0 0 0 0 0 0 0 0 0 19
0 0 1 1 0 0 0 0 0 0 0 0 0 0 36
5 0 0 2 0 0 0 0 0 0 0 0 0 0 35
2 0 0 1 0 1 0 0 0 0 0 0 0 0 7
2 4 1 1 0 0 0 0 0 0 0 0 0 0 11
0 1 1 2 1 0 1 0 0 0 0 0 0 0 6
0 0 1 1 1 0 0 0 1 0 0 0 0 1 6
0 0 0 1 2 2 0 0 0 0 0 0 0 1 7
0 0 0 0 0 3 1 0 1 0 0 0 0 2 8
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 1 0 0 1
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
9 5 4 9 4 6 2 0 2 0 0 1 0 4 264

Please see additional important disclosures at the end of this report. 251
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

Section V. Originator Delinquencies


We revisited our periodic report examining the credit performance of various CMBS
loan originators using September remittance report data.
Delinquencies on the CMBS universe that we examined declined 29 bp to 1.38% of
current balances since we last analyzed the data (January 2004 remittance reports).
Cumulative losses on CMBS remained low, rising 7 bp since our last report to 37 bp.
When we examined the data by originator type, as we have done in the past, we
found each originator type posted delinquencies and cumulative losses fairly close to
the mean (Exhibit 19).
CREDIT C OORDINATES M ATRIX
In order to provide a visual representation encompassing more variables (delinquen-
cies, cumulative losses, origination year, and originator), we applied the credit coordi-
nates matrix developed by our ABS home equity research team to this study.
The average cumulative loss rate and delinquency rate for a given sample of data
provide the boundary point separating the quadrants within the graphic. The lower
left hand quadrant is the most desirable or “sweet spot”, with cumulative losses and
delinquencies below the average. The upper right hand quadrant is the least desir-
able with losses and delinquencies above the average.
In order to put all of the originators on the same playing field in terms of loan sea-
soning, we produced a matrix for each origination year.
We focused our analysis on originations that occurred between 1995 and 2002, since
CMBS issuance was limited prior to 1995, and loans originated after 2002 have low
delinquencies and no cumulative losses. We also limited our analysis to the most
active originators based on current balances outstanding1.

exhibit 19 DELINQUENCIES AND CUMULATIVE LOSSES


BY INSTITUTION TYPE

Number of Original Current % 30


Originator Type Issuers Balance ($MM) Balance ($MM) Days Del
Commercial Bank 22 91,563.9 74,441.3 0.26
Finance Company 29 79,366.7 59,229.2 0.27
Investment Bank 28 249,928.2 189,848.4 0.19
Insurance Company 20 25,628.6 18,819.1 0.04
Total/Weighted Average 99 446,487.2 342,338.0 0.21
Source: Morgan Stanley, Intex

1
For investment bank, commercial bank and finance company originators we used a $3 billion outstanding bal-
ance cut off. Since life company collateral accounts for only $18.8 billion in current balances, we used a $1
billion cut off.

252
exhibit 20

CREDIT
COORDINATES High losses and low High losses and High
delinquencies delinquencies
MATRIX Cumulative Losses

Average
Low losses and low
delinquencies Low losses and
"Sweet Spot" high delinquencies

Delinquencies

Source: Morgan Stanley

Regardless of the origination year, the “sweet spot” was not dominated by one origi-
nator type over time. Investment banks, commercial banks, finance companies and
life companies were all represented in the lower left hand quadrant during each year.
Very few originators were located in the least desirable quadrant (upper right); how-
ever, between 1995 and 1999, investment banks accounted for 8 out of the 11 origi-
nators in that quadrant.
Although these graphics provide a quick view of five important variables, other fac-
tors outside the scope of this analysis will affect the performance of a particular
transaction. Subordination levels, structure and collateral mix will also play a role in
the performance of bonds within specific deals.

Change
% 60 % 90 % % Total Since % Cum
Days Del Days Del Foreclosure % REO Del 01/04 Loss
0.04 0.34 0.12 0.42 1.17 0.09 0.30
0.09 0.77 0.15 0.41 1.68 -0.29 0.48
0.07 0.41 0.15 0.56 1.38 -0.52 0.35
0.20 0.66 0.10 0.23 1.23 0.54 0.48
0.07 0.47 0.14 0.48 1.38 -0.29 0.37

Please see additional important disclosures at the end of this report. 253
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chapter 13 Transaction Monitoring

Most transactions are comprised of collateral from several different originators.


Therefore, the loan performance of a single loan contributor should not be used to
determine the credit quality of a particular transaction. Investors need to assess the
performance of all originators that contribute to a transaction.
For example, TOP transactions contain collateral originated by five originators: Bear
Stearns, John Hancock, Morgan Stanley, Principal, and Wells Fargo. Examining the
loans of any one of these entities is not necessarily an indicator of how the TOP
program will fare over time. Examining the long term loan performance of all the
originators contributing to TOP transactions should be a good benchmark for the
credit quality within the deals. In addition to contributing collateral to TOP transac-
tions each of these originators also contributes to other dealer programs.
In the eight years of data examined, loans from these originators delivered solid
credit performance. Bear Stearns appeared in the lower left hand quadrant in all
eight years, Morgan Stanley, Principal, and Wells Fargo appeared in six out of eight
years, while John Hancock appeared in four years.
The credit coordinate matrices for 1995-2002 are contained in Exhibits 26 through
33 at the end of this piece.
ORIGINATION Y EAR P ERFORMANCE
Investors are often interested in how particular loan vintages perform over time. We
examined CMBS loan origination years between 1986 and 2004 and found no origi-
nation year with cumulative losses over 1.06%. Although subordination levels have
been declining over time, cumulative losses of each vintage year remain well below
the 5% credit enhancement on BBB CMBS issued in 2004.
The 1995 vintage experienced the highest cumulative loss rate (1.06%).
Approximately one-quarter of the cumulative losses on 1995 collateral were due to
the $23.0 million Columbia Mall loan liquidation in DLJMA 1995-CF2 and the $17.3
million Perimeter Square Shopping Center loan in MLMI 1995-C2.
Vintages with at least $20 billion of collateral outstanding followed a seasoning
curve with cumulative losses rising each year between 1997 and 2004.
However, vintages prior to 1997 do not follow this trend. For example, 1996 collat-
eral had cumulative losses of 0.63% while 1997 collateral had cumulative losses of
1.00%. This may be explained by small original balances in years prior to 1997 since
CMBS was in its infancy.

254
exhibit 21

CUMULATIVE
LOSSES BY
ORIGINATION YEAR
(%)

Source: Morgan Stanley, Intex

exhibit 22 DELINQUENCIES AND CUMULATIVE LOSSES


BY ORIGINATION YEAR

Original Current
Original Balance Balance % Total % Cum
Year ($MM) ($MM) Del Loss
Pre-1986 1,832.7 211.4 0.16 0.10
1986 752.3 27.2 0.00 0.30
1987 1,099.3 145.4 2.26 1.01
1988 1,046.1 99.5 0.00 0.29
1989 1,201.2 148.4 0.00 0.77
1990 1,202.2 244.4 15.60 0.37
1991 945.5 83.4 0.00 0.80
1992 2,054.9 217.3 0.03 0.32
1993 5,347.5 546.0 1.51 0.32
1994 9,239.7 805.2 3.40 0.67
1995 11,252.5 3,372.0 3.82 1.06
1996 21,924.5 9,923.6 1.91 0.63
1997 48,154.4 29,418.8 3.28 1.00
1998 81,813.9 58,709.3 2.00 0.57
1999 49,198.6 35,046.5 2.50 0.42
2000 47,407.6 33,892.5 2.03 0.28
2001 69,041.0 53,291.1 0.97 0.07
2002 58,111.7 50,566.9 0.32 0.02
2003 86,370.3 82,974.9 0.06 0.00
2004 21,309.8 21,188.7 0.00 0.00
Total/Weighted 519,305.7 380,912.5 1.27 0.33
Average*

*Total and Weighted Average of the entire universe. See the methodology section for more detail.
Source: Morgan Stanley, Intex

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Transforming Real Estate Finance
chapter 13 Transaction Monitoring

PROPERTY T YPE
Finally, we examined cumulative losses by property type to assess the effect on an
originator’s delinquency and cumulative loss performance. For example, if an origi-
nator type had an above average concentration in unconventional property types it
might explain the originator’s higher than average cumulative loss rate.
To evaluate how an originator’s average cumulative loss rate is influenced by proper-
ty type, we calculated property type concentrations for each originator type.
Our data support the conventional wisdom that life insurance companies tend to be
more conservative by lending less often to non-conventional property types while
investment banks are more active in non-conventional property types.
Life companies originate more retail loans (37%) than the average and fewer hotel
loans (4%) than the average. Investment banks issue the greatest percentage of
hotel loans (10%) and the lowest percentage of multifamily loans (15%).
In addition to property type concentrations, we examined originator cumulative loss
rates by property type. Investment bank collateral had cumulative loss rates below
the average for all property types except multifamily. Finance company loans had
cumulative loss rates above the average for office, hotel, and other collateral.
Hotel collateral experienced the highest cumulative loss rate by property type
(1.19%), but comprised only 8% of the CMBS universe we examined.

exhibit 23 PROPERTY TYPE CONCENTRATION


BY ORIGINATOR GROUP (%)
(BY ORIGINAL BALANCE)
Commercial Finance Investment Insurance
Bank Company Bank Company Average
Office 23 22 28 25 26
Hotel 5 7 10 4 8
Retail 30 25 33 37 31
Multifamily 26 21 15 15 19
Other1 15 25 14 19 17
Total 100 100 100 100 100
1
Other includes industrial, self storage, senior housing, and mixed use.
Source: Morgan Stanley, Intex

METHODOLOGY
This analysis of CMBS collateral was based on the Intex database, which contains
$519.3 billion in original balances from 796 transactions. In the previous version of
this study, our data did not contain paid down transactions within Intex, limiting our
analysis to outstanding deals. In this update, we added data from paid down deals
and provided cumulative loss information by originator.

256
exhibit 24 CUMULATIVE LOSSES
BY INSTITUTION AND PROPERTY TYPE (%)

Commercial Finance Investment Insurance


Bank Company Bank Company Average
Office 0.19 0.25 0.20 0.30 0.21
Hotel 1.98 1.54 1.01 0.22 1.19
Retail 0.24 0.28 0.31 0.95 0.34
Multifamily 0.16 0.20 0.25 0.08 0.21
Other1 0.23 0.83 0.32 0.18 0.43
Total 0.30 0.48 0.35 0.48 0.37
1
Other includes industrial, self storage, senior housing, and mixed use.
Source: Morgan Stanley, Intex

For the purposes of this study, we analyzed all originators with more than $100 mil-
lion in original balances outstanding. After eliminating the smaller originators, our
universe contained $446.5 billion in original balances from 99 different originators.
All CMBS collateral was analyzed including large loans and floating rate loans.
Delinquencies and cumulative losses were evaluated at the loan level. If several orig-
inators contributed to one transaction, delinquencies for each loan were assigned to
the respective originator. Over the past several years, some originators have merged,
so certain entities such as DLJ no longer exist.
For this study, we do not combine data for originators that have merged over
time. Maintaining the original underwriter’s name allows investors to benchmark
their portfolios.
We also grouped the collateral by originator type (commercial bank, finance
company, investment bank or insurance company). Within the insurance com-
pany category, 18 of the 20 originators are life insurance companies. The
other two originators (Nationwide and State Farm) predominantly provide
casualty insurance.
In addition to analyzing CMBS collateral performance by originator, we assessed
collateral performance by origination year. We included the entire Intex universe
for this analysis. Since the data is evaluated at the loan level, the origination year
provided is the year in which the loan was originated, not the year in which the
CMBS transaction was issued.
The overall delinquency rate we provided includes 30-day delinquencies.
However, it is important to note that loans often move in and out of the 30-day
bucket due to timing of payments rather than fundamental deterioration.
Secore is a temporary shelf used by originators that are not registered in a par-
ticular state where the property is located. For our analysis, we only had suffi-
cient data to assign Secore originated loans to Morgan Stanley where appropri-
ate. We did not have sufficient information on the remaining Secore collateral to
assign them to their respective originators.

Please see additional important disclosures at the end of this report. 257
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 25 LOANS ORIGINATED IN 1995:


CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

258
exhibit 26 LOANS ORIGINATED IN 1996:
CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

Please see additional important disclosures at the end of this report. 259
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 27 LOANS ORIGINATED IN 1997:


CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

260
exhibit 28 LOANS ORIGINATED IN 1998:
CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

Please see additional important disclosures at the end of this report. 261
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 29 LOANS ORIGINATED IN 1999:


CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

Cumulative Losses (%)


2.0
TIAA Morgan Guaranty*
(Total Delinquencies =0.00,
1.8 Cumulative Losses =4.08)

1.6 Morgan Stanley

1.4

1.2

1.0

0.8
Lasalle
0.6
PrincipalWells Fargo GACC
Prudential GMAC Salomon Brothers
0.4 Keybank CSFB
Greenwich
Bear Stearns Merrill Lynch Column
0.2 First Union* GE Capital
Lehman Bank of America CIBC
UBS Chase*Archon John Hancock Goldman Sachs
0.0
0.0 2.0 4.0 6.0 8.0 10.0 12.0
NationsBank Total Delinquencies (%)
Nomura
Nomura Conduit*
Secore
Wachovia Investment Bank -- Plain Text
Commercial Bank -- Italic Text
Finance Company -- Gray Text
Insurance Company -- Gray Italic Text

*Inactive originators
Source: Morgan Stanley, Intex

262
exhibit 30 LOANS ORIGINATED IN 2000:
CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

Please see additional important disclosures at the end of this report. 263
Transforming Real Estate Finance
chapter 13 Transaction Monitoring

exhibit 31 LOANS ORIGINATED IN 2001:


CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

264
exhibit 32 LOANS ORIGINATED IN 2002:
CUMULATIVE LOSSES AND CURRENT DELINQUENCIES

*Inactive originators
Source: Morgan Stanley, Intex

Please see additional important disclosures at the end of this report. 265
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266
Chapter 14

Transforming Real Estate Finance


European CMBS

Please see additional important disclosures at the end of this report. 267
Transforming Real Estate Finance
chapter 14 European CMBS

Poised for Growth


• CMBS poised for growth in Europe.
• European CMBS remain attractive.
• The CMBS advantage could close further.
• Move up in rating and pick up spread.
EUROPEAN M ARKET P OISED F OR G ROWTH
Growth in the European CMBS market picked up in 2004, and most analysts proj-
ect that the sector is entering a period of steady increases in issuance volumes.
The market saw $23 billion in issuance in 2004, a 50% increase from 2003. The
slowdown in 2003 resulted from a number of factors including the ramping up of
several new conduits, the delay of a large Italian deal, and a downturn in the U.K.
office market.

exhibit 1

EUROPEAN CMBS
ISSUANCE
(IN BILLIONS OF
U.S. DOLLARS)

1
Forecast by Morgan Stanley Research; SCIP is an Italian government mixed residential and commercial
mortgage transaction.

Source: Morgan Stanley and Commercial Mortgage Alert (CMA)

In terms of issuance, the European CMBS market is nine to ten years behind
the U.S. The pattern of issuance growth in Europe between 1999 and 2003 par-
allels U.S. growth from 1990-1994.
While we do not expect the same surge in European CMBS growth that
occurred in the U.S. in 1998, we expect steady growth over the next five years.
European CMBS has the potential to grow to a market with $40-50 billion of
annual issuance within a few years. Two forces that could lead to substantial
growth are the implementation of the Basel II accords in 2006 and the passage
of a “true sale initiative” in Germany that would ease the process of securitiza-
tion in Europe’s largest economy.

268
exhibit 2

EUROPEAN CMBS
MARKET…THE
NEXT U.S.?

1
Estimate by Morgan Stanley Research. F=Forecast by Morgan Stanley Research.
Source: Morgan Stanley

Historically, half or more of all European CMBS issuance has been out of the
the U.K. Recently, deals have been issued in several other countries, including
France, Italy, Sweden, and Poland. There has also been a proliferation of “pan-
European” deals with collateral from several countries.

exhibit 3

2003 EUROPEAN
CMBS ISSUANCE
BREAKDOWN (BY
COUNTRY)

Source: Morgan Stanley

RELATIVE V ALUE: E UROPEAN C MBS R EMAINS A TTRACTIVE


VERSUS C ORPORATES
Floating-rate European CMBS spreads source moved to historically tight levels
in 2004, yet remain wider than corporate and some U.S. alternative investments.
For example, as of December 2004, 5-year AAA floating-rate European CMBS

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Transforming Real Estate Finance
chapter 14 European CMBS

traded at LIBOR + 20 bp, 40 bp tighter than at the start of the year. Spreads
have also tightened further down the credit curve.

exhibit 4

AAA FLOATING-
RATE CMBS
SPREADS, DEC.
1999- DEC 2004
(bp)

Source: Morgan Stanley

With the investor base for European CMBS increasing, the gap between CMBS
and European corporates has narrowed by 40-100 bp in 2004 and could close
further, in our view. In addition, the increasing amount of information on
European CMBS should be another force pushing in bid-ask spreads.
RATING A DVANTAGE F OR E UROPEAN C MBS
In addition to the spread advantage over corporate bonds, European CMBS are
rated more conservatively than both European corporates and U.S. CMBS.
European AAA subordination levels are at 20-30%, close to the U.S. levels of
several years ago and substantially higher than today’s U.S. AAA levels of 12%
to 18%.

exhibit 5
WESTERN EUROPE – 1-YEAR RATING TRANSITION MATRIX,
1993-2002
(%) AAA AA A BBB BB B
AAA 100.00 0 0 0 0 0
AA 3.33 95.00 1.67 0 0 0
A 0 5.08 93.22 1.69 0 0
BBB 0 1.82 1.82 94.55 1.82 0
BB 0 0 0 0 100.00 0
B 0 0 0 0 0 0
CCC-C 0 0 0 0 0 0

Source: Fitch

270
European CMBS have been one of the best performing asset classes in terms of
the ratio of upgrades to downgrades. Exhibit 5 shows that in the period 1993-
2002, for example, twice as many BBB CMBS (2 x 1.82%) were upgraded as
downgraded.
CMBS R ISK A ND T RANSACTION S TRUCTURES
We outline below some of the key features of transaction structures and associ-
ated risks that need to be considered by investors when considering investment
in CMBS. Although the description is based heavily on our experience of U.K.
transactions, the general principles are applicable to all real estate markets,
although legal processes will vary between jurisdictions.
TRANSACTION S TRUCTURES
Exhibit 6 sets out in a simplified schematic form some of the key relationships
that commonly feature in CMBS transactions.

exhibit 6

TYPICAL CMBS
ISSUANCE
STRUCTURE

Source: Morgan Stanley

Please see additional important disclosures at the end of this report. 271
Transforming Real Estate Finance
chapter 14 European CMBS

The following table highlights the common structural features of transactions.

exhibit 7 KEY STRUCTURAL FEATURES OF CMBS TRANSACTIONS

Legal Structure
Exhibit 6 describes a simplified typical structure and can be used to illustrate
both single-asset/single corporate sponsor and conduit-style transactions.
Single asset/corporate transactions
An issuing vehicle will make a loan of bond proceeds to one or more borrow-
ers, who in turn will be property-owning subsidiaries within a company group
structure (Borrowers A and B) ultimately owned by a holding company. These
borrowers will in turn be the owners of specific properties that will be leased
to underlying lessees. The leases generate the rental flows to the borrowers
that in turn will enable the borrowers to service the loans from the issuer. The
issuing SPV can be included within the corporate structure with the same ulti-
mate holding company owner as borrowers A and B.
Conduit transactions
Conduit transactions are broadly similar except that Borrowers A and B will be
unconnected and the loans to these borrowers will instead usually have been
originated by a commercial lender prior to being assigned to the issuer at the
time of the bond issue. The assets of Borrowers A and B will be owned prop-
erty assets leased to end-users.
For both single asset and conduit transactions, Borrowers A and B will nor-
mally be limited or special purpose companies with contractually limited other
activities. These borrowers will fulfill no material role other than to borrow
from the issuer (or intermediate borrower) and to own and lease the relevant
property and to enter the asset pledge and collateral agreements.
Cross-C
Collateralization
An important distinction between conduit and non-conduit transactions is
that, in the case of conduit transactions, the underlying borrowers are not
normally part of the same corporate entity and therefore underlying prop-
erties cannot be cross-collateralized.
However, excess interest on the pool of loans (in simple terms the differ-
ence between the interest earned on the loans and the interest costs of the
bonds) can be used to help absorb losses in those conduit transactions that
are not cross-collateralized.
Although the absence of cross-collateralization may be a negative feature in
conduit transactions, compensating features usually include borrower and
property diversity

1
See “Commercial Mortgage Defaults: An Update” in Real Estate Finance (Spring 1999).

272
Asset Sales
Particularly in the case of corporate transactions, borrowers may want to
preserve the option of selling specific assets from the portfolio. Structures
can permit this, but for concentrated portfolios there is normally a require-
ment for proceeds to be generated to the extent that they raise 115%-130%
of the underlying financing allocated to that property which is then used to
pay down the financing. This technique avoids the potential negative
adverse selection through the cherry-picking of properties and reduces the
LTV of the remaining financing. Clearly, this mechanism will not apply to
non cross-collateralized conduit transactions.
Liquidity Support
Although legal structures of U.K. transactions are arranged in the expecta-
tion that underlying loans will not become embroiled in extended insolven-
cy proceedings, liquidity facilities from highly-rated banks provide support
for timely payment of interest and principal in the event of borrower insol-
vency or temporary disruptions to cash flows due to re-tenanting. Liquidity
facility providers are ultimately senior to bond investors, and such facilities
usually contain restrictions on how much liquidity can be advanced to sup-
port junior classes.Liquidity facilities also normally contain borrowing base
restrictions which require underlying assets to provide minimum coverage
levels for liquidity drawings.
Interest Rate Hedging
Bond marketing considerations may require at least partial issuance in float-
ing rate instruments. Underlying lease cash flows are by their nature fixed
flows and cash flows on underlying conduit loans can be fixed. This mis-
match is covered by interest rate hedging with bank counterparties.
Cash Control
Rentals due on underlying leases are ideally directed to special trustee
accounts to avoid commingling and associated corporate bankruptcy risks
where applicable.
Reserve Accounts
Reserve accounts are funded (at the expense of the equity holder in the
transaction) for various reasons. These may typically include reserves
required if specified debt service coverage levels are breached or special
reserves that may be required, for example, if a defined share of underlying
leases are due to terminate within a certain period prior to a refinancing
date. Debt service reserves are alternatively seen pending achievement of
certain rental levels in lease-up situations.

Please see additional important disclosures at the end of this report. 273
Transforming Real Estate Finance
chapter 14 European CMBS

The following table describes the key credit risk concerns in CMBS transactions
and some of the ways in which bondholder protection is structured to overcome
the credit issues.

exhibit 8 KEY CREDIT RISKS OF CMBS TRANSACTIONS

Tenant Quality
The credit quality of transactions will benefit from a preponderance of
investment grade tenants. This is a rare feature outside of ‘trophy’-type securi-
tizations. The value of higher rated tenants is that they are less likely to
default on leases in times of economic stress, which will reduce the exposure
of the transaction to re-leasing on tenant default with associated cash flow
losses arising from both the time taken to re-lease the property and the asso-
ciated potential cash flow losses that might arise from the need to re-lease the
property at lower rental rates in difficult economic circumstances.
Tenant Diversity
High tenant quality is frequently combined with limited tenant diversity. This
is a feature of city office developments but less conspicuous with large-scale
retail developments, where the tenant base is usually more widely spread,
although the tenants may be in the same industry and retail operators may
each suffer similar business stresses at the same time. Risk to transactions can
therefore become concentrated: a single lessee default can cause material dis-
ruption. For example, in the Canary Wharf II transaction 65% of closing
rentals was derived from 2 tenants – yet in ELoC 4 there are 440 separate ten-
ants with a maximum rental of 4% from a single tenant.
Lease Maturities
Long lease terms at the outset - in excess of 15 years - are a strong support
to a transaction as they improve the relative assuredness of cash flows.
Similarly, the existence of average remaining lease terms exceeding 10 years
at the point of any assumed refinancing also helps to provide confidence
that debt can be refinanced.
Lease Break Clauses and Maturities
Key analytical assumptions when reviewing real estate financings involve
taking account of the pattern of lease maturities and break clauses within leases.
Transactions are assessed according to how well they may perform if lease ter-
mination (or lessee default) coincides with recessionary conditions, which require
material discounts in rentals or rent-free periods to entice new tenants.
Transactions are required to withstand progressively higher levels of discount in
line with higher desired ratings on underlying securities. Rental decline assumed
in recessions may range from 20-35% depending on the credit rating desired.
An even distribution of lease maturities is preferable to bunching as this
reduces the risk of lease maturities coinciding with economic stresses.

274
Generally, the assumptions for rated transactions are that 65% of maturing
leases are renewed by tenants, with the balance re-leased, after an interval,
at lower rental levels.
Re-L
Leasing Periods
Assumptions for time periods required for re-leasing vacated properties or finding
new lessees post default will depend upon the desired rating of the underlying
bonds with assumed periods normally between 15 and 18 months.
The nature of real estate collateral is also key here as the assumed re-leasing periods
may be lower in the case of high quality leading city developments or retail park sites
that are multi-tenanted rather than isolated, specialized, single tenant sites.
Macro-perceptions on the durability of certain underlying industries may also
affect views on re-leasing prospects. For example, long-term perceptions concern-
ing the viability of London as a financial centre will affect views on City office re-
lettings, whereas views as to the threat to retail locations from home/internet
shopping could impact perceptions of the Trafford Centre transaction.
Valuations
Valuations at closing are obtained from leading valuation companies and trans-
actions have been able to support the issuance of BBB securities at LTVs of
70.2% (Canary Wharf Finance II), 73.1% (MS Mortgage Finance (Broadgate))
and 69.3% (Trafford Centre).
The ELoC conduit transactions have been able to issue variously at BBB-
levels at LTVs of 70%, BBB at 78%, BB at 76%. The underlying structure
and nature of the assets will impact these levels.
For example, at the BBB level Canary Wharf Finance II had an initial DSC of
1.14X (interest only) – but this was forecast to rise to 1.39x in Year 2 as dis-
counted rents expired – whereas initial interest cover for similarly-rated tranch-
es on the ELoC transactions ranged between 1.18x and 1.64x.
Amortization Structures
Arrangements vary, although it is common for transactions to require bal-
loon refinancing even at the end of extended debt tenors – Canary Wharf
II features a £100m (21% of original principal) refinancing requirement
after 30 years. The assumption is, notwithstanding the extended maturity,
that the real estate can be comfortably re-financed at these levels. Trafford
Centre, however, is scheduled to amortize fully over its 22-year life.
In contrast, the ELoC transactions are much shorter term with final matu-
rities not exceeding 9 years. Amortization reducing the underlying loan
LTVs compared to LTVs at closing of approximately 10% occurs in all
transactions and it is assumed that due to the high degree of interim amor-
tization (principal is paid down faster for the transaction life than would be
required under a 30 year mortgage-style amortization profile), and also with
the benefit of projected strong interest cover levels at the refinancing date,
then refinancing opportunities for the underlying loans would be available.

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276
Chapter 15

Transforming Real Estate Finance


Japanese CMBS

Please see additional important disclosures at the end of this report. 277
Transforming Real Estate Finance
chapter 15 Japanese CMBS

A JPY 25 Trillion Market?


The Japanese commercial mortgage-backed securities market is still in the early
stages of development. In 2004, issuers brought close to US$7 billion in
Japanese CMBS to market, roughly the size of the U.S. market in 1991. Does
the Japanese CMBS market have the potential to grow at the rate of the U.S.
market over the past decade? What are the risks and opportunities for investors
in this relatively new fixed-income product?
Our main findings are:
Growth Potential
• The Japanese CMBS market has the potential to grow over the next decade
to a market cap of JPY 25 trillion (US$200 billion) or more.
Conduit Market
• If a conduit market develops, annual issuance could reach JPY 3 trillion
(US$25 billion) over the next 4 to 6 years.
Japanese Economy
• Long term growth in the Japanese CMBS market is dependent on the recov-
ery in the Japanese economy and stabilization or growth in real estate values.
Expanding Investor Base
• Growth of a Japanese CMBS conduit market will likely lead to an expansion
of the investor base and greater liquidity.
In the next section, we first review the historical development of the Japanese
CMBS market. We then discuss the current structural features of Japanese
CMBS and rating agency methodology. Following is a section on pricing of
Japanese CMBS and relative value. Then we present data on recent Japanese
CMBS and the Japanese real estate market and end with the questions an
investor should ask before buying a Japanese CMBS.
REASONS F OR J APANESE C MBS E MERGENCE
Much as in the U.S. CMBS market, Japanese CMBS are evolving out of dis-
tressed conditions for commercial real estate in Japan. The steep real estate
recession of the late 1980s and early 1990s in the U.S. was the worst since the
Depression of the 1930s. Prices of commercial real estate fell by 50% or more
in some areas and delinquency rates on loans soared to all-time highs. Japan in
the 1990s has seen real estate values fall as much as 90% after the bubble period
of the 1980s.

278
Before the mid-1990s the U.S. real estate business was predominately a private
market. Lending was dominated by a handful of banks, life insurance companies,
and pension funds. Losses on commercial loan portfolios led to the exit of many
traditional lenders from the commercial mortgage market. Regulators and rating
agencies turned more negative on commercial mortgage holdings, so that the
remaining lenders became less willing to extend credit. As the chart below
shows, thrifts and insurance companies went from supplying over $40 billion in
commercial and multifamily loans in 1985 to decreasing their holdings by $46
billion by 1992.

exhibit 1

NET SUPPLY BY
INSURANCE
COMPANIES AND
THRIFT
INSTITUTIONS TO
THE U.S.
COMMERCIAL/
MULTIFAMILY
MORTGAGE
MARKET
(IN BILLIONS OF $)

Source: Federal Reserve Board, Flow-of-Funds

In Japan, we could see a similar process growing out of the current downturn.
Many banks and insurance companies are in financial distress and are less will-
ing to extend long-term credit to real estate borrowers. As in the U.S., the
Japanese CMBS market is a natural substitute for traditional originators of com-
mercial mortgages.
A B RIEF H ISTORY O F C MBS: U .S. A ND E UROPE
In the U.S., investment banks started to apply securitization legal structures, and
technology developed during the 1970s and 1980s for residential mortgage
backed securities to commercial mortgages. In the mid- to late-1980s, issuers
securitized a few loans on single properties into CMBS.
Packaging of diversified pools of mortgages into CMBS developed in the U.S. in
the early 1990s when the Resolution Trust Corporation (RTC) pooled nonper-
forming loans from failed institutions. Some transactions exceeded $1 billion and
led to the growth in the investor base for CMBS. After the success of the RTC
transactions, CMBS gained wider acceptance with investors and nongovernment,
or “private-label conduit,” issuers.

Please see additional important disclosures at the end of this report. 279
Transforming Real Estate Finance
chapter 15 Japanese CMBS

Issuance of CMBS in the U.S. grew rapidly in the mid-1990s, reaching $78 bil-
lion in 1998. In Europe, CMBS has also taken hold as a financing vehicle, with
$13 billion issued in 2001. Most of the transactions are out of the United
Kingdom, but deals have been done in several other countries.
The Second Stage
As the table below shows, we believe that the Japanese CMBS market is current-
ly in the second stage of development, comparable to the early 1990s in the U.S.
This phase comes at the end of a period of distress for real estate. This period
lasted for about five years in the U.S. – in Japan it could go on for longer.
Toward the middle or end of this period we would expect to see the growth of
conduit deals and a decrease in CMBS backed by distressed deals.

exhibit 2 CMBS GROWTH: U.S. AND JAPAN


(BILLIONS OF U.S. $)

United States Japan


Non-
Year RTC RTC Total Year Total
Stage 1 – Early Development
1989 0 4.1 4.1 1998 0.0
1990 0 3.4 3.4 1999 1.1
Stage 2 – Distressed Assets
1991 2.7 5.0 7.6 2000 5.2
1992 8.8 5.2 14.0 2001 4.9
1993 3.1 14.1 17.2 2002p 9.0
1994 3.0 14.4 17.4 2003 TBD
1995 1.2 16.7 17.8 2004 TBD
Stage 3 – Conduit Growth
1996 0.0 28.8 28.8 2005 TBD
1997 0.0 40.4 40.4 2006 TBD
1998 0.0 77.7 77.7 2007 TBD
p= Morgan Stanley Forecast; TBD= to be determined
Source: Morgan Stanley, Commercial Mortgage Alert

Japanese CMBS: JPY 25 Trillion?


In its next phase, we believe that the Japanese CMBS market has the potential to
grow in the next decade to a market capitalization of JPY 25 trillion (US$200
billion) or more. In order for this growth to occur, in our view, a Japanese ver-
sion of the U.S. conduit market must develop. A conduit originates loans solely
for the purpose of securitization and not for portfolio holding.
The development of CMBS conduits spurred growth of the U.S. CMBS market.
Conduit originations account for more than half of all CMBS collateral in the
U.S. In Europe as well, conduits have been a main contributor to the growth of
the CMBS market.

1
Moody’s Investors Service, “Japanese Securitization Market: 2001 Year in Review and 2002 Outlook,”
May 9, 2002.

280
exhibit 3 % of GDP
1.0
RATIO OF CMBS
ISSUANCE TO GDP 0.8

0.6

US
0.4

0.2

Japan
0.0
US: 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
Japan: 1998 1999 2000 2001 2002

Source: Morgan Stanley, Commercial Mortgage Alert

Conduits do not want to hold collateral for a long period. They therefore tend to
originate standardized pools of mortgages since this speeds the securitization
process. This standardization attracts money managers who are not real estate
experts. These investors do not have to spend a lot of time analyzing a pool and
are attracted by the commodity-like nature of conduit pools. The broadened
investor base has been one of the main factors behind the growth of the CMBS
market in the U.S.
Although still in the early stages, conduits are starting to develop in Japan. It is our
belief that conduits will not start to grow at a rapid pace until the Japanese econo-
my begins a sustained recovery. In the U.S., conduit originations did not grow rap-
idly until the real estate recovery was under way. In the initial stages of the market,
growth in conduit originations depends on both a high level of real estate transac-
tions and investor willingness to buy securities related to real estate. Another
important element is the willingness of some investors to hold the unrated and
lower-rated classes of CMBS, which are a levered real estate investment.
If the conduit market does eventually take off, we believe the Japanese CMBS
market could eventually become as large a share of the mortgage market as in
the U.S. The size of the U.S. market is rapidly approaching $400 billion dollars,
or about 20% of the value of all commercial and multifamily mortgages.
Although there are not exact numbers available, we estimate that there is the
potential for the commercial and multifamily mortgage market to grow to JPY
125 trillion (US$1 trillion). This assumes a slightly lower mortgage to GDP ratio
than in the U.S. If we also assume that the Japanese mortgage market continues
to grow and the Japanese CMBS share of mortgages approaches the U.S. ratio,
the size of the Japanese CMBS market has the potential to grow to JPY 25 tril-
lion (US$200 billion). We think that annual issuance could approach JPY 3 tril-
lion (US$25 billion). This would put the ratio of Japanese CMBS to Japanese
GDP roughly in line with the current ratio in the U.S.

Please see additional important disclosures at the end of this report. 281
Transforming Real Estate Finance
chapter 15 Japanese CMBS

STRUCTURAL F EATURES
CMBS have very simple structures compared to their residential mortgage coun-
terparts. Bonds are almost always sequential pay, with amortization, prepayments,
and default recoveries paid to the most senior remaining class. The lowest rated
remaining class absorbs losses, after equity and reserves are reduced to zero. In
the U.S., commercial mortgages almost always have some form of prepayment
penalty, so credit analysis plays a more important role than prepayment analysis.
In Japan, call protection has not become a standard feature yet, but we believe
that this is necessary for a conduit market to develop.
CMBS are static pools of commercial real estate loans divided into tranches with
varying subordination levels and credit ratings. In the U.S., a typical transaction
has about 90% investment grade bonds, concentrated in AAA securities, with the
remaining 10% noninvestment grade. Interest only (IO) bonds can be stripped
off all or part of the structure.
A typical structure consists of sequential pay, fixed rate bonds. The AAA bonds
are time-tranched with a 5-year AAA bond ahead of a 10-year AAA bond. The
subordination level for a AAA conduit deal ranges from 15% to 25%.
In Japan, since the market is still in its early stages, no standard structure has yet
developed. Most performing loan deals, however, have the sequential structure
described above. The tranches are typically 5 to 7 year bullets, with an additional
2 to 3 years until the legal final maturity. The extra time until the legal final is to
allow for workouts of loans that default at the bullet payment date.
CALL P ROTECTION, S ERVICING, A ND O THER F EATURES
Call protection on Japanese CMBS is not as strong as in the U.S, where defea-
sance is the most common form of prepayment penalty. For a defeased loan, the
prepaying borrower must place Treasury securities into the trust to generate cash
flow that matches the mortgage payments. For European CMBS, fixed-rate loans
usually have call protection. Most floating-rate loans in Europe have weak or no
call protection. In Japan, defeasance is rarely used, although some loans have
prepayment penalties.
The Trustee, Master Servicer and Special Servicer each play an ongoing role in
the transaction. The Pooling and Servicing Agreement, Prospectus, and other
legal documents outline each party’s responsibilities and fees. Typically, the
Trustee is responsible for reporting monthly payments and collateral perform-
ance data to certificate holders. The Master Servicer is responsible for servicing
all performing loans and monitoring loan document requirements. The Special
Servicer resolves defaulted or delinquent loan issues.
In both Japan and the U.S., in addition to the mortgage collateral, credit enhance-
ments may be in the form of reserve funds, guarantees, letters of credit, cross-col-
lateralization and cross-default provisions. Loans within the pool may have certain
cash control provisions such as a “lock box” that requires payments from tenants
to go directly to the trust instead of through the borrower if certain default trig-
gers occur. Virtually all loans within CMBS are bankruptcy remote.

282
Under new accounting rules issued by the Japan Association of Certified Public
Accountants, an originator cannot move a securitized asset off balance sheet
unless its holding of the subordinate class is less than 5%. The impact of this
change has been minimized by the development of a sub-investment grade
investor base.
THE M YCAL C HALLENGE
In 2001, the Japanese corporation Mycal, a major retailer, went into bankruptcy.
A bankruptcy court administrator challenged the bankruptcy-remoteness of the
collateral in two CMBS backed by shopping centers leased by Mycal.
Although the specific case is still being negotiated, most observers believe that it
should not have any negative long-term effects on securitization in Japan. Rating
agencies have downgraded some classes of the deals because of collateral per-
formance, but have not taken any negative rating actions because of the case.
They also have not changed rating criteria.
In June 2002, Emeritus Professor Shindo of Tokyo University published an arti-
cle supporting the position of investors in the Mycal CMBS case. The opinion
was a counter-argument to the opinion of Professor Yamamoto of Kyoto
University, which Mycal’s administrator made public in May. Shindo believes that
receivables in a securitization should not be part of bankruptcy reorganization
under the Japanese Corporate Rehabilitation Law.

In Japan, the rating agencies have published limited credit enhancement guide-
lines for CMBS deals. We believe, however, that the rating agencies will apply a
similar methodology to the rating of Japanese conduit CMBS. The table below
shows Standard and Poor’s published criteria for Japanese CMBS.

exhibit 4 JAPANESE CMBS BASE-CASE CMBS RATING CRITERIA

Rating DSCR LTV (in %)


AAA 2.25-2.5 35-40
AA 2.0-2.25 40-47.5
A 1.8-2.0 47.5-55
BBB 1.6-1.8 55-60
BB 1.4-1.6 60-65
B 1.2-1.4 65-75
Source: Standard and Poor’s

Early on, some rating agencies looked at the volatility of real estate values com-
pared to the U.S. as a basis for Japanese CMBS ratings criteria. Recently, however,
most have used a cash flow approach to evaluating credit risk. This methodology
tends to lead to more stable valuations than using individual property appraisals.

Please see additional important disclosures at the end of this report. 283
Transforming Real Estate Finance
chapter 15 Japanese CMBS

MONITORING
After a transaction is issued, rating agencies monitor deals for changes in credit
risk. As the Japanese CMBS market is relatively new and many deals are private,
it is often difficult for investors to receive detailed monthly monitoring reports.
In the more developed U.S. market, private vendors such as Trepp, RealPoint,
and Conquest provide loan level monitoring details on every transaction.
As the Japanese CMBS market develops, we expect to see a growth in the
number of readily available monitoring reports and the amount of detail in
each report. Improvement in monitoring systems will help the investor base
for Japanese CMBS to grow, as less time will be needed to keep track of
investments in the sector.
LACK O F J APANESE D EFAULT D ATA
In Japan there is scant default data and not enough deals or history to evaluate
rating changes. How, then, can we assess the expected default rates on Japanese
CMBS? The short answer is we can’t, at least to the degree of confidence as in
the U.S.
What we can do, though, is look at what sort of scenario it would take to cause
default on a AAA Japanese CMBS. We can then attempt to judge the probability
of such an event occurring. We estimate that the combination of subordination
and equity in current Japanese CMBS exceeds 50% and can be as much as 65%
on performing loan deals. Rating agencies (and originators) also usually reduce
or “haircut” the current cash flows of a property in their underwriting.
Given these assumptions, we estimate that it would take a fall in current property
values of 70% or more to expose the AAA-rated classes to losses. BBB classes
could withstand a fall of prices in excess of 40% in most cases.
PRICES D OWN 5 3%
The Japan Real Estate Institute (JREI) has the longest time series of property
values in Japan. The JREI publishes a commercial land price index for urban
areas that dates back to the mid-1950s. In Japan, a high percentage of property
value is in land since there is a limited amount of space for development. The
national commercial land price index has fallen 53% from March 1990 through

exhibit 5 120
Nationwide
6 Largest Cities
COMMERCIAL 100
LAND PRICES IN
80
JAPAN
60

40

20

0
Mar-55 Oct-66 Jun-78 Feb-90 Sep-01

Source: JREI

284
March 2002. This is by far the worst period of decline in the 47-year history of
the index. In large cities, prices have fallen even more. The commercial index for
large cities has fallen by 84% from 1990 to 2002.
While it’s possible that the index could decline further, a drop of the magnitude
to threaten AAA CMBS seems unlikely. A further 70% fall in the land price
index would put its value in nominal terms close to the level in March 1967. In
real terms, the fall in prices would put values close to the level of the early
1960s, or almost 90% below the peak value in 1990.
In large cities, an additional drop of 60% would put values at less than 5% of
the peak. A similar percentage drop in another bubble market, the NASDAQ,
equates to a decline from the peak of 5000 to 250, less than 20% of its value as
of June 2002.
INSULATION
In the U.S. CMBS market, the high subordination levels for investment grade
CMBS insulated those securities from the recent downturn in U.S. real estate
markets. In 2001 and 2002, vacancies in many areas of the U.S. were moving to
double-digit levels as real estate markets declined, yet investment grade CMBS
spreads were flat to tighter. Subordination had the effect of removing much of
the direct real estate risk from the higher-rated classes of CMBS.
In Japan, it is too early to say whether subordination levels are of the same
degree of conservatism as in the early days of U.S. CMBS. Under current rating
criteria, however, the Japanese real estate market could undergo further signifi-
cant declines without causing defaults on investment grade Japanese CMBS. The
severe downturn of the past ten years could be repeated without causing a
default of most AAA-rated Japanese CMBS. Since most Japanese CMBS have a
maturity of 5 to 7 years, the decline would also have to occur in a much shorter
time frame than the current downturn to affect investment grade bonds.

Please see additional important disclosures at the end of this report. 285
Transforming Real Estate Finance
chapter 15 Japanese CMBS

Case Studies: Selected Japanese CMBS


EAST R EALTYCO., L TD.
Issuer East Realty Kabushiki Kaisha
Amount JPY 83.9 billion (US$670 million)
Issue date March 2002
Final maturity 2009 Expected maturity: 2007
Collateral Tobu Dept. Store (Ikebukuro) and adjacent buildings; Tobu
Dept. Store (Funabishi) and adjacent buildings; land in Harajuku.
Ratings Standard and Poor’s, Fitch

STRUCTURE/PRICING
Amount Spread to LIBOR
Class Rating (Bil. of JPY) (in bp) Coupon
A AAA 44.1 60 Fixed
B AA 10.2 80 Fixed
C A 10.4 100 Fixed
D BBB 11.2 160 Fixed
E BB+ 8.0 350 Fixed

RATING A GENCY P OSITIVES RATING A GENCY C ONCERNS


• Location of stores • Concentration risk in Ikebukuro store
• Prime location of Harajuku land • Single tenant risk
• Geographical diversification • Outlook for domestic retail
• High alternative use • Illiquid property types (railway facilities
• Tobu as creditworthy tenant and department stores)
• Liquidity facility • Balloon risk (nonamortizing loans)
• Strong trustee (Yasuda Trust)

LTV AND DSC RATIOS

Class Rating S&P LTV Fitch LTV S&P DSC Fitch DSC
A AAA 36 35.8 2.77 2.53
B AA 44 44.1 2.25 2.05
C A 52 52.6 1.89 1.72
D BBB 61 61.7 1.61 1.47
E BB+ 68 68.2 1.46 1.33

Source: S&P Presale Report, 2/18/2002; Fitch New Issue Report, 3/26/2002

Reserves JPY 3 billion capital expenditure reserve; JPY $1.5 billion


operational expense reserve; JPY 4.2 billion security reserve
Payments Semi-annual
Underwriter Mizuho Securities (lead), Daiwa, Kokusai
Property Manager Tobu Railway
Trustee Yasuda Trust
Rating Analyst Contact S&P: Tomoyoshi Omuro 3593-8584; Fitch: Masaaki Kudo
3288-2830
Source: S&P and Fitch Presale Reports

286
J-C
C MBS-1
1 L TD.
Issuer J-CMBS-1 Ltd.
Amount JPY 21 billion (US$171 million)
Issue date May 2000
Final maturity 2007 Expected maturity: 2004
Collateral 13 properties in central Tokyo. Largest loan: Akasaka 1, an
office building (27%)
Ratings Standard and Poor’s/Moody’s/Fitch
STRUCTURE/PRICING
Rating Amount Spread to LIBOR
Class (Moody’s/ S&P/Fitch) (Bil. of JPY) (in bp) Coupon
A Aaa/AAA/AAA 13.0 30 Floating
B Aa2/AA/AA 2.5 45 Floating
C A2/A/A 2.5 70 Floating
D Baa2/BBB/BBB 3.0 130 Floating
X Aaa/AAA/AAA N/a N/a Floating

RATING A GENCY P OSITIVES RATING A GENCY C ONCERNS


• Cross-collateralized portfolio • Low occupancies in some
• Location in central Tokyo buildings
• Diversified tenant base • Supply concerns in Tokyo
• Conservatively underwritten cash flow office market
• Cash trap trigger at DSCR of 1.50x • No amortization
• Well capitalized sponsors

LTV AND DSC RATIOS

Class Rating S&P LTV Fitch LTV S&P DSC Fitch DSC
A AAA 36 2.6
B AA 43 2.1
C BBB 50 1.9
D BBB 58 1.6
X AAA NA 1.46

Source: S&P Presale Report, 5/26/00

Reserves Holdback of JPY 3 billion for 6 months


Payments Semi-annual
Underwriter Salomon Brothers
Property Manager Mitsui Fudosan
Trustee Cititrust
Servicer GMAC Commercial Mortgage
Rating Analyst Contact S&P: Kenji Kondo 3593-8590

Source: S&P Presale Report

Please see additional important disclosures at the end of this report. 287
Transforming Real Estate Finance
chapter 15 Japanese CMBS

JLOC 2 001-II I L TD.


Issuer Centennial Funding
Amount JPY 71 billion (US$590 million)
Issue date November 2001
Final maturity 2008 Expected maturity: 2006
Collateral 20 trust certificates backed by 313 properties (80% office)
Ratings Moody’s/Standard and Poor’s/Fitch

STRUCTURE/PRICING
Rating Amount Spread to LIBOR
Class (Moody’s/ S&P/Fitch) (Bil. of JPY) (in bp) Coupon
A Aaa/AAA/AAA 50.0 35 Floating
B Aa2/AA/AA 8.0 55 Floating
C A2/A/A 7.0 80 Floating
D Baa2/BBB/BBB 6.0 125 Floating

RATING A GENCY P OSITIVES RATING A GENCY C ONCERNS


• Geographical diversity • Potential volatility of prices in
• Property locations in central business small cities
districts • Office concentration
• Asset manager has established disposition plan • 10% concentration in one
• Completed liquidation of some assets office building
• Assets formerly owned by Daihyaku Mutual • Higher vacancy rates than
Life market
• Fast-pay triggers dependent on debt
service coverage
• Asset manager experience
Other: Interest and principal payments dependent on cash flow from buildings and
proceeds from sale of properties. Proceeds from sale of properties used to pay
down classes sequentially, starting with the AAA class. No scheduled amortization.

Reserves Cash reserves of JPY 4.4 billion


Payments Quarterly
Underwriter Morgan Stanley
Property Manager Nomura Real Estate Development Co., MF Building,
Sumitomo Real Estate, Pacific Development
Trustee Bankers Trust
Asset Manager Morgan Stanley Properties, Japan

Source: Moody’s/S&P/Fitch Presale Reports

288
The Japanese Real Estate Market
It has long been my contention that spreads on investment-grade CMBS (in the
U.S. market) have little correlation with real estate fundamentals. In 1998, the
U.S. commercial real estate market was booming, but spreads on CMBS moved
to the widest level ever after the Russian default and Long Term Capital failure.
In 2002, spreads tightened 20 bp or more for all investment-grade conduit rat-
ings even though the real estate market was weakening and office vacancies
exceeded 20% in many cities.
I believe that in Japan, CMBS spreads will similarly be detached from real estate
fundamentals. I think that this will be especially true for diversified conduit deals.
Rating agencies have required high levels of subordination for investment-grade
rated CMBS, providing insulation from further moderate declines in real estate.
Despite this insulation, it is nonetheless instructive to examine the current state of
the Japanese real estate market. Lower-rated CMBS could be affected by real estate
trends and even highly rated-classes might feel the impact of a sharp downturn.
Ten-Y
Year Decline
The Japanese real estate market has been in almost steady decline for the last
decade. After the bubble period of the 1990s, prices have declined in every
region in Japan.
On a nominal basis, land prices in Tokyo and Osaka have declined to near the
pre-bubble levels of the early 1980s. In real terms, or as measured as a ration to
GDP, prices have fallen even further.

exhibit 6 160
Kanto (Tokyo)
Kinki (Osaka)
REGIONAL LAND 140 Chubu- Tok (Nagoya)
PRICES Tohoku (Sendai)
Kyushu (Fukuoka)
120

100

80

60

40
Mar-85 Mar-89 Mar-93 Mar-97 Mar-01

Source: JREI

Please see additional important disclosures at the end of this report. 289
Transforming Real Estate Finance
chapter 15 Japanese CMBS

exhibit 7

RATIO OF LAND
PRICE INDEX TO
GDP

Source: JREI

290
Chapter 16

Transforming Real Estate Finance


Factors to Consider Before
Investing in CMBS

Please see additional important disclosures at the end of this report. 291
Transforming Real Estate Finance
Factors to Consider Before
chapter 16
Investing in CMBS
ECONOMIC/INTEREST R ATE O UTLOOK
Investors should be aware of the growth outlook for the U.S. economy.
Investment-grade bonds tend to do well on a total return basis when GDP
growth is slow and the Federal Reserve is in an easing mode. Credit spreads,
however, might widen and defaults rise during an extended slowdown.
SWAP S PREADS
Investment-grade CMBS and swap spreads are highly correlated. The swap
spread represents the price of exchanging a fixed-rate cash flow for a floating-
rate one. Swap spreads are also a proxy for overall credit risk.
A ten-year swap spread of Treasuries + 80 bp means that one party must pay
the 10-year U.S. Treasury (UST) yield plus 80 bp to the counterparty to receive a
floating-rate (LIBOR) cash flow. If a CMBS has a yield of the UST + 130 bp
and the swap spread is 80 bp, then the CMBS is said to trade at Swaps + 50 bp.
That is, the purchaser of the CMBS receives UST +130 bp, can pay out UST +
80 bp, and receive Libor plus the 50 bp difference between 130 bp and 80 bp.
Investors should be aware of the historical trading ranges of CMBS to swaps for
each rating category. CMBS buyers should put current spreads in the context of
historical data and be able to explain circumstances that might drive spreads out-
side of trading ranges.
GLOBAL R ISK
CMBS investors should also have a view of the global economy and potential
effects of global credit risk on U.S. fixed-income markets. In 1998, the Russian
debt crisis had a major impact on U.S. markets, including CMBS.
REAL E STATE F ACTORS
Real estate cycle
High subordination levels insulate most investment-grade CMBS investors
against default during real estate downturns of the magnitude experienced over
the past 30 years. Non-investment grade buyers are more vulnerable to weaken-
ing real estate conditions. All investors, however, should monitor changes in
macro real estate trends to judge if spread widening could occur versus
Treasuries, swaps, or other sectors.
Real estate data
There are a myriad of sources from which to obtain data on real estate condi-
tions. Providers include:
• American Council of Life Insurers (commercial mortgage delinquencies and
originations).
• Federal Reserve Board (Beige Book on regional economic conditions; flow-of-
funds data on commercial and multifamily originations).
• U.S. Census bureau (construction).
• Torto Wheaton Research (vacancy data by property type and market).

292
• CB Commercial (vacancies and rents).
• F.W. Dodge (construction).
• REIS (property market overviews).
• PricewaterhouseCoopers (property market overviews).
• Smith Travel Research (hotel occupancies and room rates).
• Moody’s, Standard & Poor’s, Fitch (periodic reports on real estate and CMBS).
RELATIVE V ALUE
Investors use several benchmarks for CMBS spreads:
• Single-A bank and finance – Formerly used as a benchmark for AAA CMBS;
now used for both AAAs, AAs, and single-As.
• Unsecured REITs – Benchmark for BBBs and BBB- CMBS.
• Single-A corporate industrials – Benchmark for investment-grade CMBS.
• Mortgage pass-through OAS – Comparison for AAAs.
• ABS – Benchmark for short AAAs.
CMBS investors examine the historical relationships among CMBS spreads and
those from each of these sectors. “Relative value” analysis involves judging
whether the divergence of spreads represents a buying opportunity.

Please see additional important disclosures at the end of this report. 293
Transforming Real Estate Finance
Factors to Consider Before
chapter 16
Investing in CMBS
BOND-S
S PECIFIC
In analyzing a specific class of CMBS, an investor should consider the
following factors:
Ratings
Most CMBS have at least two ratings. The rating agencies in the U.S. market are
Moody’s, Standard and Poor’s (S&P), and Fitch. Some investors require that
either Moody’s or S&P rate the bond. A potential investor should check if bond
purchased in the secondary market is on ratings watch. Rating agencies state that
they continually monitor outstanding ratings. Fitch and S&P conduct annual
reviews and are more likely to change a rating at that time.
Rating agency analysts are available to answer credit questions about new issues
or bonds in the secondary market. With a new issue, it is sometimes valuable to
call the rating agency that has not rated the bond, since that agency is likely to
have analyzed the credit more conservatively.
Subordination levels
An investor should compare the subordination level of the bond in question to
others in the market and to older transactions. Lower subordination is not neces-
sarily an indication of lesser credit quality. Issuers with highest quality collateral
obtain the lowest credit enhancement levels, and will often have the lowest delin-
quency rates.
Subordination levels have trended down over time. An investor should be com-
fortable that the current enhancement levels are appropriate for the expected
future default rates.
Issuer quality
Spreads in the CMBS market have tiered based on the perceived quality of the
issuer’s collateral. As a general rule, bank and insurance companies are viewed as
having the highest credit quality mortgages.
Investors should consider the possibility that an issuer will exit the CMBS busi-
ness. Even though CMBS are bankruptcy remote, the failure of an issuer might
lead to spread widening because a market perception of reduced liquidity.
One quantitative check on the quality of an issuer’s collateral is the performance
of seasoned transactions. Morgan Stanley and other dealers publish delinquency
rates by issuer.
Cash flows
Investors can model simple cash flows on Bloomberg for almost all CMBS.
More detailed modeling services include Trepp LLC and Conquest. These
services allow for loan-by-loan default modeling and also provide detailed
monitoring information.
Liquidity
Investors should try to determine how many dealers make a market in a particu-
lar CMBS. If only one or two dealers trade a bond, the market will place a liq-
uidity premium on the security.

294
Property/Regional concentration
Concentrations of various property types or within regions are important factors
in analyzing CMBS. Property type or regional concentrations above 40% of a
pool may raise a warning flag. Non-standard property types such as cold storage,
health care, or manufactured housing communities also draw increased scrutiny.
This is not to say that these property types should be avoided. Instead, an
investor should make sure that the rating agencies have made proper adjustments
and that the pricing reflects any potential risk.
Deals with high (greater than 30%) concentrations of multifamily loans are often
viewed favorable, since Federal agencies are more likely to purchase these deals.
ERISA-eeligibility
Effective August 23, 2001, the Dept. of Labor ruled that CMBS rated as low as
BBB- are eligible as pension fund amendments under ERISA. For most deals
closed before that date, the issuer needs to amend the original documents to
achieve ERISA-eligibility for bonds rated less than AAA. As of August 2001,
Morgan Stanley, Nomura, and Bank of America had amended deals issued from
their shelves before the effective date.
Remittance reports
For seasoned transactions, an investor should obtain the most current remittance
report and special servicing report. Every month, the trustee compiles the
report, which details distributions and loan delinquencies. Special servicing
reports highlight loans transferred from the servicer to the special servicer.
Total delinquency rates of less than 2% are usually not a concern for AAA
investors. Thirty-day delinquency rates are of lesser concern than 60 day+ rates.

exhibit 1 CREDIT ENHANCEMENT


PNCMA 2001-C1 A2
Current At Issuance Credit
Class Balance Cpn Type Rating Enhancement
A1 141,114 5.91 Fixed Rate AAA/Aaa 19.75%
A2 560,781 6.36 Fixed Rate AAA/Aaa 19.75%
B 33,060 6.58 Fixed Rate AA/Aa2 16.00%
C1 18,856 6.80 Fixed Rate A/A2 12.50%
C2 12,000 2.57 Fixed Rate A/A2 12.50%
C2X 12,000 — IO, Other Non-Fi A/A2 —
D 11,020 6.93 Fixed Rate A–/A3 11.25%
E 8,816 — WAC/Pass Thru BBB+/Baa1 10.25%
F 13,224 — WAC/Pass Thru BBB+/Baa2 8.75%
G 7,714 — WAC/Pass Thru BBB–/Baa3 7.88%
H 16,530 5.91 Fixed Rate BB+/Ba1 6.00%
J 14,326 5.91 Fixed Rate BB/Ba2 4.38%
K 5,510 5.91 Fixed Rate BB–/Ba3 3.75%
L 8,816 5.91 Fixed Rate B+/B1 2.75%
The sources for exhibits 1-6 are cash flow runs on Trepp LLC analytics on Bloomberg.

Please see additional important disclosures at the end of this report. 295
Transforming Real Estate Finance
Factors to Consider Before
chapter 16
Investing in CMBS
Price/Yield tables
The following tables show details for a new issue conduit transaction, PNCMA
2001-C1. The deal represents an average CMBS transaction. The tables show the
resilient nature of both AAA and BBB bonds under a number of default and
prepayment scenarios.
The first table shows the capital structure of the transaction, with credit support
and ratings. The AAA bond has 19.75% subordination and the BBB 8.75%. These
levels were close to the average for conduit transactions as of August 2001.
The following table shows the types of call protection on the loans for each year after
issuance. In the first year, 97.42% of the loans have defeasance or are locked-out (LO).

exhibit 2 PREPAYMENT PENALTY MATRIX


PNCMA 2001-C1 A2
No. Date LO YM PP>=5% PP>=4% PP>=3% PP>=2% PP>=1% None
1 8/01 97.42% 2.58% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
2 8/02 96.51% 3.49% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
3 8/03 94.24% 5.76% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
4 8/04 92.85% 7.15% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
5 8/05 92.90% 5.88% 0.00% 0.00% 0.00% 0.00% 0.00% 1.22%
6 8/06 90.87% 7.41% 0.00% 0.00% 0.00% 0.00% 0.00% 1.72%
7 8/07 92.46% 7.17% 0.00% 0.00% 0.00% 0.00% 0.00% 0.37%
8 8/08 91.90% 6.39% 0.00% 0.00% 0.00% 0.00% 0.00% 1.71%
9 8/09 91.17% 6.48% 0.00% 0.00% 0.00% 0.00% 0.00% 2.35%
10 8/10 71.60% 2.40% 0.00% 0.00% 0.00% 0.00% 0.00% 26.01%
11 8/11 100.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%
12 8/12 100.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

The yield table below shows the effects of changing prepayments on the yield of
the AAA bond, priced at 101-22 1/4. Note that the yield, average life, and
spread are almost unchanged across a wide range of prepayments. CPR or some-
times “CPY,” stands for the annual prepayment rate on loans not in lockout or
defeasance. Before year 10, no more than 8.83% (100% – 91.17% in the previ-
ous table) of the loans are able to prepay. In addition, the 5-year AAA class is
absorbing the effects of prepayments.

exhibit 3 PRICE/YIELD TABLE


PNCMA 2001-C1 A2
CPR when PP <= X% 0.00 15.00 30.00 45.00 60.00
101-22¼ Price 6.172 6.172 6.172 6.171 6.171
WAL 9.35 9.34 9.33 9.31 9.30
Sprd Swaps +45.02 +45.06 +45.11 +45.17 +45.24

296
The yield table below shows the effects of changing prepayments on the yield of
the BBB bond, priced at 101-1. As with the AAA, note that the yield, average
life, and spread are almost unchanged across a wide range of prepayments.

exhibit 4 PRICE/YIELD TABLE


PNCMA 2001-C1 F
CPR when PP <= X% 0.00 15.00 30.00 45.00 60.00
100-1 Price 7.073 7.073 7.073 7.073 7.073
WAL 9.62 9.62 9.61 9.59 9.57
Sprd Swaps +131.98 +132.02 +132.10 +132.21 +132.33

The following yield table shows the effects of defaults on the AAA class. The
default rate is an annual default rate of the remaining balance, abbreviated as
CDR. The yield changes very little up to 3% CDR, an extremely high default rate
by historical standards. The change in yield at higher CDRs is caused by the
reduction of the average life of a premium security.

exhibit 5 PRICE/YIELD TABLE


PNCMA 2001-C1 A2
Default Rate 0.00 0.50 1.00 2.00 3.00
101-22¼ Price 6.172 6.171 6.170 6.166 6.162
WAL 9.35 9.31 9.25 9.10 8.91
Sprd Swaps +45.02 +45.19 +45.43 +46.06 +46.92

The yield table below shows the effects of defaults on the BBB class. The yield
is unchanged up to 2% CDR. At a default rate of 3% CDR, principal is not
affected, but the yield decreases slightly. The yield decrease is from the shorten-
ing of a premium bond.

exhibit 6 PRICE/YIELD TABLE


PNCMA 2001-C1 F
Default Rate 0.00 0.50 1.00 2.00 3.00
100-1 Price 7.070 7.070 7.070 7.070 7.159
WAL 9.62 9.62 9.62 9.62 14.13
Sprd Swaps +132.01 +132.01 +132.01 +132.02 +107.51

Please see additional important disclosures at the end of this report. 297
This Page Intentionally Left Blank

298
Transforming Real Estate Finance
Glossary

Please see additional important disclosures at the end of this report. 299
Transforming Real Estate Finance
Glossary

Anchor Store A major grocery, discount retailer, or department store that attracts
shoppers to the mall.
Anchored Strip Center A shopping center with at least one anchor store. All else
being equal, an anchored strip center is more valuable than an unanchored strip
because of the extra flow of shoppers.
ASERS (Appraisal Subordinate Entitlement Reductions)/CVA (Collateral Valuation
Adjustments) Structural deal feature that estimates unrealized losses on defaulted
loans and prevents payment of current interest on the estimated losses. Designed
to prevent conflicts between the interests of subordinate and senior classes.
Assisted Living Facilities A property type targeted to elderly needing assistance, but
not full time medical care. These facilities typically consist of apartment style units
with a kitchenette. The operator of the facility provides three meals a day and
assists residents with daily activities such as feeding, bathing, dressing, and
medication reminders.
Average Daily Rate Total guest room revenue divided by total number of
occupied rooms.
B-p
piece See Subordinated Tranche.
Call Protection The main forms of call protection in CMBS loans are lockout,
penalty points, yield maintenance and defeasance. The purpose of call protection is
to protect the lender from borrower prepayment. Defeasance and lockout provide
for the most stable cash flows. The only cash flow variability will be a result of
credit events.
Capital Expenditures (Cap Ex) Extraordinary expense items necessary to maintain
the property. Examples would include repairing a roof, repaving a parking lot, or
replacing heating and air conditioning systems.
Capitalization Rate Rate of interest (or return) used to convert a series of property
cash flows into a building value. The higher the cap rate, the riskier the asset.
CDR Annualized default rate expressed as a percentage of the remaining pool
balance; a default is assumed to be a liquidation.
Class A Properties Trophy quality properties with higher quality finishes and
prominent locations.
Class B Properties Generic real estate; 10-20 years old, well maintained, average
locations, fewer amenities.
Class C Properties Older properties needing renovation; uncertain future.
Community Center Over 100,000 - 275,000 square feet of space; multiple anchors
but not enclosed.
Congregate Senior Housing These are independent living facilities that provide a
common dining facility and other services. Congregate senior housing has no
medical component, but may provide access to emergency medical care through call
buttons. Not licensed as a nursing home.

300
Continuing Care Retirement Communities These facilities offer the entire continuum
of seniors housing from independent living to skilled nursing facilities. Residents
move within the facility depending on the level of care required. Licensed operator.
Co-o
op Loans/Blanket Loans Very low loan to value multifamily loans. Loans senior to
co-op share loans.
Co-T
Tenancy Provisions A provision in a retail lease which permits the tenant to
cancel its lease if another major tenant closes.
CPR The constant rate of the outstanding collateral principal expected to be
prepaid in a year. Also see Constant Prepayment Yield (CPY).
CPY A modified CPR that assumes prepayments to be zero until all yield maintenance
provisions are expired. CMBS IOs are priced assuming a 100 CPY speed.
Credit Tenant Lease A type of retail lease. All payments guaranteed by credit of
tenant (i.e., Wal-Mart).
Debt Service Constant Annual Principal and Interest Payment/Original Loan Amount.
Debt Service Coverage Ratio (DSCR) Net Income/Annual Debt Service. An indica-
tor of protection from cash flow volatility.
Defeasance Upon prepayment of the loan, the borrower is required to provide the
lender with U.S. government securities in an amount such that the lender receives
the same yield as if the borrower had not prepaid the loans. From the lender’s per-
spective, a defeased loan is positive. The yield is the same, but there is a credit
upgrade from commercial real estate credit to U.S. Government credit.
Distribution Space Structure in an industrial property. Principal use is distribution
or light assembly. Minimal office space as a percentage of total space (typically
0–10%). “Clear heights”, 24’ ceiling heights, are the minimum for modern distribu-
tion buildings. Higher clear heights are more economical for the tenant as they
stack goods vertically and rent fewer square feet.
Dollar Price The price at which bonds are currently trading, with a $100 dollar pric-
ing being a par bond.
Double Wide/Single Wide Describes the size of manufactured home that a given
slab will support. The double wide segment has experienced the fastest growth due
to the growing acceptance of manufactured homes as a single family housing alter-
native.
E-CCurve The front end of the swap curve is constructed with Eurodollar futures con-
tracts, which are future contracts on 3-month LIBOR. Unlike the J-spread, which is a
spread over the bond’s average life point on the Treasury curve, the E-spread is a sin-
gle constant spread that is added to each relevant point on the Eurodollar futures
curve.
EAs (Extension Advisor) Provides representation for the senior classes in a loan modi-
fication process. Typically the transaction documents require the special servicer to
get approval from the EA to grant any extensions to a loan beyond a certain date.
Fee Simple Ownership of both land and building in perpetuity.

Please see additional important disclosures at the end of this report. 301
Transforming Real Estate Finance
Glossary

FF&E Furniture, Fixtures, and Equipment; standard hotel underwriting includes a


deduction as an operating for the ongoing replacement of FF&E, typically 4% to
5% of gross revenue. This differentiates hotel underwriting from apartment under-
writing where some of those same expenses are considered capital expenditures
and are not an operating expense deducted from NOI. Typical hotel refurbishment
should occur at least every 7 years.
Flex Space/Office Warehouse Higher amount of office space as a percentage of
total space. This results in higher tenant improvement costs necessary upon lease
renewals. These tenants are less sensitive to clear heights and more sensitive to
accessibility of qualified labor pools.
Franchise Fee Fee paid to hotel company that allows hotel owner to “fly the flag”
of the hotel company (i.e., Marriott, Sheraton, etc). Fee ranges from 4% to 7% of
gross revenue.
Full Service Hotel A hotel that offers banquet and convention services; one or more
full service restaurants.
Fusion Transaction Commercial Mortgage Alert defines a fusion deal as a transac-
tion that has conduit style loans and either has one loan that is more than 10% of
the pool balance or all loans of $50 million or more are at least 15% of the deal.
Market participants often classify a deal as a fusion transaction if the top 10 loans
account for at least 40% of the collateral.
Garden Apartments Multiple buildings; usually no more than 2-3 stories.
Go Dark Provisions A provision in a retail lease. Prevents tenant from vacating the
space while continuing to pay rent; landlords like this because this vacant space is a
detriment to other stores’ sales at the center.
Ground Lease Building owner leases land from land owner.
Haircut Difference between the loan underwriter cash flow and the cash flow used
by the rating agency to size the loan. Examples of haircuts given by the rating agen-
cies include above market rents and apartment occupancies greater than 95%.
High Rise Apartments Over three stories; usually located in downtown areas.
I-C
Curve Interpolated Treasury curve. Pricing a 9.5-year CMBS bond as a spread to
the I-Curve involves interpolating yields for the remaining maturities of the on-the-
run 5-year and 10-year Treasury notes. If both notes were issued three months ago,
the interpolation would involve 4.75 years as the starting point and 9.75 years as the
ending point. For more details, see pages 90-91.
Independent Living Facilities Multifamily apartment complexes catering to senior
citizens. They supply few services beyond building and ground maintenance.
These facilities are unregulated.
In-L
Line Store Smaller store within a center (i.e.., Foot Locker or Hallmark Cards
store).
Investment Grade Tranches Tranches in a CMBS transaction that are rated between
AAA and BBB-.

302
J-C
Curve Interpolated nominal Treasury curve. Pricing a 9.5-year CMBS bond as a
spread to the J-Curve involves interpolating yields for the original maturities of the
on-the-run 5-year and 10-year Treasury notes. The J-Curve ignores any seasoning
that may have taken place in either issue. For more details, see pages 90-91.
Junior AAA Tranches See Super Senior AAA Tranches.
LTV See Loan to Value.
Leasehold Interest Building owner leases land. Lender wants ground lease term to
exceed loan amortization period.
Leasing Commissions Fees paid to brokers to bring tenants for office leases, typical-
ly $2-4 per square foot at lease signings. Landlords bear this expense.
Levered IO (Interest Only) The Levered IO is stripped off of the senior and surbor-
dinate classes of the CMBS structure. The levered IO has more exposure to collat-
eral defaults than the PAC IO, which is stripped off of the mezzanine bonds in the
capital structure. The levered IO is AAA rated because of its top priority in receiv-
ing cash flows.
Limited Service Hotel No food service other than continental breakfast, minimal
public space and small staff.
Loan to Value (LTV) Loan Amount/Appraised Value. A 70% LTV is the average for
commercial loans in CMBS transactions.
Lockout Borrower prohibited from prepaying; same as a non-call in corporate bonds.
Loss Severity Realized loan loss (in dollars)/remaining outstanding loan balance at the
month of write-off.
MAI (Member, Appraisal Institute) Designation given to certified appraisers.
Manufactured Housing Communities The land, streets, utilities, landscaping, and
concrete pads under the homes comprise a manufactured housing community. The
homes are independently financed. Homeowners pay monthly rent for the pad to
the manufactured housing community owner.
Master Servicer Receives a 2-10 bp fee to collect monthly mortgage payments and
reserve payments required by the loan documents.
Mezzanine Debt Debt secured by borrower’s equity interest in the property.
There is no lien on the property. Usually this refers to debt in addition to the
first mortgage.
Mezzanine Tranches Typically the CMBS tranches rated between AA and BBB.
They are not as senior as the AAA tranches, but are senior to the B-pieces.
NOI (Net Operating Income) Property revenues minus property expenses.

Please see additional important disclosures at the end of this report. 303
Transforming Real Estate Finance
Glossary

OA (Operating Advisor) Majority owner of the first loss class controls certain
aspects of the special servicing; generally preferred by rating agencies as an
enhancement to credit.
OAS (Option-A
Adjusted Spread) A measure of spread that adjusts for default and call
option costs.
Occupancy Rate Number of occupied units/total number of units.
PAC IO See Levered IO.
Pad Concrete slab that supports each manufactured home in a manufactured hous-
ing community.
Pari Passu Loan Pari passu loans are created when an issuer splits a large loan into
smaller pieces. These smaller pieces are often securitized in separate transactions
and are paid monthly principal and interest simultaneously and on a pro-rata basis.
Power Center/Big Box Predominantly anchor tenants and few small stores. Typically
big discounters or mass retailers.
Prepayment Penalty Points A prepayment penalty that is equal to a percentage of
the remaining loan balance (i.e., 5%, 4%, 3%, etc). Generally, the least preferable
form of call protection.
Recapture Provisions A provision in a retail lease. Permits the owner to cancel a
lease and to regain control of space after a tenant closes its store.
Regional Mall Over 750,000 square feet with several department stores (2-3) as
anchors.
REO (Real Estate Owned) A property becomes REO upon foreclosure of the loan.
The lender or trust now owns the property.
RevPAR (Revenue Per Available Room) Average Daily Rate x Occupancy Rate.
Used mainly for analyzing hotel/lodging properties.
Rollover Term used to describe expiration of a tenant lease in an office property.
Lease terms are generally for 5-10 years; credit tenants may be longer. It is prefer-
able not to have rollover concentrations, which would expose an owner to uncer-
tain rental market or potentially reduce NOI below debt service.
Self-S
Storage Facility Commercial property that leases storage space to individuals or
businesses on a month-to-month basis. The average self-storage facility has
between 40,000 and 10,000 square feet of rentable space divided among 400 to
1,000 individual units.
Shadow Anchored Strip Similar to an anchored strip except that the shopping center
does not own the anchor store.
Shadow Rating A rating on an individual loan in a large loan pool given by the rat-
ing agencies.

304
Skilled Nursing Facilities Independent nursing homes or a designated wing in a hos-
pital. The facility provides full-time licensed skilled nursing, medical and rehabilita-
tive services. Average length of stay can range from 2 months to 2 years, or more.
24-hour care is provided, with doctors and registered nurses on call. Facilities are
licensed by the state; operator must obtain a certificate of need from the state
before beginning operation.
Special Servicer Handles workout situations of delinquent or defaulted loans for
a fee. Usually, the special servicer owns the most subordinate bonds in the transac-
tion. Real estate expertise is key for special services.
Stressed DSCR Rating Agency Adjusted Cash Flow/Debt Service Payment using an
assumed debt service constant.
Sub Servicer A servicer who performs specialized tasks for the master or special
servicers. The master or special servicer that contracts out the work remains legally
responsible.
Super Regional Mall Over 1 million square feet with multiple department (4-5) stores
as anchors.
Super Senior AAA Tranches The most senior tranches in a CMBS transaction. They
are structured with higher credit support levels than the junior AAA class.
Tenant Improvements Costs to build walls, ceilings, carpet for a new office tenant.
Typically $5-40 per square foot. The landlord usually incurs this expense. In strong
demand markets the landlord can pass this expense through to the tenant in terms
of a higher rental rate. In weak markets, landlords must take tenant improvements
out of net income, which reduces cash flow.
Tilt-U
Up Construction This is the preferred construction type for industrial buildings.
It includes pre-cast concrete panels that are “tilted-up” on a steel frame. Tilt-up is
preferable to corrugated metal exteriors for maintenance reasons.
Trailer Park This is a lower-end asset class, often confused with manufactured hous-
ing communities. Trailer parks are highly transient, dense communities of homes
on wheels. Tenants are provided with no amenities other than simple utility
hookups. Not typically seen in conduit pools.
Triple Net Lease A type of retail lease. Tenant pays rent, real estate taxes, expenses,
and maintenance.
Trustee The trustee represents all investors in a CMBS transaction and acts as the
trust that holds the title to the collateral. The trustee is responsible for enforcing
the pooling and servicing agreement, supervising the master and special services,
and distributing the monthly proceeds to the bond holders.

Please see additional important disclosures at the end of this report. 305
Transforming Real Estate Finance
Glossary

UCF (Underwritten Cash Flow) The cash flow number used by the lender to estab-
lish a desired debt service coverage ratio. Typically includes a standardized deduc-
tion from net operating income to account for expenses need to maintain the prop-
erty. Net Operating Income less reserves.
Unanchored Strip No major destination type tenant. Usually smaller local tenants.
Location needs natural traffic to be successful. Properties perform best if they are
located in a highly developed area with little vacant land.
WAC (Weighted Average Coupon) The higher the WAC, the greater the prepayment
risk; the lower the WAC, the greater the extension risk.
WAL (Weighted Average Life) The average number of years until all mortgage prin-
cipal is expected to be paid off, weighted by the dollar balance of the mortgages. A
more widely used measure than duration for CMBS.
Yield Maintenance A prepayment penalty that requires a borrower to make a penal-
ty payment to the lender if the lending rate at the time of prepayment is lower than
the mortgage rate on the loan. Yield maintenance formulas vary, but generally, they
discount the difference between the remaining contractual mortgage payments and
a hypothetical mortgage payment at current market rates. Most yield maintenance
formulas use the Treasury rate as the discount rate to determine the present value
of the difference in the two payments. Using the Treasury rate is advantageous to
the lender, since the lender made the loan at the Treasury rate plus a spread, but
recovers the remaining cash flows at the Treasury rate. Yield maintenance is gener-
ally assumed to equal lock-out in modeling CMBS transactions.
Z-S
Score A calculation developed by Professor Edward Altman of NYU to assess
financial risk of a company; based on data contained in the company’s financial
statements.
Z-Score = 1.2* (Working Capital / Total Assets) +
1.4* (Retained Earnings / Total Assets) +
3.3* (EBIT / Total Assets) +
0.6* (Market Value of Equity / Liabilities) +
1.0* (Sales / Total Assets)

306
Transforming Real Estate Finance
Disclosures

Please see additional important disclosures at the end of this report. 307
Transforming Real Estate Finance
Disclosures

CREDIT PRODUCTS RATING DISTRIBUTION TABLE


(AS OF DECEMBER 1, 2004)
# of Ratings in % Total Fixed Income
Rating Coverage Universe Instrument Coverage
Overweight 193 22%
Equal-weight 466 54%
Underweight 210 24%
Total 869 100%
Coverage includes all companies that we currently rate.

ANALYST R ATINGS D EFINITIONS


Overweight (O) Over the next 6 months, the fixed income instrument’s total return is
expected to exceed the average total return of the relevant benchmark, as described in
this report, on a risk adjusted basis.
Equal-weight (E) Over the next 6 months, the fixed income instrument’s total return
is expected to be in line with the average total return of the relevant benchmark, as
described in this report, on a risk adjusted basis.
Underweight (U) Over the next 6 months, the fixed income instrument’s total return
is expected to be below the average total return of the relevant benchmark, as
described in this report, on a risk adjusted basis.
More volatile (V) The analyst anticipates that this fixed income instrument is likely to
experience significant price or spread volatility in the short term.
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308
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Please see additional important disclosures at the end of this report. 309
Transforming Real Estate Finance
Disclosures

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310
This book is an overview of the Commercial Transforming Real Estate Finance

Mortgage-Backed Securities (CMBS) market. CMBS Information

The contents of this publication are over eight World Wide Web Sources
years in the making and include excerpts of TRUSTEES
LaSalle www.etrustee.net
research reports from as early as 1997. In this StateStreet
Wells Fargo
www.statestreet.com
www.wellsfargo.com/com/comintro.jhtml
fifth edition of our primer, we have reorganized Chase www.jpmorgan.com/absmbs

the chapters to highlight the different investment SERVICERS


Amresco www.amresco.com
options within CMBS. New material since our Midland
GMAC
www.midlandls.com
www.gmaccm.com
last edition includes sections on the various types RATING AGENCIES

of AAA CMBS classes, total rate of return swaps, Fitch


Moody’s
www.fitchratings.com
www.moodys.com
floating rate large loan transactions, and an S&P www.standardandpoors.com

updated version of the commercial mortgage AGENCIES

default study.
Fannie Mae www.fanniemae.com
Ginnie Mae www.ginniemae.gov

Contacts
We hope you find this book useful and welcome U.S. CMBS TRADING/CAPITAL MARKETS

comments so that we can improve future editions. Jon Strain, jonathan.strain@morganstanley.com


Kara McShane, kara.mcshane@morganstanley.com
212.761.2270
212.761.2164
Scott Stelzer, scott.stelzer@morganstanley.com 212.761.2055
Jahan Moslehi, jahan.moslehi@morganstanley.com 212.761.2177
Manwin Sidhu, manwin.sidhu@morganstanley.com 212.761.2090
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Jon Miller, jon.miller@morganstanley.com 212.761.1317

EUROPEAN CMBS RESEARCH


Howard Esaki, howard.esaki@morganstanley.com 44.20.7677.7592
Asim Qureshi, asim.qureshi@morganstanley.com 44.20.7677.8670

U.S. CMBS RESEARCH


Marielle Jan de Beur, marielle.jandebeur@morganstanley.com 212.761.1454
Masumi Goldman, masumi.goldman@morganstanley.com 212.761.1080

U.S. PRODUCT SPECIALISTS


Bob Karner, robert.karner@morganstanley.com 212.761.1605
Matt Salem, matt.salem@morganstanley.com 212.761.2040
THE AMERICAS
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© 2005 Morgan Stanley

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