Commercial Mortgage Loans

The NAIC’s Capital Markets Bureau monitors developments in the capital markets globally and analyzes their

potential impact on the investment portfolios of U.S. insurance companies. Please see the Capital Markets Bureau

website at INDEX.

Analyst: Steven J. Bardzik, Ph.D.

Executive Summary

Generally, What Is a Commercial Mortgage?

A commercial mortgage is essentially a private bond transaction between an insurance

company and a borrower. The borrower may be a corporate entity (either private, limited

liability company (LLC), non-public or public corporation) or individual. The borrowing is

secured by a mortgage (or deed of trust), which pledges a property as collateral for the

borrowing. The mortgage may be taken by the lender and sold at foreclosure to satisfy

repayment of the debt in the event of default (nonpayment) by the borrower. The properties

thus securing the transaction are generally commercial, income-producing properties, such as

apartment, industrial, office, retail and hospitality (hotel) buildings. For insurance companies,

they are typically high-quality, completed, well-located and operating stabilized.

• Commercial mortgages represent a significant portion of U.S. insurers’ investment portfolios,

matching long-lived, secured assets with stable, predictable cash flows with similar liabilities.

For this reason, the greatest proportion by far of commercial mortgage loans are held by life

insurance companies.

• Commercial mortgage loans amounted to approximately 9% of life companies’ total invested

assets.

• This primer represents an introduction to commercial mortgages, analysis of individual

mortgages, and explanation and analysis of commercial mortgage portfolios.

Types of Commercial Mortgages and Insurance Company Commercial Mortgage Portfolios in

CRE Lending

Commercial mortgages made by life insurance companies are a distinct subset of the overall

commercial real estate financing market. The overall commercial real estate (CRE) market is

estimated at $4.1 trillion outstanding as of 2Q2018, of which $471 billion (11.5%) is held by life

insurance companies (LICs). The major share of commercial mortgages, $2.2 trillion (52.7%), is

held by commercial banks, with commercial mortgage-backed securities (CMBS) and

government-sponsored entities (GSEs) at $375 billion and $306 billion, respectively, and certain

other minor sources.

It is important to understand that LIC commercial mortgage portfolios are selectively composed

of the best quality commercial mortgage in terms of construction, location, leasing and

operational status, and general desirability. Their loans are selected for these qualities in order

to support their generally long-dated maturities with a minimum of disruption. Since they are

the highest quality commercial mortgages and thus the most desirable, there is intense

completion for these loans. This competition drives their pricing, i.e., coupon rate of interest,

lower; thus, the coupons of LIC commercial mortgages may be seen as a floor for interest rates

on other riskier commercial mortgages. The quality of the LIC commercial mortgage portfolios is

demonstrated by their significantly lower default rates over time.

Commercial banks, on the other hand, are ubiquitous and serve a wide commercial real estate

clientele, both national and local. They can underwrite local properties, properties under a

range of development, properties of an unusual or unique nature, and the borrowers and their

capabilities to support the loan out of other sources. Thus, commercial banks can make other

types of commercial mortgage (property-based) loans that may or may not have the

established cash flow of properties suitable for LICs:

• Land acquisition and development.

• Property acquisition, development and construction.

• Property transition.

• Small commercial mortgage loans.

• Homebuilder loans.

• Unusual property types: golf courses, farms and ranch, restaurant and small hospitality.

• Shorter term loans.

• Loans for these property types secured by recourse to the borrower.

Accordingly, these loans generally will carry higher interest rates than LIC commercial mortgage

loans to account for the increased risk. They often are floating rate to reflect the commercial

banks’ funding costs, and they often require recourse to and/or financial guarantees of the

borrower.

Also, there is a range of “secondary financing” such as:

• Second and third mortgages on a specific property.

• Blanket mortgages (covering multiple properties).

• Cross-collateralization and cross default of multiple properties and loans.

• Mezzanine financing (wherein the security for the loan is a pledge of ownership

interests rather than a lien on the property).

LICs may make some of these loans from time to time as market conditions dictate, but these

are not “bread and butter” LIC commercial mortgage transactions.

Commercial Mortgage Definition

Although “commercial mortgage” is the common terminology, a commercial mortgage is

technically two contemporaneous documents: 1) a promissory note that evidences the

borrowing; and 2) either a mortgage or deed of trust, either of which provides the lender access

to the security collateral in the event of default by the borrower. The note contains the

following terms:

• Date of loan.

• Amount of the loan, initial and subsequent fundings, if any.

• Interest rate; fixed rate or floating, including index, spread above index, reset dates, etc.

• Terms of amortization period or interest only.

• Maturity date of loan and provision for extension, if any.

• Prepayment penalties.

• Recourse to the borrower, if any.

• Payment specific terms.

The security for the loan is provided by either a mortgage or deed of trust. In both cases, the

document pledges the specific property(ies) securing the payment of the note, which may be

taken by foreclosure and sold to satisfy payment of the debt. There are technical differences

between a mortgage and a deed of trust. Deeds of trust are considered to be a more

expeditious means of taking the property. However, deeds of trust are only used in 16 states, as

other states consider deeds of trust equivalent to a mortgage.

Analysis of Commercial Mortgages I

Analysis of a commercial mortgage occurs at origination of the mortgage and throughout its

life. The focus of the analysis is on the capacity of the operation of the property to: 1) generate

the income necessary for the ongoing payment of the mortgage; and 2) maintain the value of

property sufficient to insure repayment of the outstanding balance of the commercial mortgage

at loan maturity (since commercial mortgage loans are usually not long enough to fully

amortize).

The debt coverage ratio (DCR) is the key metric to measure the capacity of the operation of the

property to generate the income necessary for the ongoing payment of the mortgage and is the

first metric calculated. This is calculated by taking the annual rental income of the property and

subtracting expenses to arrive at net operating income (NOI):

(Eq. 1) Debt Coverage Ratio = Net Operating Income / Annual Debt Service

or, DCR = NOI/ADS (or = NCF/ADS)

A further step is to subtract certain other expenses such as allowance for capital improvements

and leasing commissions to generate net cash flow (NCF). Then annual debt service (ADS) is

calculated by calculating the monthly mortgage payment (given loan amount, interest rate and

amortization period) and multiplying by 12 (months per year). The DCR = NOI/ADS (or =

NCF/ADS). A DCR greater than 1 indicates excess capacity to pay the debt; a DCR less than 1

indicates insufficient capacity to service the debt. The higher the DCR above 1, the greater the

capacity to absorb fluctuations in cash flow (i.e., loss of revenue from tenants.) For the most

part, lenders look for a DCR well above 1, typically 1.2 or more. LICs will lend lower (i.e., more

conservative) amounts in order to generate DCRs of ~1.5 and above, despite their generally

lower interest rates.

The loan-to-value (LTV) is the second key metric calculated and indicates the margin of safety of

recovery of principal (i.e., outstanding loan balance) in the event the borrower defaults. That is,

upon foreclosure, could the property be sold for enough to pay off the debt? It is calculated by

dividing the outstanding loan balance by the value of the property, or LTV = loan balance /

property value:

(Eq.2) Loan to Value Ratio = Outstanding Loan Balance / Property Value

or, LTV = OLB / Value

The loan balance at any point in time is readily calculable. Thus, the question is that of property

value. The value may be provided by an appraisal, which is calculated by comparison of

replacement (construction) costs, comparison of comparable properties sold and income

capitalization. For income-producing properties, the latter approach is considered the most

reliable, as it relates cash flow to current valuation of that cash flow in the market. The

calculation is:

(Eq. 3) Value = Net Operating Income / Capitalization Rate

or, Val = NOI / CR

The capitalization rate is derived from the sales price or valuations of comparable properties

and their cash flows, adjusted for perceived differences. Although LTV ratios span the range

depending on the type of loan, type of property, borrower, etc., generally lenders look for

ratios below 1, indicating that there is sufficient value in the property to cover the outstanding

loan balance; LTVs in the range of 70% to 80% may be considered reasonable. LICs prefer the

safest, most conservative loans, so their LTVs are more usually in the 60% to 70% range. (Note

also that the lower LTV requires less debt service, so lower LTVs generally result in higher

DCRs.)

DCR and LTV are point in time calculations. Competent lenders (and equity investors) will

develop a projected discounted cash flow (DCF) analysis to calculate these ratios annually

throughout the life of the loan (or investment), typically 10 years or more. The DCF should

incorporate the current level of leasing of the property (and vacancy) and the income

generated, projected leasing and rental rate increases, additional income generated, current

and projected market leasing, vacancy and rental rates in comparison to the subject property,

the current and projected state of the real estate cycle, etc., thus generating projected DCR and

LTV at each year through the life of the loan. Especially important is the projection of the

capitalization rate used to value the income stream at mortgage maturity. Any potential source

of refinancing the current mortgage will look to the then current income and valuation of the

property for viability of refinancing. Unduly optimistic assumptions could jeopardize not only

the current mortgage, but also its ultimate payoff. Optimally, throughout the life of the loan,

the DCR should be increasing as income increases in relation to debt service, and the LTV

should be decreasing as value increases (capitalized income increases) and loan balance is

amortized.

A further measure of commercial mortgage loan performance is debt yield (DY). DY has become

a more popular measure of an outstanding mortgage loan’s capacity to be refinanced, as it

relates income available to service the debt to the amount of debt to be refinanced.

Theoretically, this should be increasing over time as operating income of the property increases

and the loan balance declines with amortization. DY is calculated as:

(Eq. 4) Debt Yield = NOI / Outstanding Loan Amount

or, DY=NOI / OLA

Analysis of Commercial Mortgages II

In recent years, more sophisticated analytical tools have been developed. These take the form

of probabilistic computer simulations of commercial mortgage performance under a variety of

different scenarios. The scenarios may be externally specified, or user-generated but specify

probabilistic distributions of growth rates in NOI and value of the property, which are applied to

the NOI and value of the subject property over the life of the commercial mortgage loan.

Depending on the scenario specified, the projected performance of the income and value of the

property may be better or worse than that assumed in the DCF analysis.

At each point in time over the anticipated life of the loan, using multiple (1,000+) random

draws from the specified distribution of growth rates, distributions of DCR and LTV are

calculated. Each set of DCR and LTV is fed into an empirically derived econometric equation that

generates:

• Probability of default (PD), a percentage from 0% to 100% that measures how likely

there will be a “credit event.”

• Loss given default (LGD), if a “credit event” should occur, what percentage of the

value loan will be lost, given that LTV.

• Exposure at default (EAD), the outstanding loan balance.

• Expected loss (EL), multiply PD (%) x LGD (%) x EAD ($), to summarize, expressed

either in dollars, or in basis points of the loan. When expressed as basis points of the

loan, it may be converted to an annualized percentage measure and considered

yield degradation (YD) of the expected return of the loan.

When multiple draws are performed, a statistical distribution of each of these measures at each

point in the life of the loan and at maturity is developed. This includes both the mean of each

measure (the expected value) and the standard deviation (the variability). It should also be

noted that Debt Service Coverage (DSC) and LTV can substitute for each other in certain

circumstances. For instance, a temporary decline in NOI may be compensated for by a

conservative LTV such that a default does not necessarily occur when DSC drops below 1.

However, value is ultimately a result of income generation, and an extended decline may be

unrecoverable.

Depending on the scenario specified, the results of this analysis may provide more insight as to

riskiness of the loan. For instance, if the scenario specified is that of the macro market for the

property type and location, this may be more conservative than the assumptions going into the

DCF. Thus, the more statistically driven approach might result in a more conservative view of

the transaction. Also, different markets by property type and location may have different

economic drivers, resulting in different growth rates. A careful examination of the pattern of

NOI and LTV growth may reveal the riskiest points in the life of the loan. Finally, different types

of loans (e.g., LICs vs. CMBS vs. bank loans) may have different default characteristics owing to

the relative risk appetites, investment horizons, etc., of the respective lenders.

Analysis of Commercial Mortgage Portfolios

Because of the specialized knowledge necessary for effective, cost-efficient commercial

mortgage lending, commercial mortgage investors, to include LICs, generally invest in portfolios

of commercial mortgages, which may range from hundreds to thousands of individual

mortgages, and in value amount from the tens of millions to billions of dollars. These portfolios

are ongoing enterprises with portions of the portfolios continually maturing and being paid off

and new originations being added to the portfolio. As this process takes place, the investor is

adjusting the investment program to achieve an optimal return vs. risk profile.

The commercial mortgage investment portfolio is generally composed of a variety of property

types in different geographic areas, and the mortgages may be of fixed or variable rate, of

varying maturities, senior or subordinate position, etc. Accordingly, the portfolio may be

analyzed in terms of the aggregate metrics outlined above (debt service coverage ratio [DSCR],

LTV, DY, EL, PD, LGD) for each component of the portfolio, i.e., property type (multifamily,

office, retail, industrial, hotel and other); geographic area (central business district vs.

suburban); metropolitan area (New York, Los Angeles, etc.); primary vs. secondary vs. tertiary

markets; by maturity; etc. By calculating the average (typically, value weighted) coupon vs. the

DSC, or LTV, or other risk characteristic, the investor can gain insight into the types of new

originations to be targeted in order to achieve the optimal risk/return tradeoff.

A further consideration is the beneficial effect on the overall risk of the portfolio of the

diversification of the various investments. A full discussion of diversification is beyond the

scope of this primer, but it is shown by Modern Portfolio Theory and well recognized in the

investment community that investments in multiple assets whose return series are less than

perfectly correlated results in a reduction of portfolio risk at no loss of aggregate return.

Accordingly, the commercial mortgage investor may conduct an analysis of the portfolio

holdings by type, location, etc., with respect to overall portfolio returns and risk to determine

the effect of an increased focus on a particular property type and/or location on portfolio risks

and returns. For instance, many large LICs have particular concentrations in commercial

mortgages secured by office and retail properties, portfolios that may benefit by risk reduction

from additions of multifamily and industrial properties. Also, research has shown that portfolios

that are concentrated in major metropolitan areas may benefit from addition of investments in

secondary and tertiary markets. However, as all commercial mortgage investors discover these

benefits and focus on these investments, the benefits tend to evaporate as the prices of these

assets are bid up.

To carry this analysis to its logical conclusion, the well capitalized sophisticated commercial

mortgage investor, i.e., LICs, may develop or buy commercially available software to analyze

every investment in its portfolio with respect to risk and return, assess the marginal effect on

its portfolio of any proposed new investment, and fine-tune its portfolio by selective

acquisitions and judicious “pruning” of its existing portfolio.

Key Terminology

Potential Gross Income

The total amount of rental income a property can generate if fully leased, to include both rental

income and incidental additional income.

Effective Gross Income

The total amount of rental income a property will generate based on space actually leased, to

include both rental income and incidental additional income.

Expenses

Costs associated with operation of the property, both direct and indirect, and fixed and

variable.

Vacancy Allowance

Space not leased; or, a portion of spaced considered not leased at any given time to allow for

transition for planning and projection purposes.

Net Operating Income

Total rental income plus incidental additional income less operating expenses.

Net Cash Flow

Net operating income less capital expenses, leasing commissions and certain other expenses.

Value

The numerical amount of money that could be exchanged for the property. Calculated by

appraised value (estimated as the amount of money a willing buyer would pay a willing seller),

capitalized value (NOI divided by capitalization rate) and discounted cash flow value (forecasted

cash flows over the anticipated holding period discounted to present value at an appropriate

discount rate).

Capitalization Rate

The ratio of net operating income to value of the property. Usually derived from analysis of

similar properties, which is the applied to the net operating income of the subject property to

calculate a “capitalized value.”

Debt Coverage Ratio

The ratio of net operating income to annual debt service. Represents the capacity of the

property to support its debt.

Loan to Value Ratio

The ratio of outstanding loan balance to property value. Represents the capacity of the

property to protect the lender against loss in the event of a credit event.

Probability of Default

In a statistical simulation analysis, the likelihood of a credit event as a percent out of certainty.

Exposure at Default

Loss given default. In a statistical simulation analysis, the amount of capital owed to the lender,

including outstanding mortgage balance.

Expected Loss

In a statistical simulation analysis, the average percentage of the owed amount expected to not

be recovered.

Yield Degradation

In a statistical simulation analysis, the expected loss expressed as an absolute percentage to be

subtracted from the contract rate of interest.