CMBS Interest Only Strips An IO-pening Introduction.

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1 CREDIT RESEARCH Altaf Nanji, CFA (416) Sunil Shah, CFA (416) August 19, 2005 This report is priced as of August 15, All values in Canadian dollars except where indicated. For pertinent disclosure, please see last page. CMBS Interest Only Strips An IO-pening Introduction. Summary The combination of a supportive fundamental credit environment and a strong technical underpinning has pulled spreads in the Canadian corporate bond market to new 52-week lows. Following the lead of the broader corporate market, Asset-Backed spreads have also enjoyed a bout of relentless tightening, and now trade at all time tights. Against this backdrop the relatively unknown CMBS PAC-IO offers spreads ranging from +65bps to +75bps over the curve and is structured to withstand many of the payment and return sensitivities that plague a traditional IO. While we are of the opinion that CMBS, like the broader corporate market, is exposed to pockets of burgeoning risk, there is little imminent danger for investors given the benign characteristics of the current economic and credit environments. As such, PAC-IOs presently offer an attractive yield/risk relationship for investors willing to consider alternatives to traditional fixed income securities. Overview IOs represent securities backed by the excess interest generated from a pool of commercial mortgages underlying a CMBS transaction i.e. the interest above what is required to pay regular certificate coupons. In the absence of an IO, issuers would be forced to sell the regular certificates at a premium. In their simplest form, IOs are structured by stripping the excess coupon from various tranches within a CMBS structure. With cash being stripped from multiple classes, the IO is credit sensitive. The triple-a rating, therefore, reflects the IO holder s right to excess interest rather than the credit risk being assumed. Any unanticipated return of capital, or any loss of capital, whether through prepayments or defaults, is detrimental to the IO. While commercial mortgages are generally structured such that voluntary prepayments entail a significant financial penalty, losses and recoveries from defaults will erode both the highest and lowest classes within a structure. In an effort to enhance the marketability of the IO strip, issuers will structure a more stable, investor friendly PAC-IO. Through a Support-IO tranche, the PAC-IO is designed to be less sensitive to prepayments (or default recoveries) and losses. PAC-IOs stand out as one of the cheaper fixed income alternatives in the Canadian market. In the U.S., PAC-IOs actually trade through many of the triple-a tranches.

2 CMBS IO Strips August 19, 2005 What is an IO? Introduction Looking through the prospectus of your typical CMBS offering, one inevitably comes across the mysterious Class X notes in the certificate summary (Exhibit 1). XP-1? XC-1? XP-2? What are these triple-a rated notes that seem to exist only in the prospectus? The Class X certificates represent Interest Only (IO) strips that are designed to optimize the efficiency of the entire structure while satisfying investor preferences. The IOs enhance the marketability of all notes while maximizing the proceeds generated for the issuer. From the investor s perspective, the hunt to find yield wherever available has caused spreads to compress to a point where it is difficult to distil any value across the various corporate and asset-backed sectors. In this context investor friendly PAC-IOs could represent an interesting relative value opportunity. This paper will examine various considerations involved in evaluating CMBS IOs. Exhibit 1: Overview of the Certificates REAL-T Certificate Balance or Notional Amount Credit Support Rating by S&P / Moody's Weighted Average Life Pass Through Rate / Semi- Annual Equivalent Rate Class A-1... $199,110, % AAA/Aaa % 4.31% Class A-2... $107,488, % AAA/Aaa % 4.91% Class XP-1.. $1,000 N/A AAA/Aaa N/A - - Class XC-1.. $1,000 N/A AAA/Aaa N/A - - Class B... $10,965, % AA/Aa % 5.10% Class C... $8,688, % A/A % 5.29% Class D-1... $5,955, % BBB/Baa WAC WAC Class E-1... $1,000, % BBB-/Baa WAC WAC Class D-2... $1,500, % WAC WAC Class E-2... $668, % WAC WAC Class F... $3,475, % % 5.432% Class G... $1,737, % % 5.432% Class H... $869, % % 5.432% Class J... $869, % % 5.432% Class K... $869, % % 5.432% Class L... $869, % % 5.432% Class M... $3,476, % % 5.432% Class XP-2 $324,732,000 N/A - N/A - - Class XC-2 $347,537,868 N/A - N/A - - Source: RBC Capital Markets The CMBS IO The standard commercial mortgage-backed security incorporates a senior/subordinate payment structure whereby collections from the underlying mortgages are passed on to noteholders, with principal payments being passed on sequentially in order of seniority. Given that par-priced triple-a securities account for 87% to 90% of the typical structure, the pool of underlying mortgages will generate interest above what is required to pay certificate coupons. This excess interest is stripped and sold as triple-a rated IO certificates. It is important to keep in mind that an IO has no principal balance that is returned to investors and has no security interest in the underlying collateral the IO purchaser is simply acquiring the right to a stream of excess interest payments. 2 Altaf Nanji, CFA

3 August 19, 2005 CMBS IO Strips How the IO Benefits Issuers and Investors Selling IO strip securities permits the issuer to market the conventional principal/interest (P/I) bonds close to par, despite the high yielding underlying collateral 1. In the absence of an IO, an issuer looking to maximize the proceeds received from a pool of mortgages would be forced to increase the coupon on the P/I bonds and sell them at a premium (a premium bond can be dissected into two discrete components (1) the cost of a par bond, plus (2) a price for the excess interest payments, i.e. the IO). Generally, investors prefer bonds priced closer to par and would demand a spread premium to buy a bond at a high-dollar-price. In this respect, the IO enhances the marketability of the P/I bonds, thereby improving the overall execution for the issuer, while at the same time satisfying investor preferences. Creating an IO The Basic Structure In their simplest form, IOs are structured by stripping the excess coupon from various tranches within the structure and are priced against the weighted average life of the collateral. In the case of REAL-T , in which the pool of 70 mortgages yielded a weighted average coupon (WAC) of 5.63%, the IO was stripped from classes A to C and from classes F to M (Exhibit 2). Using the Class A-1 notes as an example, the pass-through rate of 4.27% resulted in an excess coupon of 1.36% for the IO (5.63% less 4.27%). Due to the fact that the pass-through rates on the D and E classes vary with the weighted average coupon, these classes have no excess coupon and, therefore, do not contribute to the IO securities. Exhibit 2: Excess Coupon REAL-T % 0.8% 0.6% 0.4% 4.97% 1.4% 0.3% 4.31% 3.66% 3.00% A-1 A-2 B C D E F G H J K L M Source: RBC Capital Markets Coupon IO-Srip Since the different bond classes are responsible for varying amounts of excess interest, the IO assumes the credit sensitivity of the P/I bonds. The triple-a rating, therefore, reflects the IO holder s right to excess interest rather than the level of credit risk being assumed. 1 An Investor s Perspective on Commercial Mortgage Backed Coupon Strips Keith Gollenberg; Commercial Mortgage- Backed Securities 2 nd Edition. Altaf Nanji, CFA 3

4 CMBS IO Strips August 19, 2005 Implications of the IO Structure While the excess coupon is defined by the tranches being stripped, the actual interest payments are based on a notional balance of the underlying P/I certificates ($347.5MM for the XC certificates in REAL-T ). As such, a premature return of capital, whether through prepayments or defaults, works against the IO as it will reduce the notional amount. Given that CMBS principal prepayments are passed-on in order of seniority and losses are applied in reverse order, the credit sensitivity of the IO is a function the highest and lowest rated classes in the structure. After discussing credit sensitivity, we will revisit IO structures to address how PAC-IOs are designed to curtail credit risk, thereby creating a more palatable security for investors. Credit Sensitivity Prepayment Impact Under the senior/subordinate structure, mortgage prepayments are passed on to the senior noteholders when received. In view of the fact that much of the excess coupon is derived from the senior notes, a prepayment can have a significant impact on the cash flow to the IO. Fortunately, commercial mortgages are generally structured such that voluntary prepayments are, financially, very punitive. Typical prepayment restrictions for a commercial mortgage include lockout periods, defeasance and yield maintenance provisions 2. Lockout: Prepayment lockouts specifically prohibit prepayments for a specified period of time. While quite restrictive, a lockout is generally in effect for a specified period of time and is, therefore, supplemented with one of the other prepayment safeguards. Over 59% of mortgages underlying REAL-T incorporated a lockout provision. Defeasance: Under a defeasance provision, a borrower who prepays a mortgage must reimburse the pool by replicating the lost cash-flows through a portfolio of government securities. 79% of loans in REAL-T incorporated some level of defeasance. Yield Maintenance: Prepayments during periods of declining interest rates exposes the lender to re-investment risk. The yield maintenance penalty compensates for an early return of principal if market interest rates are lower than when the loan was originated essentially compensating for lost cash-flow. 5 REAL-T mortgages incorporated a yield maintenance provision. While protection from prepayments is clearly a key consideration in considering an IO, investors must also consider how prepayment penalties are allocated. Penalties are allocated according to a predetermined formula which is set forth in the prospectus. In the case of N , which suffered a $30.3MM prepayment in April 2005, the allocation formula allocated 85% of the $2.3MM prepayment penalty to the IO holders 3. Defaults Commercial mortgage are a key factor to consider when evaluating an IO. In some respects a default that results in foreclosure or liquidation will have a similar impact on the IO as a prepayment (of course, without the compensating penalty). A recovery from default is applied to the most senior principal receiving class and impacts the IO by reducing the notional balance upon which payments are based and by reducing the coupon (since it is a weighted average of the amounts stripped from the component 2 An Investor s Perspective on Commercial Mortgage Backed Coupon Strips Keith Gollenberg; Commercial Mortgage- Backed Securities 2 nd Edition. 3 Value and Sensitivity Analysis of CMBS IOs Philip Obazee; Investing in Commercial Mortgage Backed Securities. 4 Altaf Nanji, CFA

5 August 19, 2005 CMBS IO Strips I/P bonds). Losses suffered from a default, on the other hand, will be applied to the lowest class within the structure, thereby impacting the contribution to the IO from the junior classes (Exhibit 3). The overall impact on the IO is, therefore, a function of the structure of the transaction and the relative contributions from each P/I class. Generally, the impact of defaults can be characterized as a function of three variables 4 : Constant Default Rate: Clearly the CDR will be one of the most significant factors influencing an IO s return. All else equal, as the annual default rate of the pool increases, the yield earned on the IO will decrease. Timing: Viewed as a strip of interest payments extending into the future, the return generated by an IO benefits from time value. Other things being equal, the return achieved on an IO is enhanced as value of the notional balance is extended. As such, the longer the time to the first default under a given CDR, the greater the yield of the IO. Another aspect of timing is the time take to actually liquidate the loan. In light of the fact that the Special Servicer is obligated to advance payments to the trust during the period when a severely delinquent loan is being worked-out, the notional value of the IO is left intact until an actual liquidation of the loan. Given the time value benefit to the IO described above, a protracted time to liquidation will be advantageous to the IO holder. Exhibit 3: Non-interest Cash-flow Allocations Bond Class Application of Losses A-1 A-2 B C D E Application of Principal Payments Source: RBC Capital Markets Loss Rate: Generally a higher loss rate will adversely impact the return on the IO. However, this relationship can vary considerably based on the structure of the transaction. For instance, an IO that is not stripped off the lower class certificates will prefer a 100% loss rate as this would prevent recoveries from prematurely paying down the notional balance upon which it is paid. Structures Revisited PAC IOs Given the numerous payment and return sensitivities addressed above, it is clear that an IO is not a plain-vanilla fixed income investment. A prudent IO investment requires a degree of comfort with the real estate comprising the pool as well as the 4 Value and Sensitivity Analysis of CMBS IOs Philip Obazee; Investing in Commercial Mortgage Backed Securities. Altaf Nanji, CFA 5

6 CMBS IO Strips August 19, 2005 structure supporting the bonds. Traditionally, IOs have been purchased by the deal s B-piece buyer, as this investor has the most intimate knowledge of the collateral. In an effort to make the IO more palatable to a broader investor base, however, issuers will tranche the excess interest so as to create a more stable, investor friendly PAC- IO. As a result, PAC-IOs have recently been purchased by more traditional institutional fixed income investors. Thus far we ve discussed a variety of IO that strips the excess interest from the full spectrum of P/I bonds (i.e. from the A-1 bonds down to the lowest class within the structure). As discussed above, given the sequential pay structure of CMBS, the highest and lowest rated tranches will bear the brunt of prepayments and losses, thereby increasing the volatility of the payment sensitive IO. In a tranched IO structure, alternatively, the PAC-IO strips excess interest only from the most stable classes generally the middle classes. Using only the middle classes for PAC-IO cash-flows leaves the Support IO (through the book-end classes) to absorb the impact of prepayments, losses and recoveries. Not all CMBS transactions will offer a PAC- IO, as the decision to create this more marketable piece rests with the issuer s assessment of how the economics of the transaction can be optimized. In the case of REAL-T , the PAC-IO (XP-1 public and XP-2 private) was stripped from 96% of the class A-1 notes down to the class H notes (excluding the class D and E notes as they do not contribute to the IO; Exhibit 4). By stripping excess interest in this manner, the PAC-IO is protected from losses by the J, K, L and M classes and from default recoveries from a portion of the class A-1. Overall, the PAC-IO is quite conservatively designed to absorb a 100% CPY (i.e. the prepayment rate after the lockout period), a 6% CDR and a 35% recovery rate. To put these numbers into context, recent default experience in the Canadian market has been minimal well under 0.2%. Furthermore, a research paper published by the Federal Reserve System cited several studies estimating historical commercial real estate defaults (U.S.), with the most conservative reporting an average default rate of 2.7% over a 17 year period ( ). Default rates in this study topped out at 7% for 1992, the trough of the commercial real estate cycle. In this context, the PAC-IO structured to withstand a sustained default rate of 6% over the life of the life of the transaction (~10-years) appears very well protected. Exhibit 4: REAL-T Allocation between PAC-IO and Support IO 5.63% 4.97% 4.31% 3.66% 3.00% A-1 A-2 B C D E F G H J K L M Source: RBC Capital Markets Coupon XP (PAC) XC (Support) 6 Altaf Nanji, CFA

7 August 19, 2005 Relative Value CMBS IO Strips Spread Performance In an environment where it has become very difficult to distil any relative value across the various corporate and asset-backed sectors, the investor friendly PAC-IOs stand out as one of the cheaper products available in the Canadian fixed income market. PAC-IO spreads of +65bps to +75bps compare to triple-a spreads of +44bps in the 5-year range and +54bps for 10-years. By way of comparison, U.S. PAC-IO spreads of +65bps actually trade through 10-year super senior triple-a spreads of +68bps and much tighter to 5-year triple-a spreads of +60bps. As an unconventional fixed income product, investing in a PAC-IO does require a degree of comfort with the real estate comprising the pool. However, given the backstop of the support IO, the degree of familiarity required is typically less than that of a CMBS B-piece investor. While we are of the opinion that CMBS, like the broader corporate market, is exposed to pockets of burgeoning risk, there is little imminent danger for investors given the benign characteristics of the current economic and credit environments. As such, PAC-IOs presently offer an attractive yield/risk relationship for investors willing to consider alternatives to traditional fixed income securities. Altaf Nanji, CFA 7

8 EXPLANATION OF RBC CAPITAL MARKETS RANKING SYSTEM FOR GLOBAL CREDIT RESEARCH (CANADA) (Note: Our risk-reward assessment is based, in part, on a comparison of the spread of a particular bond to the spread interpolated by a credit ratings-derived relative value curve for a given maturity.) Top Pick (TP): Represents the analyst s best ideas in the Outperform category; provides best relative risk-reward ratio and/or is expected to significantly outperform the RBC CM Canadian corporate bond index over 12 months. Outperform (O): Provides superior relative risk-reward ratio and/or is expected to materially outperform the index over 12 months. Index Perform (IP): Provides an adequate relative risk-reward ratio and/or the spread performance is expected to be in line with index average over 12 months. Underperform (U): Provides an inferior relative risk-reward ratio and/or the spread performance is expected to be materially below the index over 12 months. Risk Qualifiers: Average Risk: Volatility and risk expected to be comparable to universe of issuers followed; average revenue and earnings predictability; no significant cash flow/financing concerns over coming months; and/or fairly liquid. RBC Capital Markets Limited IB Serv./Past 12 Mos. Ranking Count Percent Count Percent BUY [TP/O] HOLD [IP] SELL [U] Above Average Risk: Volatility and risk expected to be above universe of issuers followed; below average revenue and earnings predictability; may not be suitable for a significant class of individual fixed-income investors; may have negative cash flow; and/or low market liquidity. Speculative: Risk consistent with venture capital; potential low market liquidity; potential balance sheet concerns. Analyst Certification: All of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all of the subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report. Distribution of Rankings, Firmwide: Regulatory rules require the firm to assign all rated stocks to one of three rating categories - Buy, Hold/Neutral, or Sell - regardless of the firm's own rating categories. Although RBC DS Inc. does not consider all stocks that its analysts rate as Index Perform to be equivalent to a Hold/Neutral rating, for purposes of this ratings distribution disclosure, RBC DS Inc. automatically treats stocks rated Sector Perform as Hold/Neutral. Dissemination of Research: RBC Capital Markets endeavours to make all reasonable efforts to provide research simultaneously to all eligible clients. RBC Capital Markets Corporate Debt research is posted to our proprietary websites to ensure eligible clients receive coverage initiations and changes in rankings and opinions in a timely manner. Additional distribution may be done by the sales personnel via , fax or regular mail. Clients may also receive our research via third party vendors. Please contact your investment advisor or institutional salesperson for more information regarding RBC Capital Markets research. Material Disclosures: The author(s) of this report are employed by RBC Dominion Securities Inc., a securities broker-dealer with principal offices located in Toronto, Canada. The analyst(s) responsible for preparing this research report received compensation that is based upon various factors including total revenues of the member companies of RBC Capital Markets and its affiliates, a portion of which are or have been generated by investment banking activities of the member companies of RBC Capital Markets and its affiliates. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from N-45 First CMBS Issuer Corporation in the past 12 months. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from N-45 First CMBS Issuer Corporation in the past 12 months. RBC Capital Markets has provided N-45 First CMBS Issuer Corporation with investment banking services in the past 12 months. RBC Capital Markets has provided N-45 First CMBS Issuer Corporation with investment banking services in the past 12 months. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from REAL ESTATE ASSET LIQUIDITY TRUST in the past 12 months. A member company of RBC Capital Markets or one of its affiliates received compensation for investment banking services from REAL ESTATE ASSET LIQUIDITY TRUST in the past 12 months. A member company of RBC Capital Markets or one of its affiliates managed or co-managed a public offering of securities for REAL ESTATE ASSET LIQUIDITY TRUST in the past 12 months. A member company of RBC Capital Markets or one of its affiliates managed or co-managed a public offering of securities for REAL ESTATE ASSET LIQUIDITY TRUST in the past 12 months. RBC Capital Markets has provided REAL ESTATE ASSET LIQUIDITY TRUST with investment banking services in the past 12 months. RBC Capital Markets - Global Credit Research Team Toronto Sunil Shah, CFA (416) sunil.shah@rbccm.com Richard Hildebrand, CFA (416) richard.hildebrand@rbccm.com Altaf Nanji, CFA (416) altaf.nanji@rbccm.com London Georg Grodzki georg.grodzki@rbccm.com Miriam Hehir miriam.hehir@rbccm.com Angus MacAlister angus.macalister@rbccm.com Russell Jones russell.jones@rbccm.com Minneapolis/ Vincent Boberski, CFA (312) vincent.boberski@rbcdain.com Chicago Dan Zaldivar, CFA (312) dan.zaldivar@rbcdain.com Lowell Bolken, CFA (612) lowell.bolken@rbcdain.com Additional Disclosures RBC Capital Markets is the business name used by certain subsidiaries of Royal Bank of Canada, including RBC Dominion Securities Inc., RBC Capital Markets Corporation, Royal Bank of Canada Europe Limited and Royal Bank of Canada - Sydney Branch. 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