Real Estate Debt Markets

Transcription

1 Real Estate Debt Markets Colin Lizieri, April March 2008 Colin Lizieri

2 Overview Real Estate Debt: The Context Debt as an Investment Risk and Return Pricing Risk Risk Factors Default Risk: Exercise Debt Securitisation Debt and the Capital Markets Asset Backed Securities: RMBS, CMBS, CDOs Pricing CMBS and Risk Changes Coda: The Sub-Prime Crisis Revisited 2

3 Real Estate Debt: Context 3

4 Context: Real Estate & Debt : Huge Increase In Use of Debt: Debt to Fund Real Estate Development Use of Debt by Individual Investors Use of Debt by Public-Listed Companies (REITs, Property Companies) Use of Debt by Private Property Investment Vehicles Growth in Real Estate Debt as an Investment Asset : 2008: Sub-Prime Crisis and Credit Crunch Problems in Mortgage Backed Securities Markets Bank Liquidity Problems and Reduction in Property Lending Higher Interest Rates and Harsher Lending Terms Impact on Real Estate Prices 4

5 The Background Issue: UK Bank Lending: 193bn Q UK Resident Lending to Commercial Real Estate 250, ,000 million 150, ,000 50,000 0 Dec-86 Dec-88 Dec-90 Dec-92 Dec-94 Dec-96 Dec-98 Dec-00 Dec-02 Dec-04 Dec-06 5

6 European CMBS Issuance 6

7 Driven by Interest Rates? Interest Rates and Yields Source: Bank of England / IPD Average Rate (%) Non-Financial Lending Rates IPD Equivalent Yield Jan/1999 May/1999 Sep/1999 Jan/2000 May/2000 Sep/2000 Jan/2001 May/2001 Sep/2001 Jan/2002 May/2002 Sep/2002 Jan/2003 May/2003 Sep/2003 Jan/2004 May/2004 Sep/2004 Jan/2005 May/2005 Sep/2005 Jan/2006 May/2006 Sep/2006 What do you think has happened since the sub-prime crisis?

8 Property Debt as an Investment 8

9 For Every Borrower, There is a Lender A Loan is an Investment The Lender gives up her capital to the borrower Lender s s Objectives Obtain a return appropriate for risk Obtain a return appropriate for current market Be mindful of impact on lender solvency etc. Lender Risks Delinquency and default Prepayment Regulatory risk Reputation? 9

10 Risk and the Lender Delinquency breach of covenant Most common late with payments Breach of loan to value or interest cover covenants Default non-payment of loan Risk of default and risk of loss on default Default when the borrower is in the money Prepayment early repayment of loan When does prepayment occur? Prepayment penalties and restrictions Regulatory Risk Capital Requirement and the Solvency Ratio The Basel Accord, 8% of risk-weighted assets 10

11 Recourse Structure and Security The Lender seeks to reduce risk of the loan The Borrower offers up rights to assets/cashflow Lender seeks maximum security full recourse Rights to specified assets (charge on the property) Charges on the company s s assets Borrower: minimise security limited recourse Charge only on the project or building Off balance sheet (bankruptcy remote) vehicles 11

12 Risk Limitation (continued) Risk Reduction in Loan Design Loan to Value / Loan to Cost ratios Debt Service Coverage ratio / Interest Cover Covenants and Penalties Guarantees and Insurance Due Diligence Procedures Corporate lending: strength of company and balance sheet, cashflow and assets; Project finance: evaluation of project, costs, income projections, risk/sensitivity analysis Diversification Syndication by lead bank Exit strategies and securitisation 12

13 Interest Rates and Margin The core interest rate reflects Real risk free rate Anticipated inflation Banks set a threshold lending rate The rate at which they lend to each other short term London Inter Bank Offer Rate (LIBOR) and EURIBOR LIBOR defines rates for range of maturities/currencies Official basis for lending and derivatives LIBOR affected by: Current interest rates and bond rates Anticipated changes in interest rates (yield curve) Bank liquidity 13

14 Interest Rates and Margin Margin reflects the risk of the (type of) loan Margin reflects the costs associated with the loan Due diligence costs Collection and monitoring costs Generally quoted as basis points over LIBOR Margin reflects The risks of the activity being financed The strength of the borrower and borrower s s assets The terms of the loan contract Insurance and guarantees 14

15 Default Exercise 15

16 Default Risk in Real Estate Banks hold portfolios of commercial real estate loans These default infrequently linked to market cycle They must assess how risky each loan is To decide whether or not to lend For regulatory (Basel) purposes Must estimate Probability of Default (PD) May need to estimate Loss Given Default (LGD) What Variables are important? Consider a loan to acquire an investment property 16

17 Expert Judgement Models Absence of Robust Default Data Sample size too small Time series too short Instead Create Set of Risk Grades Similar to Rating Age categories AAA, A+, BBB etc. Each risk grade associated with Default Probability Loans Allocated to Risk Grades Loan scores on individual variables Combined together based on weighting system Grades reflect combine score But Which Variables? What Weights? 17

18 Default Variables - 1 Borrower Characteristics Type of Firm (Public Company, Private Company, Individual) Size of Firm (Large, Medium, Small Enterprise) Firm Existing Debt-to to-equity Ratio Firm Accounts Current Account / Liquidity Position Firm Accounts Profits and Return on Equity over last three years The Borrower and the Loan Contribution of Equity by Borrower Size of Loan Relative to Turnover of Firm Maturity of Loan (short, medium, long term) Loan Type: Interest Only, Part-Amortising, Full Repayment Loan Type: Floating or Fixed Interest Rate Guarantees or Insurance in Place 18

19 Default Variables - 2 Track Record Years as a Bank Client Previous History of Default or Delinquency Firm s s Core Business Experience in the Property Field Professional External Advisors or Professional Staff The Property and the Loan Loan to Market Value Ratio (LTV) Rental Income to Repayment Ratio (DSCR) Single or Multi-Let Property Length to Expiry of Main Tenant Lease Type of Real Estate (office, industrial, retail) 19

20 Your Mission Pick the Variables You Consider Will Affect Default Six to Eight Variables You May Add Other Variables You Consider Vital Decide on a Weighting System % weighting for each variable ( (Σ = 100%) For example: Loan to Value Ratio 40% Years as Bank Client 20% Contribution of Borrower 15% Guarantees in Place 15% Type of Property 10% How Would You Test Your Model? 20

21 Debt in the Capital Markets Mortgage Backed Securitisation 21

22 Securitisation Underlying Claim to a Cashflow: Repayments from a debt obligation Rents from a lease Receivables from credit cards Create Rights to Receive Part of Cashflow Paper securities based on underlying claims Defined payment rules based on underlying cashflow Risk and return based on underlying cashflow Benefits for Investors Risk and exposure spread diversification Securities tradable liquidity Minimal management and monitoring costs External rating and evaluation 22

23 CMBS and Bank Lending Commercial Mortgage Backed Securities (CMBS) Securitisation of debt portfolios by banks Bank pools mortgages and sells to SPV SPV issues bonds into capital markets Bonds are rated by rating agency Investors buy bonds proceeds to originating bank Bank passes repayments to SPV SPV passes payments to investors Default risk / default loss restricted to the SPV (Off Balance Sheet S for the bank) 23

24 Simplified CMBS Structure Tenants Liquidity Insurance Rent Owner Repayment & Security Loan Originator (Lender) Mortgage Collateral Issue Proceeds Payments Issuer Sale Proceeds Rating Servicing Investors 24

25 Some Complexities Tranche Structure Rather than selling a single issue security is split into tranches Senior tranches have right to receive available income first More junior tranches only paid after senior tranches paid Hence junior tranches are more risky pay higher interest rate Pass-Through Structures Rather than fixed interest rate, securities pay cash as received Cash may be interest payments OR capital repayments If capital repayment then retires all or some of securities Therefore Maturity is uncertain Insurance Policies Insurance may guarantee to pay proportion of face value if default Interest rate demanded lower, as risk of loss reduced 25

26 Benefits... For the Bank: Exit strategy: reduce exposure to sector of market Capital source: new capital for lending elsewhere Profits (sales proceeds, collection & management fees) Balance sheet liquidity For the Investor Access to high quality, liquid debt investments Ability to build and manage diversified portfolio Low information and management costs Risk transformation from tranche structure Investor Required Return < Bank s Req d Return 26

27 Disintermediation Property Company can go straight to market Issues Securities direct to capital market Arranged by investment bank Secured on real estate cashflow and asset values May be lower cost than through bank Property Investment Company / Corporate Real Estate Identify set of assets (e.g. major property development) Assign it to SPV (deed of trust / first mortgage) SPV issues Bonds / Paper secured on rents Bonds / Paper rated based on tenant covenant / assets Major deals by European Prop Cos British Land, Prologis e.g. Coprporate Real Estate deals: Carrefour, Tesco, Abbey National More problematic for Property Developer why? 27

28 Pricing CMBS - 1 Conventional CMBS Defined Cashflow Same principle as any fixed interest security Discount the cashflow at appropriate discount rate Rate that reflects riskiness of the cashflow Coupon payments the income return on the security e.g. 8% coupon = 8% of face vale of 100 Paid twice yearly = 4 4 per six months Present value formula = (1 (1+i) - n ) / i where i = six-monthly discount rate, n = ½ years to maturity Redemption payment the face value of the security Generally 100 Present value formula (1+i) -n where i = six-monthly discount rate, n = ½ years to maturity 28

29 Pricing CMBS - 2 Example: Security with five years to run, paying coupon of 8% appropriate discount rate believed to be 5% per six months (nominal rate of 10% per annum) Price will be: 4*PV PV 1pa(10 5%) * PV 1(10 5%) 4 {( )/.05} (1.05) (7.7217) (0.6139) =

30 What Determines Discount Rate? The General Interest Rate Environment: Government Bond yields risk free rate proxy The Yield Curve (GRYs( for different maturities) General attitudes to risk (Bond spread) Risk in this Bond Issue Prepayment Risk Default Risk (and Loss on Default) What Determines Default Risk / Default Loss? The cashflow of the security (interest rate coverage) The value of the underlying assets of the company Who Determines the Rate? The market! Supply and demand The Rating Agencies Rating and Re-rating 30

31 Rating a Bond Issue The Rating Agencies Moodys,, Standard & Poors,, Fitch The Ratings (S&P others similar) Investment Grade: AAA, AA, A, BBB Non-investment Grade BB, B, CCC, CC, C, D The Rating Process Examine the firm: balance sheet and capital structure, cashflow, assets, track record Assess the market environment for assets / projects Assess the terms of this issue Assess risks and make rating determination Monitor situation for any changes... 31

32 Downgrading a Rating Market Environment or Company Situation Worsens Rating Agency Downgrades Rating (e.g. AA => BBB) Require Return Increases Impact on Security Price What effect does this have on firm s s interest payments For this issue? For new issues? What effect does this have on bond holders? Return impact? Attitude to bonds in portfolio? 32

33 Downgrading a Rating Take the previous bond (8% coupon, 5 year maturity) Required six monthly return was 5%, price was Suppose required six monthly return increases to 5.5% after the downgrade: New Price: 4*PV PV 5.5%) * PV 5.5%) 4 {( )/.055} (1.055) (7.5376) (0.5854) = Price has fallen by 3.8% 33

34 You Try One! A Commercial Real Estate security has exactly six years to run, pays a coupon of 7% (payable in six monthly installments) ) and is redeemable at 100. Price the security, if the consensus required return in the market is 4% per six months Now re-price the security if bad news leads the ratings agencies to downgrade its credit rating and the required return rises to 5% per six months What might cause the ratings agencies to downgrade the credit rating of the bond? 34

35 CMBS as Investments Provide exposure to real estate cashflows Highly liquid, tradable asset But cashflow defined IF held to maturity IF no default (or prepayment) Hence cashflow property cashflow BUT prices in secondary market depend on risk If market situation improves, prices rise If market situation deteriorates, prices fall Thus there is a link between returns and underlying asset 35

36 Coda: the Sub-Prime Crisis 36

37 Sub-Prime Lending Banks and Mortgage Houses Lend to Risky Individuals Very high loan to value ratios / high income to repayment ratio Borrowers with marginal and uncertain incomes Markets vulnerable to downturn Banks Securitise these Loans Residential Mortgage Backed Securities (RMBS) Collateralised Debt Obligations (CDOs( CDOs) Structured Investment Vehicles (SIVs( SIVs) Rating Agencies Rate (mis( mis-rate?) these Securities Investors Acquire the Securities Underlying Mortgages Default Securities Default or Fall in Value in Secondary Markets So Why Is This a Problem? 37

38 The Credit Crunch Bank Have Short Term Operational Financing Needs They Borrow Backed By Their Assets Banks Hold RMBS, CDOs, SIVs as Assets These Fall in Value Cannot Borrow Against Them Bank Net Worth Falls Cannot Borrow Against Firm Other Banks In Same Position Lending Dries Up Inter-Bank Lending Rates Rise, Pushing Up Interest Rates General Liquidity Crisis Central Banks Inject Capital Confidence Falls: Credit Ratings Fall and Required Interest Rates for Given Credit Rating Rise 38

39 The Credit Crunch & Real Estate Cycles Banks Restrict Lending to Real Estate No Exit Strategy Non-performing Loans: Risk Rating Worsens Debt-Driven Driven Investors Cannot Raise Capital Reduces Investment Demand for Property Contributes to Falling Prices Impact on LTV for Existing Loans Increasing Interest Rates Have Impact on Cap Rates Cap Rates Increase Capital Values Fall? Positive NPV Projects Cannot Be Funded Ultimately Curtails Supply of Space 39

40 Real Estate Debt Markets Colin Lizieri, April March 2008 Colin Lizieri