Changing Leases into Investment-Grade Bonds: Financial Alchemy and Cost Reduction in Real Estate Finance
Graff, Richard A., Journal of Real Estate Portfolio Management
Executive Summary. Ownership of economic benefits from current leases of real property can be separated from ownership of economic benefits from future leases. The ownership interests can be securitized into assets that are independent of each other for investment purposes. Ownership of benefits from current leases can be regarded as a fixed-income asset. In the case of single-tenant property with a bondable-net lease and investment-grade tenant, the fixed-income asset is ratable based on the tenant credit rating and lease default provisions. In the case of general properties and leases, the fixed-income assets are ratable provided additional financial structure is superimposed. The fixed-income assets can be sold as corporate bond-equivalents in the private placement market to create low-cost leverage for real estate investments.
The 1990s have witnessed a significant effort on the part of investment banks to promote securitization of commercial real estate debt, most notably through the introduction of Commercial-MortgageBacked Securities (CMBS). The concept behind the CMBS is the same as that underlying the Collateralized Mortgage Obligation (CMO) developed a decade earlier: assemble a large pool of mortgages, divide the right to receive cash flows from the pool into tranches, and sell shares in each tranche to investors interested in the risk and reward characteristics of that particular tranche.
The fundamental problem with this finance technology is that investment risk for the tranches, and most significantly for the riskier tranches, depends on investment risk for the entire pool. Risk for the pool in turn is determined by investment risk for individual mortgages and how individual mortgage risk aggregates mathematically when pooled. It follows that accurate pricing of CMBS tranches depends on precise knowledge of the mathematical characteristics of investment risk for individual mortgages.l Although the degree of dependence may only be marginal in the case of investment-grade tranches, the dependence is critical in the case of high-risk tranches.2
The need for a precise mathematical description of mortgage investment risk can be reduced to a need for routine information about credit ratings and default protection if individual financings are securitized instead of pooled.3 This also eliminates exposure of the financial intermediary to interest rate risk while mortgage pools are being assembled, reducing any need for the intermediary to maintain a capital reserve.4 Reduction in required return on the capital reserve offsets to some extent incremental costs associated with securitizing individual financings.
An additional advantage to be gained from securitizing individual financings instead of pooled financings is that the critical cost control element becomes the structure of each financing rather than exposure of financial intermediaries to interest rate risk. In other words, securitization of individual financings encourages intermediaries to focus on each financing to obtain the lowest possible cost of capital at the targeted level of leverage rather than on reduction of elapsed time from mortgage placement to tranche sale.5
In order to design the lowest-cost real estate finance, it is necessary to take into account the basic investment characteristics of commercial real estate. Accordingly, the next section is devoted to real estate investment characteristics and their implications for securitization of individual real estate assets. Subsequent sections examine the structure and investment characteristics of the securities.
The Economics of Real Estate Finance
A tenet of basic economics is that asset investment value equals the present value of future net cash flows expected from the asset. This general characterization applies regardless of investment risk and return characteristics.
In the case of real estate, expected net cash flows can be classified by type: expected net cash flows from current leases and expected net cash flows from future leases. …