Section 18.2: “Underwriting” Basic Purpose of Underwriting:Two Foci of Underwriting: Borrower & PropertyAsset Value Criterion: Initial Loan-to-Value Ratio (LTV)The point is . . .Property Income Criteria…2) Break-even Ratio (BER): 3) Equity Before-Tax Cash Flow (EBTCF):4) Multi-year Pro-Forma Projection:Variables and loan terms to negotiate: Underwriting ExampleUnderwriting Example (cont.)Underwriting Example (cont.)Underwriting Example (cont.)Chapter 18:Chapter 18:Commercial Mortgage AnalysisCommercial Mortgage Analysis& Underwriting& UnderwritingSection 18.1:Section 18.1:Expected Returns Expected Returns vsvsStated YieldsStated YieldsMeasuring the Impact of Default RiskMeasuring the Impact of Default Risk““Expected ReturnsExpected Returns””versus versus ““Stated YieldsStated Yields””. . .. . .In a bond or mortgage (capital asset with contractual cash flowsIn a bond or mortgage (capital asset with contractual cash flows):):Stated YieldStated Yield(aka (aka ““Contractual YieldContractual Yield””) = YTM based on ) = YTM based on contractual obligationcontractual obligation..Expected ReturnExpected Return(aka (aka ““Expected YieldExpected Yield””or or ““Ex Ante YieldEx Ante Yield””) ) = = EE[[rr] = Mean of probability distribution of future total ] = Mean of probability distribution of future total return on the bond or mortgage investment.return on the bond or mortgage investment.••Quoted yields are always Quoted yields are always stated yieldsstated yields..••Contract yields are used in Contract yields are used in mortgage design and mortgage design and evaluation.evaluation.••Expected return is more Expected return is more fundamentalfundamentalmeasure for measure for mortgage investors,mortgage investors,••For making investment For making investment decisions.decisions.Difference: Difference: Stated Yield Stated Yield ––Expected Return Expected Return ÍÎÍÎImpact of Impact of Default RiskDefault Riskin in ex anteex antereturn investor cares about.return investor cares about.18.1.1 Yield Degradation & Conditional Cash Flows18.1.1 Yield Degradation & Conditional Cash Flows……““Credit LossesCredit Losses””= Shortfalls to the lender (mortgage investor) as a result = Shortfalls to the lender (mortgage investor) as a result of of defaultdefaultand and foreclosureforeclosure..““Realized YieldRealized Yield””= What the lender (investor) actually receives (as an = What the lender (investor) actually receives (as an IRR).IRR).““Yield DegradationYield Degradation””= Impact of = Impact of credit lossescredit losseson the lenderon the lender’’s realized yield s realized yield as compared to the contractual yield (expressed in IRR units).as compared to the contractual yield (expressed in IRR units).Contractual YieldContractual Yield--Yield Degradation Yield Degradation ÍÍDue to Due to Credit LossesCredit Losses----------------------------------------------------= Realized Yield= Realized YieldYield DegradationYield Degradation((““YDEGRYDEGR””) = Lender) = Lender’’s losses measured as a multis losses measured as a multi--period lifetime return on the original investment (IRR impact).period lifetime return on the original investment (IRR impact).Numerical example of Numerical example of Yield DegradationYield Degradation::••$100 loan.$100 loan.••3 years, annual payments in arrears.3 years, annual payments in arrears.••10% interest rate.10% interest rate.••InterestInterest--only loan.only loan.Here are the Here are the contractual contractual terms of the loan as an NPV equation:terms of the loan as an NPV equation:()()32)10.0(1110$)10.0(110$)10.0(110$100$0++++++−=Contractual YTM = 10.00%.Suppose:Suppose:••Loan defaults in 3Loan defaults in 3rdrdyear.year.••Bank takes property & sells in foreclosure, butBank takes property & sells in foreclosure, but••Bank only gets 70% of OLB: $77.Bank only gets 70% of OLB: $77.()()32)0112.0(177$)0112.0(110$)0112.0(110$100$0−++−++−++−=Here are the Here are the realizedrealizedcash flows of the loan as an NPV equation:cash flows of the loan as an NPV equation:Realized IRR = -1.12% Yield Degradation = 11.12%:Contract.YTM – Yld Degrad = Realized Yld:10.00%. – 11.12% = -1.12%.• $33 = “Credit Losses”.• 70% = “Recovery Rate”.• 30% = “Loss Severity”.From an From an ex anteex anteperspective, this 11.12% yield degradation is a perspective, this 11.12% yield degradation is a ““conditionalconditional””yield degradationyield degradation. . It is the yield degradation that will occur It is the yield degradation that will occur ififthe loan defaults in the third the loan defaults in the third year, and year, and ififthe lender gets 70% of the OLB at that time. the lender gets 70% of the OLB at that time. (Also, 70% is a (Also, 70% is a conditionalconditionalrecovery rate.)recovery rate.)()2)0711.0(177$)0711.0(110$100$0−++−++−=Suppose the default occurred in the 2Suppose the default occurred in the 2ndndyear instead of the 3year instead of the 3rdrd::Yield Degradation = -17.11%.Other things being equal (in particular, the conditional recoverOther things being equal (in particular, the conditional recovery y rate), rate), the conditional yield degradation is greater, the earlier the the conditional yield degradation is greater, the earlier the default occurs in the loan lifedefault occurs in the loan life. . From a loan lifetime performance perspective, lenders are hit woFrom a loan lifetime performance perspective, lenders are hit worse when rse when default occurs early in the life of a mortgage.default occurs early in the life of a mortgage.Note: Note: ““YDEGRYDEGR””as defined in the previous example was:as defined in the previous example was:••The reduction in the IRR (yield to maturity) below the The reduction in the IRR (yield to maturity) below the contract rate, contract rate, ••ConditionalConditionalon default occurring (in the 3on default occurring (in the 3rdrdyear), and year), and ••Based on a specified conditional Based on a specified conditional recovery raterecovery rate(or (or loss loss severityseverity) in the event that default occurs.) in the event that default occurs.ttttDEFseveritylossIRRYTMDEFYLDYTMYDEGR )(−=−=()()32)0287.0(188$)0287.0(110$)0287.0(110$100$0++++++−=For example, if the loss severity were 20% instead of 30%, For example, if