Real Estate-Backed Securities

Standard & Poor's rating of property-specific financings addresses the ability of an SPV, as the owner or first ranking security interest holder of an income-producing property, to service payment obligations to the debt holders, and encompasses a study of both the real estate market and the bond structure. Standard & Poor's analyzes the viability of the property (and any additional collateral), as well as the security's payment structure, to determine the likelihood of timely and ultimate payment to security holders. Standard & Poor's does not rate the physical real estate, but rather securities
backed by mortgages on real estate and other collateral.

The basis for Standard & Poor's rating is the relative risk underlying the collateral and the ability of the cash flow from the collateral to be received on time and in full by security holders. A thorough review of the property and the determinants of its cash flow and value are performed. The elements of the analysis entail a review of specific property features such as:

ĦE Location;
ĦE Tenancy;
ĦE Leases;
ĦE Market rental rates and expenses;
ĦE Building quality assessments;
ĦE Supply and demand considerations; and
ĦE Management.

The key financial indicators are the property's debt service coverage and loans-to-value ratios. Standard & Poor's analysis seeks to determine a stabilized net cash flow for each property in a securitization. Based upon this figure, Standard & Poor's will determine the appropriate amount of debt at various rating categories in accordance with certain debt service coverage and loans-to-value ratios. The debt structure payment mechanisms that allow the proceeds from the properties to pass through to security holders are also evaluated. These elements are not separate and distinct, but part of an integrated credit picture of the asset. In many cases, the property may not be
sufficient by itself to enable the issuer to obtain its desired rating. In these situations, additional collateral, such as cash or letters of credit, may be necessary to achieve the desired rating.

Standard & Poor's general approach so far outlined is used for all income-producing real estate, including office property and retail property. Given that most transactions feature unique elements, however, Standard & Poor's analysis is tailored to each specific transaction.

Criteria for rating property-specific transactions are broken into three components: real estate quality, payment structure, and legal issues.

Real Estate Quality
There are numerous quality attributes to consider when analyzing property. The following explains in more detail the specific criteria Standard & Poor's employs in property-specific and pool transactions.

Location.
Commercial real estate depends on its location for its economic viability. Several factors are considered in examining location including diversity of the local economy, competition, zoning requirements, and other location-related risk factors.

Tenancy.
A building occupied by one tenant is vulnerable to the risk of that tenant vacating the entire space. A building with a multitude of tenants in diverse industries, and in which there is not a large percentage of leases rolling over at the same time, is least vulnerable to this risk. The lease expiry schedule must be examined in conjunction with the bond maturity.

Leases.
The value of commercial property is derived from its cash flow, which is a function of the leases already signed by the owner and current tenants, and of leases that may be signed by the owner and future tenants. This cash flow is reduced by the expenses incurred from building operation and by tenants of poor credit quality, who may prove unable to meet scheduled payments. The pertinent aspects of each leaseĦXits length, concessions (if any) given to the tenant; timing and amounts of step-ups; and provisions for expense pass-throughsĦXare analyzed to determine the effect each will have on cash flows. In addition, rental rates and expenses are analyzed to determine if they are at supportable market levels. Above-market rental rates are lowered to market rates to derive a property's stabilized net cash flow.

History.
Understanding a property's past performance and track record helps evaluate its ability to support the rated debt. While past performance is not necessarily indicative of future results, the operating performance of a property can be a good source of information on its inherent strengths and weaknesses.

Management.
Given the competitive environment in most markets today, management has become a critical factor in the success of any property. Quality management, illustrated by continued reinvestment in the property, leasing expertise, and tight control of day-to-day operations, can ameliorate lessee turnover and support an argument for long-term stable cash flow.

Construction quality/energy efficiency.
An independent engineering report is provided to Standard & Poor's to determine the construction quality of the premises. These reports should contain reliable information on the remaining economic life of the building, its structural integrity, operating systems, and interior finish. Such information helps ascertain the continued ability to lease, the stability of future income generation, amount of deferred maintenance and needs for capital improvements, levels of maintenance expenses, and reserves for replacement presented in the appraisal. The costs for ongoing general maintenance and future capital needs will be sized into Standard & Poor's stabilized net cash flow used for debt sizing. A report by a qualified, third party engineer will help determine these costs.

Insurance requirements.
Standard & Poor's requires that sufficient insurance coverage be in place to protect against loss. The insurer must have a financial strength rating commensurate with the rating on the securities.

Environmental risk.
Increasingly, Asian countries are tightening laws for hazardous waste cleanup, but requirements differ between one jurisdiction and another. The risk of a lien being placed on a pledged commercial property must be assessed when rating debt secured by that property. As appropriate, this risk is assessed by a site visit by Standard & Poor's analysts, close scrutiny of current tenants and their activities, consideration of prior site usage and adjacent land uses, and a check of currently known hazardous substance sites. An environmental study may be required from a qualified professional engineer. Standard & Poor's reviews the scope of the report for sufficient coverage and determines the overall quality of each report and the potential environmental risk.

Subordinated debt.
Standard & Poor's will not generally rate a transaction with subordinate debt unless the subordinated debt is nonrecourse, and the total debt amortizes down so that the combined loan-to-value ratio at the refinance date is equal to Standard & Poor's targeted loan to value at maturity. Standard & Poor's must also be sure that the transaction documents, the subordinated debt documents, and applicable insolvency legislation do not give rights to subordinated debt holders that would provide subordinated debt holders with an incentive to seek to wind up the borrower.

Commercial real estate used to secure debt varies enormously. Location desirability, lease terms, and other features unique to certain properties result in evaluations on a case-by-case basis.

Payment Structure
A commercial mortgage-backed security has risks beyond those of the pledged property's performance. The rating on the security reflects the likelihood of the debtor's fulfilling all payment obligations on a timely basis.

Security term risk.
There are three basic payment terms that a security can take (and occasionally a combination of the three is used): fully amortizing; interest-only with a balloon payment; and zero coupon.

Fully amortizing is considered the least risky. There is limited risk of having to refinance or sell the property at maturity and, with each debt service payment, the mortgage increases its equity in the property.

Interest-only debt is considered more risky than fully amortizing debt. There is no gradual build-up of equity by the owner, which means that the bondholders' risk remains constant throughout the life of the issue rather than diminishing over time. Also, there are added risks associated with the need to meet the balloon payment at maturity. The market in which the property is located may be in a downturn at the time of maturity, or interest rates may be prohibitively high. And there is the risk that the property, having aged, may not be as attractive to prospective lenders as other buildings. Through careful property and cash flow analysis, debt sizing, and deal structuring, Standard & Poor's may be able to get comfortable with certain balloon refinance risk.

Zero-coupon debt is the riskiest type of financing. While fully amortizing debt has equity build-up, zero-coupon debt has equity erosion over time because interest accrues, becoming principal. In addition, like interest-only balloon debt, zero-coupon debt has financing risk.

Transfers, Ownership, Security Interests
Standard & Poor's bankruptcy analysis involves the evaluation of the nature of each party's property rights and whether third parties have retained rights that may impair the timely repayment of debt service on the bonds.

Standard & Poor's examines the documents to ensure that the trustee has a first priority fixed and floating charge over the property pledged to secure the bonds. Depending on the structure of the transaction, this may involve a mortgage, one or more assignments of mortgage, assignments of rents or leases, the establishment of various reserve funds, or credit support under the trust deed.

Standard & Poor's requires an opinion of counsel to the effect that the trustee has a first priority security interest in the trust estate. If a transaction involves transfers of property, Standard & Poor's also evaluates these transfers to ensure that the bankruptcy of the transferor will not affect the transaction.

If the transferor is not a bankruptcy-remote entity, Standard & Poor's may require opinions of counsel to the effect that, in an insolvency of the transferor:

ĦE The transfer would be viewed as a "true sale" of the property by the transferor; and
ĦE The amounts (or property) transferred and the related debt service payments to the bondholders would not be recoverable as a preference payment.

Recent transactions have made increased use of various funds and cash deposits as credit support. Issuers and developers have used various structures to deal with preference concerns including ageing of funds with trustee, providing letters of credit, bankruptcy insurance policies, and capital contributions to a bankruptcy-remote entity. Standard & Poor's will cooperate with each issuer to ensure that the transaction meets the rating criteria.

Standard & Poor's may require opinions that, in an insolvency of the party exercising control over the funds, such funds will not be deemed to be "property of the estate" of such party, and that payments of debt service would not be subject to an automatic stay.

SPVs
In property specific transactions, Standard & Poor's credit analysis focuses on the property mortgaged by the borrower as collateral for the loan. It is critical to the analysis that the borrower not be subject to economic problems unrelated to the borrower's real estate collateral. It is for this reason that the borrower in the property-specific transaction must be an SPV. In structures where the borrower is a different entity than the owner of the property, the owner of the property must also be an SPV.