Commercial Mortgage Loans: A Historically Attractive Asset ...

AAM THOUGHT LEADERSHIP

Commercial Mortgage Loans: A Historically Attractive Asset
Class for Insurance Investors

Commercial mortgage whole loans currently provide insurance investors with an attractive yield
advantage to investment grade bond alternatives. Some of the features of the asset class for
insurers include favorable risk based capital treatment, enhanced risk adjusted returns versus fixed
income alternatives, and low correlation to other asset classes. The strong track record of this asset
class, along with new loan terms and investment vehicles, warrants the attention of insurers of all
types and sizes.

This paper will explore the value of commercial mortgage loans in an insurance company
portfolio.

Privately placed first lien commercial mortgages, or commercial “whole loans,” have been a staple
of U.S. insurance portfolios since the late 19th century. Insurance companies, and particularly life
insurers, dominated the fixed rate whole loan market until the late 1980’s, when sloppy
underwriting, bank deregulation, and excessive property valuations shook the market and resulted in
insurers managing losses rather than growing whole loan portfolios. This released insurers’
stranglehold on new whole loan origination and, beginning in 1993, paved the way for investment
bankers to seize market share and securitize private real estate debt in a new product – commercial
mortgage backed securities (CMBS). This new entrant forced life insurance companies to learn
from the self‐inflicted challenges of the late 1980’s and recalibrate their whole loan investment
model to a more prudent, long‐term oriented approach.

The updated insurance whole loan lending model has focused on originating conservatively
underwritten loans, secured by high quality assets and located in attractive markets. As such,
delinquencies on loans originated by life insurance companies fell from a peak of 7.53% in 1992 to
only 0.08% in the second quarter of 2013 (see Exhibit 1). In contrast, and as a result of CMBS
lenders underwriting on unrealistic valuations, second quarter 2013 CMBS delinquency was
10.73%; falling into the same trap insurers experienced 20 years prior in the mid-1990’s.

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

Exhibit 1: Commercial Mortgage Delinquency Rates

12.00% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
11.00%
10.00%

9.00%
8.00%
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%

2001

CMBS- 60 day + Life Insurance Companies

Source: CMBS data Barclays Capital as of June 30, 2013.

Note: Life Insurance Companies as reported by ACLI as of June 30, 2013. CMBS delinquency represents securitized loans delinquent for 60 days
or longer. ACLI represents total commercial property loan delinquency rates for life insurance company portfolios.

Over the past two decades, the reconfigured life insurance whole loan model has become a lower‐
risk, profitable and easily replicated framework for many insurance investors for three reasons: 1)
the spread focus and asset/liability duration matching mitigates interest rate risk; 2) whole loans
offer enhanced risk‐adjusted returns versus public market alternatives, and 3) privately originated
whole loans provide structural benefits versus CMBS. Insurance companies can benefit from
duration matching assets to liabilities with fixed spreads. This offers insurers an opportunity for
accretive income return and a profit margin for insurers for the entire life of such liabilities, thereby
limiting the effect of fluctuating interest rates. This feature of conservative whole loans is
especially valuable in today’s historically low interest rate environment.

Falling rates have created an increasingly difficult conundrum for fixed income investors. Although

this environment has produced strong total return, investors are faced with the challenge of

reinvesting capital at historically low rates. It appears likely that portfolio level cash flow generation
will remain low in the intermediate term, so over‐weighting asset classes offering superior current
cash flow and attractive risk‐adjusted yields is crucial.

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

Exhibit 2

U.S. Fixed Income Yields

(Approximately 7-7.5 year Mod. Duration)

Yield 10-Year Total 10-Year Standard Credit Spread (bps)
Return Deviation
(9/3013) (9/30/13)
(Annualized) (9/30/13)
Asset 2.36% (9/30/13)
3.30% 6.58% N/A
U.S. Treasury Notes 3.90% 5.30%
6.07% 142
(Barclays UST, 7-10 Years Index) 5.27%
6.60% 187
Investment Grade Corporate Bonds 5.88%

(Barclays Corporate Bond Index)

BBB Industrial Corporate Bonds

(Barclays Corporate Bond Index)

(2) 4.72% 5.21% 4.24% 236

Commercial Mortgage Loans

Source: Barclays, Quadrant Real Estate Advisors.
Note: Commercial Mortgage Loans represent privately place whole loans (first mortgages). Total return and standard deviation calculations from the
Giliberto-Levy index as of 6/30/2013. Commercial mortgage yields and spreads are based on market opportunities seen by Quadrant Real Estate
Advisors. The yield represents the bond equivalent weighted spread across property types for 75% LTV loans.

As Exhibit 2 shows, U.S. private whole loans offer enhanced yields relative to public market
alternatives. Whole loans also offer the following attributes:

• Superior call protection relative to corporate bonds
• Materially higher recoveries following default than both corporate bonds and CMBS
• Significantly lower volatility as measured by the standard deviation of quarterly total returns

over the past 10 years

Structurally, whole loans offer particular advantages over CMBS for buy‐and‐hold investors. Private
whole loans afford lenders more control in structuring loans and in realizing a recovery in the
unlikely event of default; whereas CMBS investors are subject to third party special servicers, which
vary widely in competency and effectiveness as fiduciaries. This is due to conflicts of interest
created by both the typical fee structures and the special servicers’ right to buy the assets they
service at ‘fair market value.’ Also, CMBS pools must pay additional third‐party costs such as
master servicing and trustee fees that total approximately 10 to 25 basis points more than
comparable whole loan expenses. Put together, these structural benefits have produced much
higher default recoveries for private whole loans than CMBS loans over time, and ultimately led to
long-term loss rates that compare positively with investment grade corporate bonds (Exhibits 3 and
4).

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

Exhibit 3: Long-term Average Default Recoveries

Commerical Mortgage Whole Loans 80%

CMBS Conduit Loans 47%

Source: Commercial Mortgage Loans – American Council of Life Insurers 1998-2012,
CMBS Conduit Loans – Bank of America Merrill Lynch 2004-2012

Exhibit 4: Long-term Average Annual Loss Rate

Commercial Mortgage Whole Loans 0.01%

Investment Grade Corporate Bonds 0.06%

Source: Commercial Mortgage Loans - ACLI 1998-2012, Investment Grade Corporate Bonds –
Moody’s Global Corporate Default 1982-2012.

Property Underwriting Factors

Commercial whole loans secured by income‐producing properties, while highly defensive when
conservatively underwritten at origination, are not 100% invulnerable to the commercial real estate
cycle. The soaring incidence and severity of default rates in the late 1980’s to early 1990’s
(insurance lenders) and, more recently, in the late 2000’s (CMBS lenders) were largely driven by
lending based on unwarranted property valuations resulting in overleveraged assets once values
eventually normalized. In both cases, valuations were artificially inflated by poor underwriting,
unrealistic income growth projections, and excessive cash chasing ‘trophy’ assets. For this reason,
realistic valuations should be a major focus of whole loan investors.

Unlike the aforementioned periods of overvaluation, income‐producing property values currently
provide an appropriate basis for near‐term lending opportunities, because 1) elevated vacancies and
low rents provide cash flow upside for well‐positioned properties as economic and property
fundamentals improve, 2) the 2008 to 2009 credit crisis resulted in valuation normalization.

Non‐bank institutional lenders are in a position to very carefully underwrite loans and pick only the
most attractive opportunities. Similarly, many of the most sophisticated borrowers have exhibited a
clear preference for institutional, rather than CMBS lenders due to the greater flexibility institutional
investors can offer in terms of rate, loan structure, prepayment options, and earn‐outs. Therefore,
insurance company lenders have a distinct advantage in winning higher quality loan opportunities.

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

Considerations for Whole Loan Investing

Property fundamentals such as market, tenancy, and particular individual property characteristics
support an asset’s valuation and differentiate the best whole loan investments. Institutional quality
U.S. assets are most often found in in‐fill locations within top 25 markets (e.g., New York City,
Washington D.C., Houston, and San Francisco) or in secondary markets (e.g., Austin, TX, and
Portland, OR) with particularly attractive demographics and employment statistics. Among the most
important considerations are population size, age, income, and educational attainment as well as
dominant industries and drivers of job growth. Furthermore, an asset should present favorable
supply constraints such as zoning issues for new construction, easements, or limited buildable land.
Lastly, vacancy and rent growth trends should reflect market strengths via stable or improving
metrics.

A property’s tenancy is the second major consideration in underwriting a whole loan opportunity.
Investment grade tenants are always preferable, but a diverse and staggered rent roll is equally
important. In the case of a single tenant or owner‐occupier, the lease term should ideally extend
well beyond the loan maturity. Furthermore, either multi‐tenant or single‐tenant properties should
exhibit advantages over the competitive set to support re‐leasing in the event of unplanned vacancy.
Such individual property characteristics include: location within a market, construction quality,
vacancy and rent relative to market, borrower and property manager experience, and the property’s
overall capital structure.

• A building in an attractive submarket within an average secondary market might underwrite
more favorably than a building located in a somewhat overbuilt or otherwise soft submarket
within an attractive primary market. Strengths such as access to transportation nodes,
submarket demographics, and area economic development initiatives can affect such a
scenario.

• Construction quality includes building materials, layout, and accessibility. The best
buildings exhibit flexibility in terms of configuration and access.

• Rents may be near or below market rates, and vacancy should be around the market level (or
slightly below with demonstrable upside).

• Highly experienced borrowers and property managers will be more apt to fill vacant space in a
timely and cost effective manner than less‐seasoned operators.

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

• Furthermore, well capitalized borrowers are often more likely to come out of pocket to cover
unexpected leasing and tenant improvement expenses or interest shortfalls if reserve
balances prove insufficient.

• Since whole loans are senior in the property capital structure to the borrower’s equity, the
lender’s primary concern is the borrower’s ability to service the first mortgage under a default
scenario. However, given the conservative underwriting associated with whole loan
origination, the probability of a senior note holder losing principal is remote.

From an overall portfolio perspective, insurance investors seeking to diversify their current holdings
may also find that commercial mortgage loans have historically exhibited low correlation with other
public market alternatives (Exhibit 5).

Exhibit 5: Diversification Benefits

U.S Treasury Notes Corporate Bonds Equities Private Commercial
Mortgage Loans
U.S. Treasury Notes Barclays U.S. Treasury (7-10 Yr) Barclays Corporate S&P 500
Corporate Bonds 1.000 Bond Index -0.528 IPD/MSCI Giliberto-Levy Index
Equities 0.354 0.232
1.000 1.000 0.016
Private Whole Loans 0.300
0.285
1.000

Source: Bloomberg, Barclays, IPD/MSCI Giliberto-Levy Index, AAM. Note: Correlation of quarterly total returns 6/30/2003 – 6/30/2013.

How to Invest in U.S. Commercial Mortgage Whole Loans

Investing in commercial mortgage whole loans can be accomplished via two mechanisms:

1) Separate Single Client Account - Recommended for allocations $100 million and above

• This vehicle is most appropriate for significant allocations to ensure appropriate portfolio
diversification.

• A single‐client account provides an investor with the most control over structuring the
mandate, and controlling assets in foreclosure scenarios.

•

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

2) Statutory Investment Trust - Recommended for allocations $100 million and below

• Statutory Investment Trusts are especially appropriate for smaller allocations to ensure
proper diversification. This vehicle allows multiple investors to co‐invest in a pooled
vehicle with a fully pre‐negotiated structure, while maintaining the favorable risk based

capital treatment of the Separate Single-client Account

As shown in Exhibit 6, access to commercial mortgage loans has typically favored larger insurance
companies with sufficient resources to build a diversified portfolio of loans. For instance, only 23%
of life insurers with less than $300 million in assets owned direct commercial mortgages at the end
of 2012 in comparison with 55% of companies between $300 million to $1 billion, and over 70%
of those with assets over $1 billion. Accordingly, a Statutory Investment Trust vehicle is worth
consideration for small and mid-sized insurers looking for diversified exposure to the asset class.

Exhibit 6: Insurance Company Commercial Mortgage Loans (CML) Holdings

LIFE - UNDER $ 300 MILLION IN ASSETS P&C - UNDER $300 MILLION IN ASSETS

Year % with CML as % CML as % Year % with CML as % CML as %
Ending CML of Assets of Surplus Ending CML of Assets of Surplus

2004 28.81% 6.41% 34.51% 2004 7.28% 1.42% 3.43%

2005 26.92% 7.61% 40.50% 2005 7.59% 1.60% 3.58%

2006 26.69% 7.11% 35.26% 2006 7.60% 1.47% 3.07%
2007 25.64% 7.70% 38.71% 2007 7.11% 2.39% 5.32%
2008 25.53% 7.30% 43.04% 2008 7.13% 2.89% 6.58%
2009 26.05% 7.56% 43.37% 2009 6.94% 2.85% 6.26%
2010 24.89% 6.61% 38.43% 2010 6.46% 2.48% 5.55%
2011 23.63% 4.82% 28.59% 2011 6.20% 3.13% 7.77%

2012 22.75% 5.61% 40.40% 2012 5.93% 2.59% 6.68%

LIFE - $300 MILLION TO $ 1 BILLION IN ASSETS P&C - 300 MILLION TO $1 BILLION IN ASSETS

Year % with CML as % CML as % Year % with CML as % CML as %
Ending CML of Assets of Surplus Ending CML of Assets of Surplus

2004 55.56% 6.03% 50.30% 2004 18.18% 1.39% 4.10%

2005 61.22% 5.60% 38.11% 2005 18.69% 1.32% 3.83%

2006 63.04% 6.10% 48.48% 2006 17.74% 1.25% 3.49%
2007 61.70% 6.35% 45.89% 2007 13.08% 1.13% 2.98%
2008 54.90% 7.44% 49.72% 2008 12.50% 1.82% 5.40%
2009 56.00% 6.23% 43.33% 2009 12.40% 2.02% 5.72%
2010 54.00% 6.10% 39.77% 2010 10.32% 2.72% 7.62%
2011 55.10% 6.84% 51.32% 2011 9.52% 3.12% 8.34%

2012 56.00% 6.11% 46.41% 2012 9.23% 2.99% 8.66%

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

LIFE - OVER $1 BILLION IN ASSETS P&C - OVER $1 BILLION IN ASSETS

Year % with CML as % CML as % Year % with CML as % CML as %

Ending CML of Assets of Surplus Ending CML of Assets of Surplus

2004 87.10% 6.53% 120.50% 2004 39.68% 0.51% 1.59%
0.62% 2.17%
2005 84.68% 6.44% 123.26% 2005 30.30% 0.57% 1.65%
0.70% 2.01%
2006 85.83% 6.33% 123.94% 2006 28.89% 0.65% 1.91%
0.55% 1.52%
2007 82.03% 6.47% 129.72% 2007 29.93% 0.45% 1.19%
0.51% 1.37%
2008 80.31% 7.43% 144.59% 2008 29.79% 0.53% 1.44%

2009 78.29% 6.71% 120.74% 2009 30.07%

2010 75.76% 6.09% 111.14% 2010 31.03%

2011 74.26% 6.20% 115.17% 2011 31.13%

2012 71.74% 6.19% 113.58% 2012 30.26%

Source: SNL
Note: Companies in which mortgage loans constituted >50% of total assets were eliminated as outliers.

As is indicated in Exhibit 6, life insurers have been a much larger investor in commercial whole loan
mortgages given the typical fixed rate, longer duration nature of the loans. Recent trends in the
ability to structure shorter-term as well as floating rate loans might be appealing to property &
casualty or health insurers with shorter duration liabilities.

Typical terms of new original whole loans are currently:

• Term: Between 3 and 15 years
• Amortization: 20 to 30 year schedule; selectively Interest Only
• Loan‐to‐Value: Maximum 75%
• Debt Service Coverage: Minimum 1.20x on Net Cash Flow
• Fixed Rate Spread to US Treasuries: 200+ basis points
• Fixed Rate Coupon: 3.5% to 5.0%
• Floating Rate Spreads: 200+ basis points

New Risk Based Capital Rules for Life Insurance Companies in 2013

The methodology used to determine risk based capital (RBC) for life insurance companies changed
in 2013 to address the shortcomings of the previous approach. The mortgage experience
adjustment factor has been eliminated in favor of establishing five risk cohorts with an assigned
RBC charge for commercial mortgages in good standing. Each loan will be assigned to a risk cohort
based on its debt service coverage (DSC) and loan-to-value (LTV). Exhibit 7 compares the RBC
charges with those of corporate bonds and Exhibit 8 provides the DSC and LTV ranges which result
in the RBC charges for commercial mortgages. The RBC factor for commercial mortgages held by

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

property & casualty companies is simply 5%. It should also be noted that both Separate Account
and Statutory Investment Trust investments in commercial mortgages are Schedule B assets subject
to the same risk based capital rules. In addition, conservative commercial mortgage whole loans
will typically fall into either RBC Group 1 or 2.

Exhibit 7: RBC Charge for Life Insurance Companies

RBC Group Commercial Mortgages Corporate Bond

1 0.90% 0.40%
2 1.75% 1.30%
3 3.00% 4.60%
4 5.00% 10.0%
5 7.50% 23.0%

Source: NAIC, AAM

Exhibit 8: Commercial Mortgage RBC Charge Description

RBC Group RBC Charge Description
1 0.90% DSC=>1.50X and LTV<85%
2 1.75% 0.95 <= DSC < 1.50X / LTV<75%
3 3.00% DSC<0.95X and LTV<85%
4 5.00% DSC<1.15X and LTV=>100%
5 7.50% DSC<0.95X and LTV=>105%

Source: NAIC, AAM

An Attractive Investment Alternative Today

Commercial mortgages have been an essential component of U.S. insurance company portfolios for
over 100 years. Barriers to entry, as well as loan structures have traditionally relegated ownership to
large life insurance companies. New investment vehicles, loan terms, and risk based capital rules,
however provide access to more subsets of the insurance industry. In the context of the current
macroeconomic environment, core commercial whole loans originated with conservative
underwriting parameters, offer compelling yields and competitive risk characteristics that are
attractive for insurance companies today.

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AAM THOUGHT LEADERSHIP
Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

About Quadrant

Quadrant is a SEC Registered Investment Advisor and leader in Commercial Mortgages with $6.4
billion of commercial and multifamily real estate assets under management for institutional clients.
Since 1998, Quadrant has originated over $9.6 billion of private debt investments.

Written by:

Scott Skowronski, CFA
Senior Portfolio Manager
AAM

Richard Sauerman
Head of Global Research
Quadrant Real Estate Advisors

For more information, contact:
Colin T. Dowdall, CFA
Director of Marketing and Business Development
[email protected]
John Olvany
Vice President of Business Development
[email protected]
Neelm Pradhan
Vice President of Business Development
[email protected]

AAM
30 West Monroe Street
3rd Floor
Chicago, IL 60603-2405
312.263.2900
www.aamcompany.com

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Commercial Mortgage Loans: A Historically Proven Asset Class for Insurance Investors

Disclaimer 1: Asset Allocation & Management Company, LLC (AAM) is an investment adviser registered with the Securities and Exchange
Commission, specializing in fixed-income asset management services for insurance companies. This information was developed using publicly
available information, internally developed data and outside sources believed to be reliable. While all reasonable care has been taken to ensure that
the facts stated and the opinions given are accurate, complete and reasonable, liability is expressly disclaimed by AAM and any affiliates (collectively
known as “AAM”), and their representative officers and employees. This report has been prepared for informational purposes only and does not
purport to represent a complete analysis of any security, company or industry discussed. Any opinions and/or recommendations expressed are subject
to change without notice and should be considered only as part of a diversified portfolio. A complete list of investment recommendations made
during the past year is available upon request. Past performance is not an indication of future returns.
This information is distributed to recipients including AAM, any of which may have acted on the basis of the information, or may have an ownership
interest in securities to which the information relates. It may also be distributed to clients of AAM, as well as to other recipients with whom no such
client relationship exists. Providing this information does not, in and of itself, constitute a recommendation by AAM, nor does it imply that the
purchase or sale of any security is suitable for the recipient. Investing in the bond market is subject to certain risks including market, interest-rate,
issuer, credit, inflation, liquidity, valuation, volatility, prepayment and extension. No part of this material may be reproduced in any form, or referred
to in any other publication, without express written permission.

Disclaimer 2: The information contained herein is derived from various sources which Quadrant Real Estate Advisors (“Quadrant”) believes, but does
not guarantee, to be accurate as of the date hereof. Neither Quadrant nor any of its affiliates nor any other person makes any representation or
warranty, express or implied, as to the accuracy or completeness of the information contained in this presentation material and nothing contained
herein shall be relied upon or construed as a promise or representation of past or future performance. Quadrant and AAM are not affiliates.

No representation is made that the investments will actually perform as described in any of the illustrative calculations presented. Investment returns
may vary based upon a number of factors, including investment strategy, allocation and execution, overall market movements, amount of leverage, etc.
A high level of sophistication concerning these issues is assumed.

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