Debt

Because of income streams, debt is often cheaper than equity. Higher debt increases the volatility of returns, so in the long term, it requires risk management, a buffer for interest rates, diversification, and stable income.

Sustainable leverage is more appropriate than aggressive leverage. Interest-only leverage is pro-cyclical and can erase equity in downturns.

Loss adjusted IRR:

• default probability,

• recovery rates,

• loan terms,

• amortisation type

+ Yield degradation

• prepayments

• volatility of income

• Credit/default risk: higher default risk in lower tranching

• Prepayment risk: early repayments or default disrupt expected cash flow

• Illiquidity: smaller secondary market than covered bonds

• Market sentiment sensitive:badly hit during the GFC, investors are more cautious due to a lack of transparency

• Pools mortgages into a Special Purpose Vehicle (SPV)

• Investors rely solely on pool cash flow

• Tranching: Senior/Junior, losses hits Junior first

• Higher yields compensate for pool volatility

• Sector/geographic diversification based on market views

• Rating agencies provide guidance, but the GFC showed potential vulnerability in rating assumptions

• Issued by the bank and stays on the banks balance sheet

• Dual recourse: cover pool + bank claim

• Over-collateralisation: pool value > bond value

• Dynamic pool: replacing non-performing loans.

• Highly regulated, also LTV caps.

• Usually AAA rated

• ESG labelled bonds

• High LTV (>80%) shows that borrower has low cushion

• DSCR should be above 1.2x – If it is below 1, income can’t cover debt service

• Tenant strength: Lease profile and tenant quality

• Property types: some asset classes have higher default rates (secondary vs prime office)

• Market conditions: oversupply, low demand, falling rents, rise in interest rates or GDP decline increase risk

• Loan structure: interest-only, balloon payments or short maturities have higher default risks

• Geographic location of assets

• Actual cash flow received

• Defaults or only partial recoveries  IRR reduced due to lower income

• Prepayments or late payments (time value effects) will lower the IRR

• The lender is likely to include penalty clauses into the agreement, which may raise the IRR

• Volatility of property prices (check historical indexes)

• Expected asset value growth

• Loan arrangement: LTV and amortisation schedule

• Investors expect the OLB to be below the asset value