BBH Strategy Insight March 2016

Rise of the Single Asset Single Borrower Market The Financial Crisis of 2008-09 clearly demonstrated the strong performance of the larger commercial real estate (CRE) loans that underpin commercial mortgage-backed securities (CMBS). Through the greatest decline in commercial real estate valuations (approximately 40%) since the Savings and Loan Crisis of the 1980s, loans greater than $500 million in size (typically extended to more sophisticated and well-capitalized borrowers) experienced cumulative losses of only 1%, according to BBH Analysis. The strong credit performance paved the way for the rapid growth of a CMBS product backed by a single asset-single borrower (SASB). Bond investors assumed a concentrated risk in better quality collateral, while sponsors were provided with a cheaper source of mortgage financing. By 2015, annual SASB issuance had scaled up to $30 billion (30% of total CMBS issuance) and the product exhibited very low volatility in returns through the credit bear markets of 2011, 2013, and 2015. Given the attractive return profile and strong credit metrics of SASB CMBS, BBH has been one of the most active investors during its rise, participating in over 60 separate transactions. SASB transactions continue to offer compelling valuations given their high credit quality, and BBH expects to source additional opportunities throughout 2016. Evolution of the SASB Market Prior to the financial crisis of 2008-09, the SASB market was small, with less than $10 billion of issuance in the prior decade. At the time the large loans could be comfortably divided and absorbed among sizable multi-loan Conduit CMBS transactions. For example, the average Conduit transaction size in 2007 was $3.6 billion, and the largest, GSMS 2007-GG10, was $7.6 billion, containing over 200 individual loans. Each Top 10 loan in the GG10 Conduit deal was in excess of $100 million in balance, with the largest being approximately $700 million or 14% of the total pool balance.

SASB Annual Issuance Volume

$ Billion 35

30.3 30 23.6 21.8

25

15

2016*

2015

2014

2011

2010

2009

2008

2007

2006

2005

2004

2003

2001

2000

2002

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2013

8.5

10

4.1 While these developments have put the CMBS market on 3.3 5 2.4 1.6 1.2 more stable long-term footing than it was pre-crisis, the 0.1 0.0 0.1 0.0 0.3 0.0 1.0 0 size and loan count of new Conduit CMBS deals has shrunk. According to Jeffries, CMBS 2.0 Conduit transactions, which refers to the post-crisis issuance, * Estimated. Data reported for full year for each time period. range from approximately $750 million to $1.25 billion Source: BBH Analysis (averaging $1.1 billion in 2015), secured by 50-100 separate loans. Investor appetite has shifted towards these smaller Conduit pools with more manageable loan counts.

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25.0

20

2012

Following 2009, however, patterns of supply and demand in Conduit CMBS markets changed dramatically. Large bank originators faced higher capital requirements and regulatory constraints, which limited their capacity and duration to warehouse new CMBS loans prior to debt issuance. The landscape of CMBS demand also shifted. Highly-levered alternative buyers disappeared from the market. Primary Conduit demand shifted to Insurance Companies and Money Managers. Limited investor capacity for the large triple-A rated senior tranche is a particular constraint on new issuance.

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Given the downscaling of Conduit CMBS transactions, many of the mega-large loans, which served as anchor loans for fixed-rate CMBS Conduit pools before the crisis, have found a new home securitized in the SASB format post-crisis. Refinancings of large loan floating-rate transactions have also contributed to the SASB pipeline, as individual large loans mature and are securitized on a stand-alone basis. The result has been a liftoff for the SASB market, with $89 billion in new debt issuance from over 150 deals since 2009, compared with less than $10 billion in SASB issuance from 2000 to 2008. These positive dynamics for SASB should continue into 2016, with another $25 billion of issuance expected, accounting for roughly one-quarter of total non-agency CMBS issuance this year, according to BBH Analysis. The range of property types underlying SASB Total Issuance By Property Type (as a % of Total) transactions has also broadened with market 2010 2011 2012 2013 2014 2015 growth. Following waves of fixed-rate regional mall Office 15% 23% 23% 33% 31% transactions in 2012 and 2013, and floating-rate Hotel 46% 34% 22% 48% 39% 29% hotel portfolio deals in 2014, no single property type Retail 26% 55% 55% 28% 14% 22% represented more than one-third of issuance in 2015 Industrial 14% 3% 13% with office deals representing 31% of total Senior Housing 10% 2% 3% issuance, hotel transactions accounting for 29%, Multifamily 1% 6% 2% and retail financings representing 22% of total Manufactured Housing 3% volume. The three largest categories, according to Da ta reported for ful l yea r for ea ch time peri od. Source: BBH Ana lys i s BBH Analysis, typically include Class A office towers in gateway cities, trophy hotels or geographically diversified pools of hospitality assets, and dominant regional malls in major markets. One notable SASB transaction in which BBH participated during the second half of 2015 was MAD 2015-11MD, collateralized by a Class A office building located at 11 Madison Avenue in Manhattan, NY. The $1.1 billion loan has a term of 10 years, and is collateralized by a 29-story 2.3 million square-foot Class A office building, originally developed by MetLife as part of its headquarters complex. The property was built in three phases between 1932 and 1950. As of August 2015, the property was 97.8% leased to 10 tenants, including the largest tenant (Credit Suisse [“CS”]) leasing 55.4% of Net Rentable Area (“NRA”) and the second largest tenant (Sony) leasing 25.3% of NRA. The property has served as the North American headquarters for CS since 1996 and is expected to be the U.S. headquarters for Sony starting in 2016. The property was being acquired by subsidiaries of SL Green Realty Corp. from the Sapir Organization for a purchase price of $2.3 billion ($1,000 per square foot), at which time the sponsor contributed approximately $1.1 billion of cash equity to the transaction. The asset’s overall credit attributes, such as its premier location, investment grade tenants, sponsor experience and financial strength, loan leverage (loan-to-value ratio of 45.7%), and contribution of cash equity at closing, met BBH credit criteria. Sound Credit Performance In Large Loans

According to JP Morgan and Trepp (data and analytics provider), cumulative losses on CMBS Conduit loans during the period from January 2009 to October 2015 reached 3.6%, while the larger loans in floater deals incurred only 0.9% in losses and SASB loans experienced no losses at all.

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Larger Loans Floaters Single Asset-Single Borrower Conduit Loans

3.0 2.0 1.0

Oct-15

Jan-15

Apr-14

Jul-13

Oct-12

Jan-12

Apr-11

Jul-10

Oct-09

0.0 Jan-09

Adding further support to SASB issuance growth has been the better than expected credit performance of large loan transactions through the roughly 40% valuation declines experienced by commercial real estate markets in 2008 and 2009. After witnessing strong large-loan performance during the trough period, investors appear to have warmed to the idea of owning more concentrated risk in single high-quality assets, and even became willing to pay a premium for the ability to be more selective.

Cumulative Loan Losses

% 4.0

Large Loans Floaters are floating-rate multi-loan pools. Conduit Loans are fixed-rate multi-loan pools. Past performance is no guarantee of future results For illustrative purposes only. Data reported from January 1, 2009 to October 1, 2015. Sources: JP Morgan, Treppk, and BBH Analysis

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Over a longer historical context, larger CRE loans, particularly on a stand-alone basis within SASB deals, have historically outperformed smaller loans by substantial margins (see the figure below). BBH examined all historical issuance of SASB transactions from 2000 to 2015, with 157 transactions representing $98.3 billion of issuance. No investment grade-rated tranche of an SASB has ever suffered a loss. Only one transaction, in 2007, secured by a portfolio of extended-stay hotel properties, experienced any loss (a partial write-down of the double-B rated tranche which represented only a low 3.5% loss severity on the loan). The observed cumulative loss rate on all SASB debt has been extremely low, only 0.15%. SASB Loans (2000-2015)

Conduit Loans (1998-2015) >500

250-500

175-250

100-175

98,307

25,135

44,173

36,786

73,615

626

718

330

204

120

Cumulative Loss

0.15%

1.03%

1.96%

4.13%

4.31%

Average Loss Severity

3.5%

5.2%

10.4%

26.2%

28.0%

Highest Loss Severity

3.5%

23.8%

68.3%

64.5%

106.9%

Aggregate Loan Amount ($ million) Average Loan Amount ($ million)

Past Performance is no guarantee of future results. Data reported from Ja nua ry 1 to December 31 for the ful l year for each ti me peri od. For i ll us tra ti ve purpos es onl y. Source: BBH Ana l ys i s .

Even within Conduit transactions, where initial loan-to-value (LTV) ratios can be higher than in SASB deals, the credit performance of the largest loans has been similarly very strong. For Conduit loans above $500 million in size, observed cumulative losses during the 1998-2015 period are only 1%, and the highest loss severity as a percentage of outstanding balance ever observed on a large loan default is 24%.

Moody’s/RCA Commercial Property Price Indices support the notion that peak-to-trough declines for major markets are smoother and recovery periods are shorter. For example, major market property valuations declined 38.4%, before rebounding 119% from the trough in 2009 through 2015. In non-major markets, the 41% decline was more severe, and the recovery slower, with only 72% growth from the trough through 2015. The institutional quality assets in SASB deals also tend to attract more sophisticated, well-capitalized investors (Real Estate Investment Trusts, Private Equity Firms, Insurance Companies,

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Index 300 250 200 150 100 50 0

Moody's/RCA CPPI* Major Markets (All-Property) Non-Major Markets (All-Property)

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

It should come as no surprise that large institutional properties located in major metropolitan areas have historically outperformed their smaller peers, located in secondary and tertiary markets. Major cities such as New York, Los Angeles, San Francisco, Boston, Houston, Miami, and Chicago typically benefit from diverse economies and a stronger employment base. Employment levels and commercial real estate prices are highly related (see the chart on the right), as employment growth drives demand for multifamily, office, retail, and industrial space, stimulating rent growth and increasing property values.

Data reported for the full year for each time period, as of September 2015 * The Moody’s/RCA Commercial Property Price Indices (CPPI) is based on repeat-sales transactions that occurred at any time up through the month prior to the current report Sources: Moody's and BBH Analysis

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Pension Funds, and Sovereign Wealth Funds). These investors are typically better capitalized and staffed to manage their property portfolios through turbulent markets. The continuing rise in international institutional demand for the highest quality assets in major markets appears to be a longer-term secular trend. According to Preqin, which tracks the alternative asset industry, approximately $87 billion was raised globally by private real estate funds during just the first three quarters of 2015. The amount of uncalled capital held by closed-end private real estate funds, so called “dry powder”, reached $244 billion as of end of Q3 2015, of which $127 billion was allocated for investment in North America, suggesting continued strong demand for trophy properties in the foreseeable future (as shown in the charts below).

SASB Spreads More Resilient Than Conduit Solid commercial real estate market fundamentals, the elevated quality of sponsors, and lower property value volatility has translated into strong investor interest in bonds collateralized by trophy assets in major markets or portfolios of geographically diverse assets. During both the “Taper Tantrum” of 2013 and the rout in credit during the second half of 2015, SASB bonds have experienced much lower spread volatility than CMBS Spread Summary Level as of 1-Day 1/6/16 Change

Recent Levels 1-Week 1-Month Change Change

52-Week YTD Change

Average

High

Low

Std. Dev

Deviation from Avg.

Current Vintage Conduit (bps to swaps) New Issue AAA 30% 10-Year New Issue AANew Issue ANew Issue BBB-

136 195 313 548

0 0 0 0

2 4 5 3

1 12 30 35

0 0 0 0

105 167 243 412

138 204 313 550

82 135 185 325

19 26 49 75

31 28 70 136

Single-Borrower CMBS (bps to swaps) Single-Borrower AAA Single-Borrower AA Single-Borrower A Single-Borrower BBB-

134 165 195 255

0 0 0 0

2 1 1 1

4 5 5 10

0 0 0 0

102 126 153 199

134 169 195 255

82 101 123 163

18 23 26 34

32 39 42 56

Corporate Spreads (bps to swaps) Investment Grade (7-10 years) REITs High Yield (7-10 years)

197 181 556

2 5 -5

5 25 2

11 19 23

2 5 -5

150 141 437

204 186 598

100 97 324

28 25 63

47 40 119

Sources: Bloomberg, LP, FINRA, Yield Book, Wells Fargo Securities, LLC, and BBH Analysis Credit Quality letter ratings are provided by Standard and Poor’s and Moody’s and are presented as the higher of the two ratings. Issues with credit ratings of BBB or better are considered to be investment grade, with adequate capacity to meet financial commitments. Issues with credit ratings below BBB are considered speculative in nature and are vulnerable to the possibility of issuer failure or business interruption. Sources: Bloomberg, LP, FINRA, Yield Book, Wells Fargo Securities, LLC, and BBH Analysis

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CMBS new-issue Conduit paper (see table on the previous page). SASB return volatility was particularly muted in the triple-B- part of the capital stack: over the 52-week period ended March 10, 2016, SASB deals deviated only 137 bps over their annual average spread compared to a deviation of 321 bps over the same period for Conduit deals. Investment Opportunity In line with the rest of the fixed income universe, CMBS credit spreads have widened dramatically, reaching the highest levels seen since 2011. We attribute much of the volatility to extraneous market factors, and continue to believe that commercial real estate fundamentals remain solid. Constraints on dealer balance sheets and the December implementation of risk retention rules (requiring issuers to retain 5% of transactions for a minimum of five years) will continue to pressure spreads in the foreseeable future. Yet underwriting standards have held up well in 2015 and we expect that trend to continue, especially as issuers themselves will be required to keep more “skin in the game” starting at year-end. Furthermore, continued demand for trophy commercial real estate from foreign investors will likely continue to buoy the values of the highest quality assets. SASB bonds accordingly currently offer an attractive long-term investment opportunity, with limited volatility, to investors seeking exposure to the highest quality U.S. commercial real estate. Conclusion To date, no investment grade SASB note has ever experienced an impairment. The demonstrated resilience of large commercial real estate loans through the Financial Crisis, coupled with rising investor comfort with loan exposures to high quality single properties and portfolios, has catalyzed the growth and maturation of the SASB CMBS over the last several years. In addition to demonstrated credit strength, the SASB market thus far exhibited lower volatility in returns relative to Conduit CMBS and corporate debt of comparable rating and tenor. Given the continuing strength of the U.S. economy and solid commercial real estate fundamentals, recent CMBS spread volatility seems to be driven more by external factors such as the decline in oil prices, the sell-off in corporate bonds, and stock market correction. Accordingly, we believe that the currently attractive valuations in SASB CMBS provide an attractive entry point for investors into a time-tested credit product.

Vaidas Nutautas Credit Analyst

Neil Hohmann, PhD Portfolio Co-Manager

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Opinions, forecasts, and discussions about investment strategies represent the author's views, as of the date of this commentary, and are subject to change without notice. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as recommendations. Single Borrower-Single Asset (SASB) lacks the diversification of a transaction backed by multiple loans since performance is concentrated in one commercial property. SASBs may be less liquid in the secondary market than loans backed by multiple loans. Neither, Brown Brothers Harriman, its affiliates, nor its financial professionals, render tax or legal advice. Please consult with attorney, accountant, and/or tax advisor for advice concerning you particular circumstances. This publication is a general guide to the views of Brown Brothers Harriman & Co. and is provided to recipients who are classified as Professional Clients and Eligible Counterparties if in the European Economic Area (“EEA”), solely for informational purposes. This does not constitute legal, tax or investment advice and is not intended as an offer to sell or a solicitation to buy securities or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code or for promotion, marketing or recommendation to third parties. This information services. Any opinions expressed are subject to change without notice. Unauthorized use or distribution without the prior written permission of BBH is prohibited. This publication is approved for distribution in member states of the EEA by Brown Brothers Harriman Investor Services Limited, authorized and regulated by the Financial Conduct Authority (FCA). BBH is a service mark of Brown Brothers Harriman & Co., registered in the United States and other countries. © Brown Brothers Harriman & Co. 2016. All rights reserved. 03/2016 IM-2016-03-14-2720

Exp. Date 05/31/2016

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