If you’re looking to finance a commercial real estate venture, or looking for the capital to cover your real estate construction and property expenses, there are quite a few loan options out there. They all have different terms, rules, and exceptions; but the most popular of them all would be Commercial Mortgage-Backed Securities.
In this article, we’re going to discuss what Commercial Mortgage-Backed Securities are, how they work, their features, and drawbacks—for both lenders and borrowers. Keep reading to learn more.
What Are Commercial Mortgage-Backed Securities Exactly?
Commercial mortgage-backed securities otherwise referred to as CMBS, or Conduit Loans, are fixed-income investments held up by commercial real estate loans (as collateral). The collateral loans in question are typically for commercial properties such as residential apartment buildings, malls, office spaces, hotels, and even factories. CMBS are useful for both commercial lenders and real estate investors because they provide liquidity, or, a high volume of cash activity.
Think of CMBS as something that facilitates the purchase of commodities. The commodities in question—land, acreage, property, etc.—can be bought as raw material and turned into a greater material to be sold for a profit. Or, they can be sold as-is to a higher bidder, which also yields a profit. The people that are making a profit are typically real estate investors or investor groups, commercial lenders, or syndicates of a commercial bank.
How CMBS Loans Work
CMBS are set up by a first-position mortgage. A first-position mortgage counts as the original mortgage that’s taken on a property. These types of loans are created in a group format that is essentially packaged and sold as a secured series of bonds. Each series bond is organized as a tranche, or, a bundle of “similar risks and rewards.”
For those who are issued lowest-risk CMBS, principal and interest payments are received first. The higher-risk CMBS are the ones who end up at a loss if their borrower defaults on payments. The risk rating issued is up to the lender’s discretion, taking into account the investment base, potential for earning, and risk capacity of the borrower in question.
CMBS loans are also given at a fixed interest rate, which may (or may not) include an interest-only payment period. The interest rates are typically based on the loan’s swap rate plus the spread (lender’s profit). They tend to range from three to five percent.
The amortization schedule for CMBS loans usually spans from 25 to 30 years, with a balloon payment towards the end of the loan. These loans are specifically meant for commercial real estate. Of course, unlike their correlating residential loans (RMBS loans), they’re less risky.
The risk factor involves the CMBS loans abundance of fixed terms in commercial mortgages. Despite the fact that CMBS loans are not standardized like RMBS loans, having fixed terms reduce any prepayment risks.
The Different Types of CMBS
As mentioned above, Commercial Mortgage-Backed Securities are classified by their tranche. Tranches are organized by level of credit risk, which simply put, are from the highest to the lowest risk.
The lower risk CMBS tranches are classified as “Senior,” which designates a higher quality loan. The higher risks, which are of the lowest quality, are referred to as “Junior” loans. The Senior tranches receive both their principal and interest payments first, whereas the Junior tranches come with higher interest rates. Additionally, the tranches that absorb more risk also absorb more of the potential losses that may occur.
Organizing CMBS loans into these classifications allows for a securitization process. Having this kind of structure is important for CMBS lenders and investors because it allows investors easier access to commercial real estate compared to traditional government bonds. It also allows banks to issue more loans with higher returns.
The Securities and Risks of CMBS
To describe the characteristics and risks of Commercial-Backed Mortgage Securities, it’s best to break down the features and requirements. Here’s what’s involved in CMBS loans:
Amortization and Term Length
As mentioned, the typical amortization schedule ranges from 25 to 30 years. However, a 5 to 10-year schedule as also a common term agreement. Term lengths depend on tranches, risk capacity, and of course, the lender’s discretion. Both amortization schedules end with a balloon payment to counteract upfront costs.
CMBS loans also come with two different prepayment penalties—defeasance and yield maintenance. A defeasance penalty involves a substitution as the source of collateral. That collateral is usually the commercial property in question or a treasury bond. Yield maintenance results in the CMBS loan being paid off in full, thereby canceling the mortgage note.
To expand on defeasance, it’s defined by the CMBS loan not being repaid in full, leaving the mortgage note intact. When this happens, the collateral on the property, which is either the property itself or bonds, replace the commercial real estate. The property in question is then either resold or refinanced by the lenders.
To expand on yield maintenance, it’s when the CMBS loan is repaid in full, which is good for both parties. However, it also means that the lender will see the same yield as if the borrower had made all the scheduled loan payments—meaning that they must still pay the anticipated interest.
Loan assumption refers to when a property owner sells a commercial real estate asset, or property, with the secured CMBS loan attached. The buyer then will assume, or, take over the terms of said loan. They will be bound by the same agreement and requirement as the previous borrower, which allows the previous borrower to avoid defeasance or yield maintenance penalties.
Despite the fact that loan assumption requires a fee, it gives the new property owner a more favorable loan outcome as opposed to a bank loan or a newly written CMBS agreement. Most CMBS loans are considered to be assumable, which leaves some wiggle room for borrowers and leaves less risk to be absorbed by lenders.
What Happens Once a CMBS Loan is Sold?
Once a CMBS loan has been sold, the borrower will work with a CMBS servicer otherwise known as a master servicer, rather than the original lender or investor. The master servicer is responsible for handling the management aspects of the loan, which includes collecting payments from the borrower and taking care of any escrow accounts in place.
If the borrower defaults on their loan, the loan in question is handed down to another level of servicer referred to as a special servicer. The special servicer is responsible for modifying the borrower’s terms and agreements of the loan to help the borrower regain stability. Of course, all modifications must be beneficial to the lenders or investors.
Which Types of Properties Are CMBS Eligible?
Commercial Mortgage-Backed Securities are primarily available for any commercial property type with the potential to produce an income. The types of properties that would include are:
Multi-family properties (apartment buildings, duplexes, gated communities, etc.)
Hotels and hospitality spaces
Retail spaces (malls, shopping centers, outlets, etc.)
CMBS loans are viewed as an investment by banks and lenders alike. Loan minimums usually begin at either one million or two million dollars. Maximum loan amounts are given at the lender or private investor’s discretion. Therefore, home buyers and those renting retail spaces don’t qualify for Commercial Mortgage-Backed Securities.
The Advantages and Disadvantages of CMBS
One of the primary advantages of a CMBS loan is its potential for lenders and investors to achieve a higher yield on their investment compared to what they would gain from a traditional government bond. Lenders and investors have complete discretion in which tranches they purchase to set up their risk/reward profiles. This also provides additional capital which increases loan liquidity, thereby lowering the cost of commercial debt.
Of course, the great disadvantage of CMBS loans is the risk. If the borrower defaults on their loan, failing to make one or more of their principal and interest payments, investors and lenders will experience a loss. The individual borrower’s risk depends on the strength of the property market of the area in which the loan originated as well as the date of issuance.
That means that an issued CMBS loan during a peak market or during a time of lower underwriting standards, the risks are much higher. CMBS loans also tend to weaken if the real estate market weakens, yielding less of a potential return. Additionally, if the CMBS loans in question are inaccurately rated or represented in a dishonest manner, the borrower is at risk as well.
Are CMBS Loans the Right Choice?
Like any type of loan, financing, or investment, Commercial Mortgage-Backed Securities come with a handful of pros and cons. Of course, if you take a calculated risk rather than a gamble, the result can prove fruitful for both the borrower and the lender. The most important thing to keep in mind when considering a CMBS loan is the state of your current—and future—financial situation.
Are you in need of a CMBS loan? We’d love to hear from you. Contact us today with any questions or concerns so we can address your needs and provide you with a consultation and let our CUPID platform find the best option available to you!