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 their 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 loans are secured by a first-position mortgage. A first-position mortgage counts as the first lien, or first in line to have their debts paid. 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 typically originated at a fixed interest rates, which may (or may not) include an introductory interest-only payment period. The interest rates are typically based on the treasury swap rate plus a spread (lender’s profit). All-in rates 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), CMBS loans contain more risk because of the operating businesses located with each property.
Commercial Mortgage-Backed Securities are highly structured to ensure the certainty of cash flows passed through to the bondholders. Despite the fact that CMBS loans are not standardized like RMBS loans, having fixed terms reduces prepayment and default 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 ranges from the lowest to the highest risk.
The lower risk CMBS tranches are classified as “Senior,” which designates a higher quality credit rating. The higher risk tranches, which are of the lowest payment, are referred to as “Junior” bonds. The Senior tranches receive principal and interest payments first, whereas the Junior tranches pay higher coupons in exchange for being the last to receive payments and first to absorb losses. Additionally, the tranches that absorb more risk also absorb more of the potential losses that may occur.
Organizing a CMBS capital structure into these classifications allows for a securitization process. Having this kind of structure is important for CMBS lenders and investors because it allows investors access to higher yields in commercial real estate investment compared to traditional government bonds. It also allows banks to recycle capital while generating a profit through arbitrage.
Structures and Risks of CMBS Loans
To describe the characteristics and risks of Commercial-Backed Mortgage Securities, it is best to break down loan features and requirements. Here is what is involved in structuring a CMBS loan:
Amortization and Term Length
A typical amortization schedule ranges from 25 to 30 years. Term lengths depend on many factors including cash flow analysis, credit risk profiles, risk profiles, and the lender’s discretion. Term lengths end with a balloon payment at maturity which is typically paid by either refinancing the existing loan or with the proceeds from selling the property.
CMBS loans include one to three different prepayment penalties—defeasance, yield maintenance, or a step-down/fixed schedule. Prepayment penalties exist to incentivize the borrower to stay with the loan for the entire term so the bondholders can receive their principal and interest payments as scheduled. CMBS loans can differ from other types of loans because they carry prepayment penalties for almost the entire term.
Defeasance occurs when a commercial real estate mortgage is removed from the CMBS trust and replaced with government bonds that produce identical cash flows. This provides bondholders with a stronger risk-adjusted investment profile.
Yield maintenance is when CMBS loan principal and interest is repaid in a lump sum, which is good for both parties. The bondholder will receive the same yield as if the borrower had made all of the scheduled loan payments.
A Step-Down prepayment penalty, also known as being on a declining or fixed schedule, is a predetermined sliding scale or fixed percentage which corresponds to the amount of time since the loan was originated.
A loan assumption occurs when a property owner sells a commercial real estate asset, with the secured CMBS loan attached. The buyer will then assume and, continue making payments on this loan. The new borrower will be bound by the same loan documents, which allows the previous to avoid prepayment penalties.
Despite the fact that loan assumptions require fees, it affords the new property owner a more efficient financing process as opposed to procuring a new mortgage. Most CMBS loans are considered to be assumable, which provides options for borrowers and less prepayment risk to be absorbed by bondholders.
What Happens Once a CMBS Loan is Sold?
Once a CMBS loan has been sold into a CMBS trust, the borrower will work with a servicer otherwise known as a master servicer, rather than the original lender. The master servicer is responsible for handling the administrative aspects of the loan, which includes collecting payments from the borrower and managing escrow accounts.
If the borrower defaults on their loan, the loan in question is transferred to a more management-intensive servicer referred to as a special servicer. The special servicer is responsible for potentially modifying the borrower’s loan terms and helping the property return to achieving a stabilized level of operating performance. All modifications must be made while taking into account the bondholder’s best interests.
Which Types of Properties Are CMBS Eligible?
Commercial Mortgage-Backed Securities(CMBS loans) are primarily available for any commercial property type which produces stabilized cash flows. 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.)
Loan minimums usually begin at one dollar. Maximum loan amounts are concluded based on perceived credit risk and are at the lender’s discretion.
The Advantages and Disadvantages of CMBS
One of the primary advantages of a CMBS loan is its potential for lending institutions and bondholders to achieve a higher yield on their investment compared to what they would gain from a traditional government bond. Investors have discretion over which tranches they purchase to achieve their risk/reward profiles. Originating CMBS loans allows lending institutions to recycle capital and increase liquidity.
The disadvantages of CMBS loans are that they carry higher closing costs and more stringent loan terms. Each individual loan’s risk is primarily measured by the stability of net operating income at the property, strength of the surrounding geographic market, and experience of the borrower. If the borrower defaults on their loan, failing to make one or more of their mortgage payments, junior bondholders will experience a loss if servicer advances remain unpaid.
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 many pros and cons. If you take a calculated risk rather than a gamble, the result can prove fruitful for the borrower, lender, and bondholder. The most important thing to keep in mind when considering a CMBS loan is the financial performance of the property as well as your intended holding period.
Are you in need of a CMBS loan? We would 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 produce the best loan options available to you!
Updated April 30, 2021