Commercial mortgage-backed securities (CMBS)

What is CMBS

Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by commercial mortgage loans on commercial properties rather than residential real estate. CMBS can provide liquidity to real estate investors and commercial lenders alike. Since there are no standardized rules for structuring CMBS, their valuation can be challenging. The underlying loans of CMBS may include a number of commercial real estate loans of varying terms, values, and property types—such as multi-family dwellings and commercial real estate properties. CMBS can offer less of a pre-payment risk than residential mortgage-backed securities (RMBS), as the term on commercial mortgages is generally fixed.

CMBS Explained

Commercial mortgage-backed securities (CMBS) are structured similarly to collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO) and are issued in the form of bonds. Commercial mortgage loans that form a single commercial mortgage-backed security act as collateral in the event of borrower defaults, with principal and interest payments passed on to investors.

CMBS loans are typically contained within a trust, featuring various loan terms, property types, and loan amounts. The underlying loans that are securitized into CMBS include loans for properties such as apartment buildings and complexes, factories, hotels, office buildings, office parks, and shopping malls, often within the same trust. These commercial real estate loans offer diversity within the same financial product.

A commercial mortgage loan is typically considered non-recourse debt, meaning it is secured only by the collateral (the commercial property). In the case of default, the lender cannot seize any assets of the borrower beyond the collateralized commercial property. This feature is common in non-recourse CMBS loans.

CMBS are complex investment vehicles that require a wide range of market participants to function properly. These participants include investors, a primary servicer, a master servicer, a special servicer, a directing certificate holder, trustees, and rating agencies. Each participant has a specific role in ensuring that CMBS loans perform properly. The securitization process of CMBS allows commercial banks and financial institutions to manage and mitigate credit risk while offering a fixed-income investment option to institutional investors.

Types

1. Senior Tranche. The senior tiers are first to be paid and hence have a lower risk profile than other parts of a CMBS. For this reason, they also tend to pay lower interest rates. Investors in the senior tranche receive principal and interest payments before other tranches, making them more secure. These are typically favored by conservative investors looking for stable returns from debt securities.

2. Mezzanine Tranche. The mezzanine tranches have more risk than higher-level tranches, but they also pay higher yields. In the event of a default, these investors are repaid after the investors in the senior tranche. Mezzanine tranches are attractive to investors seeking higher returns while still maintaining a moderate level of risk. They are common in CMBS loans typically found in conduit loans issued by conduit lenders.

3. Equity Tranche. The equity tranche is the riskiest part of a mortgage-backed security, but it also offers the highest potential gains. Investors in this tranche are last in line to receive repayments in the event of a default. This tranche is suited for investors who are willing to take on significant risk in exchange for potentially higher returns. These investors might also benefit from loan assumptions and the overall cash flow generated by the CMBS mortgages.

Structure

• Interest Rates. CMBS loans come with fixed interest rates, often based on the Treasury interest rate. These fixed interest rates provide stability and predictability for investors. Additionally, CMBS loans may offer a favorable introductory payment period to attract commercial borrowers.

• Term Length. The term length of CMBS loans typically ranges from 5 to 10 years, usually ending in a balloon payment. The specific term length is influenced by factors such as the borrower’s credit risk and the projected cash flow from the commercial property. Loan documents detail the terms, including the amortization schedule and any prepayment penalties.

• Prepayment Penalties. Prepayment penalties are designed to discourage borrowers from paying off the loan early, thereby ensuring a consistent flow of principal and interest payments. Prepayment penalties CMBS loans typically include yield maintenance clauses to compensate investors for the loss of future interest payments.

Advantages and Disadvantages

Advantages of CMBS

1. Fixed Interest Rates. CMBS loans offer fixed interest rates, providing stability and predictability for both borrowers and investors. This makes budgeting and financial planning more manageable for commercial borrowers.

2. Non-recourse Loans. In most cases, borrowers are not personally responsible for failure to make payments on CMBS loans. This means that if a borrower defaults, the lender can only seize the collateral (the commercial property) and not pursue the borrower’s other assets. This non-recourse nature makes CMBS loans attractive to commercial borrowers.

3. Loan Assumptions. When a mortgaged property is sold, the existing loan can often be passed on to new buyers through a loan assumption process. This feature provides flexibility for both the seller and the buyer, allowing the continuation of the original loan terms without needing to secure new financing.

Disadvantages of CMBS

1. High Prepayment Penalties. To discourage borrowers from paying a loan early, CMBS loans often include high prepayment penalties. These penalties can be significant and are designed to protect investors' interests by maintaining the expected cash flow from principal and interest payments.

2. Requirement for Alternative Collateral. Borrowers who wish to pay a loan early may be required to provide alternative collateral. This requirement can add complexity and additional financial burden to the borrower, making early repayment less feasible.

American VS. European CMBS

American CMBS

1. Prepayment Risk. American CMBS loans carry much less prepayment risk compared to their European counterparts. This is due to the nature of US commercial mortgages, which often include prepayment penalties to discourage borrowers from paying a loan early. These penalties, commonly referred to as prepayment penalties in CMBS loans, ensure a steady cash flow for investors by maintaining the scheduled principal and interest payments.

2. Prepayment Protection. US commercial mortgages usually provide for a block period (generally 1-5 years) during which no advance payment of the loan can be made. Borrowers wishing to repay early may face substantial prepayment penalties or must offer alternative collateral, such as yield maintenance clauses, to offset the loss of future interest payments.

3. Interest Rates. American CMBS loans typically come with fixed interest rates, providing stability and predictability for both borrowers and investors. These rates are often based on the Treasury interest rate, which aligns with traditional government bonds.

European CMBS

1. Prepayment Protection. European CMBS generally have lower prepayment protection compared to American CMBS. This means that European borrowers may face fewer restrictions and lower penalties for paying off their loans early. However, this also increases the prepayment risk for investors, as the cash flow from principal and interest payments may be less predictable.

2. Interest Rates. Interest on European CMBS bonds can be either fixed or floating rate. Floating rates are typically tied to benchmarks like LIBOR (London Interbank Offered Rate) or EURIBOR (Euro Interbank Offered Rate), plus a spread. This variability can make European CMBS more attractive to investors seeking higher potential returns but also introduces more risk compared to fixed-rate CMBS loans.

Requirements

The Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) introduced new regulations in December 2016 to mitigate some of the risks associated with CMBS by establishing margin requirements for covered agency transactions, including collateralized mortgage obligations (CMOs). These requirements aim to ensure greater stability and reduce potential credit risk in the CMBS market.

Example

A real estate investment trust (REIT) seeks to acquire a large office building in downtown Chicago. To finance this purchase, the REIT applies for a CMBS loan from a commercial bank.

1. CMBS Loan Application. The REIT submits a loan application to a CMBS lender, providing details about the office building, including its net operating income (NOI) and other financial metrics.

2. Loan Terms and Eligibility. The lender reviews the application to ensure the property meets CMBS loan requirements, such as the loan-to-value ratio and debt service coverage ratio. The office building is considered an eligible property.

3. Loan Amount and Term. The CMBS loan is approved for the entire loan amount needed to purchase the office building, with a 10-year term and a fixed interest rate based on Treasury bonds.

4. Prepayment Penalties and Amortization Schedule. The CMBS loan terms include prepayment penalties to discourage early repayment and an amortization schedule detailing regular principal and interest payments, concluding with a balloon payment.

5. Securitization Process. The approved CMBS loan is pooled with other commercial mortgage loans into a CMBS trust. The trust issues CMBS bonds to investors, including mutual funds and financial institutions.

6. Loan Servicing. A loan servicer manages the day-to-day administration of the CMBS loan, ensuring that the REIT makes timely payments and adheres to the loan terms. If any issues arise, the loan servicer acts as the primary point of contact.

7. Investor Returns. Investors in the CMBS trust receive regular interest payments derived from the cash flow generated by the underlying commercial properties, including the office building. The fixed interest rates provide predictable returns, similar to traditional government bonds.