CMBS loans create the perfect trifecta in commercial real estate lending. Banks can make more loans, commercial real estate borrowers have another way to access funds, and investors can receive fixed-income yields that are higher than government bonds.
What Are CMBS Loans?
CMBS loans – or Commercial Mortgage-Backed Securities – are first-position mortgages on commercial property. CMBS loans are made on all asset classes of commercial real estate. Once an individual loan is made, they are packaged together by Conduit Lenders, commercial and investment banks and sold as bonds to commercial real estate investors.
CMBS loans are good for lenders because when the loan is packaged and sold it’s off the lender’s balance sheet, freeing up lender liquidity to make more loans to borrowers. CMBS loans also offer investors an alternative way to invest in commercial real estate at yields higher than government bonds and many other fixed-income products.
How Are CMBS Loans Structured?
Packages of CMBS loans are usually structured – or securitized – into three of four tranches, or levels. CMBS loan tranches rank from highest quality and lowest risk assets, to assets with a lower quality and higher level of risk. By securitizing commercial mortgage-backed securities and layering tranches the Conduit Lender can balance any potential losses within a package while offering a guaranteed yield to the investor.
What Are The Lender Underwriting Requirements For CMBS Loans?
CMBS loans will ultimately be packaged and securitized, offering a fixed return to investors. Because of this payment guarantee, Conduit Lenders take a more conservative, risk-averse attitude when underwriting CMBS loans:
- Cash flows are based on in-place income and not projected lease-ups or future rent increases
- Leases are scrutinized closely to ensure that the existing rents are at-market which reduces the chance of a tenant lease default
- LTV or loan-to-value of no greater than 75%
- DSCR or debt-service-coverage ratios of at least 1.25
- Borrowers utilizing CMBS loans are expected to have “skin in the game” with cash equity invested in their property
Key Features Of CMBS Loans
Six key features of CMBS loans that borrowers and investors should be aware of are:
- Term lengths of CMBS loans are normally between 5 – 10 years and amortized over 25 – 30 years, with a balloon payment due at the end of the term.
- CMBS loans are non-recourse, meaning that the collateralized property and its income stream are the only recourse the lender has should the borrower default on its loan.
- Prepayment penalties in CMBS loans are normal because the lender will look to be compensated for the shorter loan term and a lower interest income received.
- CMBS loan yield maintenance is a borrower prepayment penalty structure that allows investors to receive the same yield even if the loan is paid off early by the borrower.
- Defeasance in CMBS loans substitutes the original commercial property with alternative collateral such as bonds or other securities that generate the same cash flow as the original property did.
- Assumption of CMBS loans is common and allows the original borrower to sell its collateralized property and have the new buyer take over the remaining loan obligation.
Rating Agencies And Loan Servicing For CMBS Loans
Just as with other bonds and fixed-income products, credit rating agencies assign ratings to CMBS loan products. Ratings range from AAA to Baa3 for investment grade classes to BB+ and B- for below investment grade.
It’s important for investors to understand that the CMBS rating agencies do not look at the quality of the individual loans that make up the security, but only at the security’s overall quality characteristics. Moody’s, Morningstar, and Fitch are some of the major CMBS Credit Rating Agencies in the U.S.
Loan servicing of CMBS loans is handled by a Trustee appointed by a Pooling and Service Agreement, or PSA. The Trustee supervises a Master Servicer and a Special Servicer. The Master Servicer handles day-to-day activities such as collecting loan payments and maintaining escrow accounts. The Special Servicer handles non-performing loans within the CMBS loan package, including coordinating restructuring and work-out activities as well as managing foreclosure of individual property backed by a CMBS loan.
How Are CMBS Loans Different From REITs?
There are two significant differences between investing in CMBS loans and REITs. First, REITs are equity investments and CMBS loans are debt securities. Secondly, CMBS loans offer investors a guaranteed rate of return while REIT returns will fluctuate based on the performance of the underlying real estate.
Many professional real estate investors believe that when a real estate market tops and then begins moving down it is safer to own debt than equity. That’s because in a down market equity is the first thing to disappear. The conservative LTV ratios of CMBS loans help ensure that the borrower’s higher percentage of equity is the first to go, providing a buffer to the underlying debt.
What Are Some Risks Of Investing In CMBS Loans?
Conduit Lenders do what they can to minimize risk by using conservative lending practices. But CMBS investors can still experience losses if too many loans within a securitized package default in the middle of a weak real estate market. Even with a low LTV, lenders may still find it difficult to sell a foreclosed property for more than the value of the loan.
Right after the Global Financial Crisis of 2008 CMBS lending all but disappeared, then eventually reemerged as an alternative form of lending as the commercial real estate market improved.
How To Invest In Commercial Mortgage-Backed Securities
Direct investment in commercial mortgage-backed securities is usually limited to ultra-high net worth individuals, family offices, and investment entities. Retail investors can invest in CMBS debt by buying shares of ETFs that specialize in mortgage-backed securities. This allows the smaller investor to benefit from the fixed-income returns that CMBS loans offer while diversifying risk.