Commercial mortgage-backed securities (CMBS) are fixed-income securities backed by mortgages on commercial properties, including office buildings, hotels, malls, apartment buildings, and more.
They provide liquidity for real estate investors and commercial lenders.
If you’re looking to finance a commercial real estate purchase, commercial mortgage-backed securities might be a great option.
In this article, we’ll explain what CMBS are, how they’re structured, their pros and cons, the risks of investing in CMBS, and much more.
Let’s dive in.
What are CMBS?
Also known as conduit loans, commercial mortgage-backed securities are fixed-income securities collateralized by commercial real estate loans.
These collateral loans are loans for commercial real estate properties—apartment buildings, malls, office spaces, hotels, manufacturing facilities, and more.
CMBS are attractive to commercial lenders and real estate investors because they provide liquidity.
They are a financial tool that facilitates the purchase of commodities.
These commodities—land, property, buildings, etc.—can be developed and sold at a profit, or they can be sold as-is to the highest bidder.
How do CMBS loans work?
First, a real estate investor or business owner purchases a commercial property. They obtain a mortgage from a bank to finalize the purchase.
The bank takes that mortgage and pools it together with other commercial mortgages.
The bank turns those mortgages into bonds, rates the bonds, bundles them in tranches, and sells those bonds to investors.
The bank earns money from the sale of those bonds, and a servicing manager takes over the bonds after the sale.
These bonds earn fixed yields for the investors who purchase them. The bank, after selling these bonds, lends the subsequent proceeds out to another party.
The entire process of CMBS allows commercial borrowers to access funds and mortgages.
CMBS loans typically come with fixed interest rates. These rates may or may not include an introductory interest-only payment period.
These interest rates typically hover around the US Treasury swap rate plus the spread. All-in interest rates fall between 3-5%.
The amortization schedule for CMBS loans typically falls between 25-30 years.
What are the different types of CMBS?
CMBS are classified by tranche.
Banks organize tranche by level of credit risk, ranging from lowest to highest risk.
“Senior” CMBS tranches are lower risk, higher credit rating.
“Junior” CMBS are higher risk, lower credit rating.
Senior CMBS tranches have first lien—they’re first in line to be repaid, in case the borrower defaults. Junior tranches have second lien or no lien; they’re the last to receive payments and the first to absorb losses.
Organizing CMBS into tranches allows for securitization.
Securitization occurs when an issuer creates a marketable financial instrument by pooling other financial assets into one group. The issuer then sells this repackaged group of assets to investors.
How are CMBS loans structured?
Amortization and term length
Typical amortization for CMBS ranges between 25-30 years.
Term lengths depend on numerous factors—cash flow, credit risk, and the lender’s personal discretion Term lengths usually end with a balloon payment.
CMBS presents 3 possible prepayment penalties: 1) defeasance, 2) yield maintenance, or 3) step-down/fixed schedule.
These prepayment penalties incentivize the borrower to continue repaying the loan so that the bondholders will receive scheduled principal and interest payments.
Defeasance occurs when a commercial real estate mortgage is removed from the CMBS and replaced with government bonds producing identical cash flows. Defeasance provides the borrower with a stronger investment profile.
Yield maintenance occurs when the borrower repays the CMBS loan principal and interest in a lump sum. The bondholder receives the same yield if the borrower pays in installments.
Step-down prepayment penalties are paid on a predetermined sliding scale or fixed percentage corresponding to the amount of time since the origination of the loan.
Loan assumption occurs when the owner of a property sells a commercial real estate asset attached to a secured CMBS loan.
The buyer of the asset “assumes” the loan.
Loan assumptions require fees, but they also afford the new property owner to avoid signing a new mortgage.
Most CMBS loans are assumable—this provides more options for borrowers and lower prepayment risk for bondholders.
What properties are eligible for CMBS?
Commercial mortgage-backed securities are available for any commercial property which produces stabilized cash flows.
Can individual investors invest in CMBS?
Individual investors typically invest in ETFs created from CMBS.
You can also invest in ETFs focused on mortgage-backed securities, which are created from residential mortgages, as opposed to commercial mortgages.
What are the pros of investing in CMBS?
Detailed underwriting standards
Detailed underwriting standards make CMBS loans popular with many commercial real estate investors.
2 main underwriting parameters guide CMBS Loans:
- Debt Service Coverage Ratio (DSCR)
DSCR refers to the ratio of net operating income to annual debt.
The lender determines the DSCR, and the ratio will vary depending on the risk level associated with the property (i.e. office spaces tend to be less risky than land investments)
- Loan to Value Ratio (LTV)
The LTV ratio refers to the ratio of money borrowed to the value of the commercial property. Third-party appraisal firms determine the value of the commercial property.
Higher LTV indicates a riskier loan. CMBS loans typically provide investors with a maximum LTV of 75%.
CMBS loans generally offer higher returns and interest rates than traditional commercial loans.
Additionally, they usually offer a fixed-rate option which gives the borrower the chance to easily plan payments.
Fixed loan terms
CMBS loans typically come with fixed interest rates, and these rates typically fall below the interest rates available through conventional mortgages.
CMBS interest rates are typically the US Treasury interest rate with a small margin added on top.
CMBS loans are non-recourse loans. That means the borrower is not held personally responsible for repaying the loan.
However, some CMBS loans contain a clause that states if you intentionally harm the property, you can be held liable by your CMBS lender (i.e. your investors).
What are the cons of investing in CMBS?
High default risk
Just like corporate bonds, commercial mortgage-backed securities are at risk of default.
When borrowers fail to pay both principal and interest payments, CMBS investors will experience a loss.
Ratings depend on the bank
Banks must be honest when financing CMBS loans. If these loans are poorly rated or falsely represented, investors have no way of evaluating their bond purchases.
During the Great Recession of 2008, shoddy ratings were a major cause of the collapse of the entire housing market.
Responsive to the real estate market
CMBS are responsive to the real estate market.
The risks of investing in CMBS will be higher during a time when underwriting standards are low, or during a market peak. Any weaknesses in the real estate market will affect the risk of investing in CMBS.
Key features of CMBS
- Loan Amount Range: $2,000,000 minimum
- Interest Rate: Fixed-rate throughout the loan term
- Loan Term: 5, 7, or 10 fixed-year
- Amortization: 25-30 years, up to 10 years of interest-only available in certain situations
- Maximum LTV: 75%
- Minimum DSCR: 1.20-1.25%
- Minimum Debt Yield: 7-8%
- Recourse: Non-recourse, except for industry-standard carve-outs
- Prepayment: 2-3 year lockout, then defeasance or yield maintenance moving forward
Should I invest in CMBS?
CMBS loans present a unique set of pros and cons. Before deciding whether to invest in CMBS loans, think carefully about your current and future commercial financing needs.
If you’re focused on locking in a great interest rate, a CMBS loan might be a great option.
However, if you prioritize flexibility, traditional commercial loans might be the better choice.
When evaluating whether to invest in CMBS, remember to consider the financial performance of the property in question, as well as your intended holding period.