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, and some of the risks of investing in CMBS.
What Is a Commercial Mortgage-backed Security (CMBS)?
Also known as conduit loans, commercial mortgage-backed securities are fixed-income securities collateralized by commercial real estate loans like those on apartment buildings, malls, office spaces, hotels, and manufacturing facilities.
CMBS are also popular among commercial real estate investors because they provide liquidity to facilitate the purchase of commodities—like land, property, and buildings—and because they are nonrecourse.
While most small investors have to sign personal guarantees when they buy commercial properties, larger projects and acquisitions that can result in CMBS often don’t require personal guarantees. So, in the event of default, the borrower is not held personally liable.
Types of CMBS
CMBS are classified by tranche. Banks organize tranche by level of credit risk, ranging from lowest to highest risk. This allows for securitization, wherein 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 as one of three tranches:
- Senior tranche. This is the safest part of the CMBS because it’s first in line to be repaid and, therefore, the last to be affected if there is a default. Because of this, senior tranches usually have lower interest rates.
- Mezzanine tranche. This is the middle part of the CMBS, and it’s second in line to be repaid in the event of a default. Mezzanine tranches often have higher interest rates than senior tranches.
- Equity tranche. This is the most junior and risky part of the CMBS because it’s last in line to be repaid if there’s a default. Equity tranches typically have the highest interest rates.
How Does a CMBS Work?
A commercial mortgage-backed security is created when a bank or other financial institution pools together a group of loans and sells them off to investors as bonds. The bonds are then given ratings by agencies like Standard & Poor’s and Moody’s.
The loans in a CMBS can be from different property types, locations, and even borrowers. But they all have one thing in common: they’re all backed by commercial real estate. That way, if any of the borrowers default on their loan, the investor still has the underlying property to collect as collateral.
The structure of CMBS can vary, but typically, the loans are divided into three parts, or tranches: senior, mezzanine, and equity. The different tranches are then sold to investors who are willing to take on different levels of risk. For example, an investor who wants a higher return might be willing to buy the equity tranche, while an investor who wants a lower-risk investment might buy the senior tranche.
Interest Rates
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 5.5% and 7.5%.
Amortization and Term Length
Amortization schedules for CMBS loans are usually 25 or 30 years, with loan terms lasting five to 10 years. Term lengths ultimately depend on numerous factors, including cash flow, credit risk, and the lender’s personal discretion, and usually end with a balloon payment.
Prepayment Penalties
Investors may encounter one of several types of prepayment fees pertaining to CMBS. These prepayment penalties incentivize the borrower to continue repaying the loan so that the bondholders will receive scheduled principal and interest payments.
- Defeasance. In the event of defeasance, the borrower pays off the mortgage in full. They may do this by buying US Treasury securities and placing them into escrow. These securities must generate enough cash flow to make all future interest and principal payments on the CMBS bond.
- Yield maintenance. Yield maintenance is a type of prepayment fee wherein the borrower must pay a penalty to the investor if they choose to prepay the mortgage. This fee is usually equal to the difference between the current interest rate and the interest rate at origination, multiplied by the remaining principal balance, multiplied by the years remaining on the loan.
- Step-down/fixed schedule. A step-down/fixed schedule is a type of prepayment fee that decreases over time. This encourages the borrower to continue making payments on the loan and not prepay early.
Loan Assumption
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 enable 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.
Pros and Cons of CMBS
| Pros | Cons |
| Detailed underwriting standards | Risk of default |
| Loans are nonrecourse | Ratings depend on the lender |
| Responsive to the real estate market | Higher interest rates |
CMBC Pros
- Detailed underwriting standards. Detailed underwriting standards make CMBS loans popular with many commercial real estate investors. Lenders typically look at a property’s debt service coverage ratio (DSCR), which is the ratio of net operating income to annual debt. Lenders also consider loan-to-value ratio (LTV), or the ratio of money borrowed to the value of the commercial property.
- Nonrecourse. CMBS loans are nonrecourse 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).
- Responsive to the real estate market. CMBS are responsive to the real estate market, but they’re generally available under any market condition. While lenders’ appetite for private loans can sometimes wane in certain market conditions, CMBS are typically always available.
CMBS Cons
- Risk of default. The risk of default is higher with CMBS loans than with other types of loans. That’s because CMBS loans are nonrecourse, meaning the borrower isn’t held personally responsible for repaying the loan. If the property forecloses, the lender can only recoup its losses by selling the property.
- Ratings depend on the lender. 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.
- Higher interest rates. Because CMBS loans are nonrecourse, they may be higher interest than recourse loans. This means they generally offer higher returns and interest rates to investors than do traditional commercial loans.
Frequently Asked Questions
What Properties are Eligible for CMBS?
Commercial mortgage-backed securities are available for any commercial property that produces stabilized cash flows. Examples include:
- Multi-family properties, such as apartment duplexes and gated communities
- Storage facilities
- Industrial or manufacturing facilities
- Office buildings
- Warehouses
- Hotels, motels, and hospitality places
When should I use a CMBS as a real estate investor?
Whether to use a CMBS to finance their next project isn’t really up to a real estate investor. Instead, the investor’s lender determines whether it will securitize and sell commercial property loans.
Can individual investors invest in CMBS?
Individual investors typically invest in ETFs created from CMBS, but can also invest in CMBS if they have an account to trade bonds. Consumers can also invest in ETFs focused on mortgage-backed securities, which are created from residential mortgages, as opposed to commercial mortgages.
What is the difference between CMBS and RMBS?
CMBS stands for commercial mortgage-backed securities, while RMBS refers to residential mortgage-backed securities. In contrast to CMBS, RMBS are backed exclusively by residential mortgages.
