CMBS Loans: 8 Essential Things to Understand

This special category of loans creates opportunities across several levels of the commercial real estate industry: an opportunity for banks to increase lending; an additional opportunity for commercial real estate borrowers to access funds; an opportunity for investors can receive fixed-income yields that are higher than from government bonds. Below, we summarize eight essential things to know about CMBS loans.

1. What Are CMBS Loans?

CMBS stands for Commercial Mortgage-Backed Securities. These are also called Conduit Loans and represent what is referred to as 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 a good option for lenders because when the loan is packaged and sold, it’s off the lender’s balance sheet, freeing up lender liquidity to give more loans to borrowers. CMBS loans are also a way to invest in commercial real estate at yields that are higher than what government bonds generally offer, as well as many other fixed-income products.

2. How Are CMBS Loans Structured?

Packages of CMBS loans are usually structured – or securitized – into three of four tranches, which are also known as levels. CMBS loan tranches rank from assets of highest quality and lowest risk, 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.

Read more  Investing in the cannabis industry

3. What Are The Lender Underwriting Requirements For CMBS Loans?

Conduit loans will ultimately be packaged and securitized, offering a fixed return to investors. Because of this payment guarantee, Conduit Lenders take a more conservative and risk-averse attitude when underwriting CMBS loans. Due diligence usually includes the following:

  • Cash flows are based on in-place income, not on projected lease-ups or future rent increases;
  • Leases are scrutinized closely to ensure that the rents at the time are at market value, which reduces the chance of a tenant lease default;
  • Loan-to-value (LTV) is no greater than 75%;
  • Debt-service-coverage-ratios (DCSR) are at least 1.25;
  • Borrowers utilizing CMBS loans are expected to have “skin in the game,” which broadly refers to having cash equity invested in the property against which the loan is issued.

4. Key Features Of CMBS Loans

Both borrowers and loan investors should be aware primarily of these six key features of conduit loans:

  • CMBS loan terms are normally between 5 and 10 years, and amortize over 25 to 30 years, with a balloon payment due at the end of the term.
  • Conduit loans are non-recourse, which means that the collateralized property, as well as the income stream it yields are the only recourse the lender has, should the borrower default on the loan.
  • Prepayment penalties in CMBS loans are common, because the lender will look to be compensated for the shorter loan term and the lower interest income that would be 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.
  • 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.
Read more  How to invest in the solar industry

5. 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 assets.

One essential aspect for investors to understand is 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. Major CMBS Credit Rating Agencies in the U.S. include Fitch, Moody’s, and Morningstar.

Loan servicing of CMBS loans is handled by a Trustee that is appointed by a Pooling and Service Agreement (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. This includes coordinating restructuring and work-out activities, as well as managing foreclosure of individual property backed by a CMBS loan.

6. How Are CMBS Loans Different From REITs?

There are two significant differences between investing in CMBS loans and investing in a Real Estate Investment Trust (REIT). First, REITs are equity investments, while CMBS loans are debt securities. Secondly, CMBS loans offer investors a guaranteed rate of return, whereas REIT returns 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 rather 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.

Read more  How to Buy Klarna Stock: 3 Ways to Invest in Klarna

7. What Are Some Of The 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.

Following 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 recovered.

8. 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 opt into CMBS debt by buying shares of an exchange-traded funds (ETF) that specializes in mortgage-backed securities. This allows the relatively smaller investor to benefit from the fixed income returns that CMBS loans offer, while also diversifying risk.

Whichever you choose to consider, proper knowledge of market conditions and market trends should be part of your due diligence as potential investor or investment consultant. A CommercialEdge membership unlocks access to in-depth research on commercial real estate in markets across the U.S. — detailed property data, as well as sales, ownership, debt and lease information.

Sign up with CommercialEdge.com and unlock essential research on more than 7 million investment properties nationwide.