Demystifying Commercial Mortgage Backed Securities (CMBS) Loans

Commercial mortgage backed securities (CMBS) loans have become an increasingly popular option for commercial real estate investors over the past few decades. However, these complex financial instruments are still poorly understood by many. In this article I aim to clearly explain what CMBS loans are how they work, and who the key players are in the CMBS loan market.

What Exactly Are CMBS Loans?

A CMBS loan is a type of loan securitized against a pool of commercial mortgages. This means that instead of a bank holding the mortgage and collecting payments, the loan is packaged together with other commercial mortgages into a bond-like security that is sold to investors.

Here is a quick rundown of how it works

• A borrower takes out a mortgage loan to purchase or refinance a commercial property like an office building, retail center, hotel, etc.
• The lender pools together multiple loans and slices them up into different risk tranches.
• Investors can buy the securities backed by the bundled commercial mortgages.
• The loan payments made by the commercial property owners provide income to the investors.

So in essence, CMBS loans allow lenders to sell off the loans they originate to free up capital to fund new loans. And investors get access to the income stream from a diversified pool of commercial mortgages.

The Key Players in CMBS Loans

There are three main parties involved in the CMBS loan process:

Borrowers

The borrowers are typically commercial real estate investors, developers, or owners who take out the actual mortgage loans. Common examples would be a retail developer building a new shopping center or a firm buying an office tower. The terms of a CMBS loan typically include:

• 5 to 10 year maturity
• Fixed interest rate
• 25 to 30 year amortization
• Loan amounts over $2 million

Lenders

Also known as “conduit lenders”, these financial institutions originate the underlying loans that get securitized into CMBS. Banks, investment banks, insurance companies, and mortgage REITs all act as CMBS lenders.

Some well-known CMBS lenders include Wells Fargo, JP Morgan, Barclays, and Starwood Property Trust.

Investors

Once the loans are bundled together and structured into bond-like securities, they are sold off to large institutional investors. Typical CMBS investors include pension funds, hedge funds, insurance companies, and real estate investment trusts (REITs).

They can choose to buy the less risky senior bonds that get paid first or higher yielding subordinate bonds with more risk.

CMBS Loan Structures and Tranches

One key feature of CMBS loans is that they are structured into different bond classes or “tranches” based on credit risk profiles:

• Senior tranches – Highest credit ratings and first to get repaid but lower yields.
• Mezzanine tranches – Middle risk/return profile.
• Subordinate tranches – Lowest ratings, highest risk, but offer the highest potential returns.

If some of the underlying mortgage loans default, the subordinate classes will take the first hits. The senior bonds are safest and will only incur losses after the subordinate classes are wiped out.

This structure allows a wide range of investors to participate based on their individual risk tolerance. Conservative investors buy the senior tranches while more aggressive players invest in the high-risk/high-reward subordinate classes.

Benefits of CMBS Loans

CMBS loans offer several advantages that make them attractive options for commercial real estate borrowers:

• Fixed interest rates – The rates are set for the full 5-10 year term and don’t fluctuate like other financing options.

• Higher leverage – LTVs up to 75-80% are common compared to more conservative bank lending.

• No prepayment penalties – Borrowers can typically refinance at any time without yield maintenance fees or defeasance.

• Assumable – Loans can be transferred to new property buyer with no acceleration of the loan.

• Non-recourse – Borrowers have no personal liability if the property defaults. The lender can only take the property through foreclosure.

The CMBS structure also provides solid benefits to investors:

• Portfolio diversification – Exposure to a pool of loans across many geographic regions and property types.

• Investment flexibility – Ability to pick bond classes matching desired risk tolerance and return hurdles.

• Collateral protection – Underlying commercial properties secure the mortgages.

Current Trends in the CMBS Market

The CMBS market has fully recovered from the slowdown during the Great Financial Crisis. Annual issuance peaked at over $230 billion in 2007 before dropping to only $3 billion in 2009. By 2022, issuance levels bounced back to over $100 billion.

However, headwinds have persisted in recent years:

• Borrowing costs have climbed with rising interest rates.
• Property values and incomes have stagnated in some sectors.
• Maturities remain high on pre-2008 loans.
• Underwriting has tightened considerably compared to years past.

These factors have led to higher delinquencies in certain property categories like malls, hotels, and offices. Most observers expect the challenges to continue in the near term but see the market remaining fairly stable overall.

CMBS vs RMBS Loans

It’s also worth noting the key differences between commercial mortgage backed securities (CMBS) and residential mortgage backed securities (RMBS):

• Property type – CMBS loans finance apartment buildings, hotels, malls, offices, warehouses, etc. RMBS loans go towards single-family homes, townhomes, and condos.

• Prepayment flexibility – CMBS loans allow prepayment anytime without penalty. RMBS loans often have prepayment restrictions and penalties.

• Average loan size – Much larger for CMBS, often over $10 million per property. RMBS loans are typically under $500k.

• Foreclosure timeline – 1 to 2 years is common for CMBS. RMBS foreclosures usually complete in under a year.

Commercial mortgage backed securities play a critical role in providing flexible financing for commercial real estate investors and stable yields for fixed income investors. The CMBS structure allows lenders to efficiently fund loans and transfer risk to bond buyers. And securitization gives investors efficient access to a diversified pool of commercial mortgages.

While facing some recent challenges, the CMBS market remains an essential capital source for the commercial real estate industry. And CMBS bonds continue to offer institutional investors attractive risk-adjusted returns relative to other fixed income options. So despite the complexity, CMBS loans provide worthwhile benefits to both borrowers and investors.