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In today’s commercial real estate (CRE) market, commercial mortgage-backed securities (CMBS) play a crucial role in financing projects ranging from hotels to office towers. The popular financial tool creates opportunities for entrepreneurs/borrowers to complete high-value projects by accessing fixed-rate and non-recourse credit.
At the same time, commercial real estate lenders earn attractive returns by providing the securitized mortgages. In this blog, we discuss what commercial mortgage-backed securities (CMBS) loans are for borrowers and investors by discussing characteristics, structure, benefits, and the rise of the new-age financing vehicle.
According to Investopedia, “Commercial mortgage-backed securities (CMBS) are fixed-income investment products that are backed by mortgages on commercial properties rather than residential real estate. CMBS can provide liquidity to real estate investors and commercial lenders alike.”
Hence, CMBS can be defined as credit solutions backed by income-producing commercial properties like hotels, office buildings, retail centers, or multifamily housing. Lenders package these loans together and transfer them to a trust. The trust issues bonds to the CRE borrowers as well as receives principal and interest payments.
Loan Pooling: Lenders diversify risks by bundling multiple CRE loans together.
Securitization: Lenders transfer the CRE loan bundles to a trust in the form of tradable bonds.
Tranching: The trust divides the tradable bonds into various layers based on risks and returns.
Non-Recourse Structure: Borrowers get CMBS loans as non-recourse credit. They are not personally liable beyond the value of collateral property.
The CMBS process is managed and monitored by several specialized parties. These participants ensure that lenders and borrowers are protected throughout the CMBS loan cycle.
Sponsor/Conduit Lender: These participants originate and pool CRE loans before securitization.
Master Servicer: The master servicer is responsible for the day-to-day administration of CMBS loans. He/she monitors borrowers as well as collects payments.
Special Servicer: Participants bring in a special servicer when the borrower defaults or the loan becomes delinquent. The special servicer usually manages modifications, foreclosures, or workouts.
Trustee: A trustee primarily oversees the CMBS trust. He/she ensures legal compliance and distributes payments to bondholders.
There are no standardized rules for structuring CMBS financing. But participants balance risks and returns by building the financing vehicles based on a layered structure. The structure controls and smoothens payment flow through loan pools and tranches.
Loan Pools
CMBS deals start with the pooling of multiple commercial real estate loans. Participants usually combine and diversify CRE loans based on specific property types – hotels, offices, retail, and multifamily. They further spread risk by considering commercial properties across the U.S.
Tranches
After pooling the CRE loans, participants divide them into tranches or slices. Every tranche carries a specific level of risk and returns. The tranching technique helps conservative lenders hold safer portions, and risk-tolerant investors opt for higher yields. Lenders usually divide a CRE loan pool into senior, mezzanine, and residual tranches.
Senior tranches provide a higher priority to investors when receiving principal and interest payments. Mezzanine tranches remain in the middle and make investors receive payment after senior investors. Investors in the residue or equity tranches receive payment in the last and absorb losses in case of loan defaults.
Waterfall Cash Flow Structure
The CMBS financing works on the waterfall cash flow structure. The monthly loan payments received from CRE borrowers flow into the CMBS trust. The trustee distributes the payments to participants according to their tranche priority. Hence, they make payments to senior bondholders first, mezzanine investors next, and equity holders in the end.
The CMBS process starts much before the CRE borrowers access credit. The participants make the bonds marketable by following origination and underwriting standards, using third-party due diligence, and evaluating risks per tranches.
Origination and Underwriting Standards
CRE lenders and investment banks originate CMBC loans and package them for securitization. A borrower can access CMBC finance through these lending institutions by meeting preset underwriting standards like debt-to-service coverage ratio (DSCR) and loan-to-value (LTV) ratio. Also, lenders evaluate risks and returns by reviewing the borrower’s profile and evaluating property quality and stability.
Due Diligence and Appraisal Process
CRE lenders protect investors and borrowers based on third-party due diligence. Before securitizing CMBS loans, they minimize surprises by confirming collateral value, assessing building conditions, determining potential environmental risks, conducting compliance reviews, and analyzing tenant and lease strength.
Credit Enhancement and Ratings
After assembling the loan pool, CRE lenders evaluate the risk of each tranche through rating agencies. The ratings assigned by reputable credit rating agencies help borrowers gain transparency into risk levels. Additionally, lenders attract CRE borrowers using credit enhancement techniques like overcollateralization, subordinations, and reserve funds.
CMBS financing offers value to both borrowers and lenders. CRE borrowers prefer CMBS to other financing vehicles to get higher-value non-recourse, and long-term credit at fixed interest rates. A borrower can secure credit worth tens or even hundreds of millions by using high-value commercial assets as collateral.
At the same time, CMBS financing creates opportunities for lenders or investors to get higher yields by diversifying loans across different types of commercial properties. Lenders can tailor risk profiles by customizing tranches. Likewise, they can maintain liquidity by trading CMBS bonds in the secondary markets before maturing. The ratings given by reputable credit rating agencies help them assess credit quality based on standardized benchmarks.
Every borrower or commercial property is not the right fit for CMBS financing. While opting for CMBS loans, CRE borrowers should assess their credit needs as well as compare available financing options.
Fixed-Rate and Non-Recourse Credit
As mentioned earlier, CMBS loans are a form of long-term, non-recourse, and fixed-rate credit. CRE borrowers usually secure CMBS loans using large and income-producing commercial properties as collateral. Hence, typical use cases of CMBS financing include acquisition and development of commercial real estate projects like hospitality assets, office buildings, retail properties, and multifamily properties.
Lending Terms
It is always advisable for CRE borrowers to compare CMBS loans to other financing vehicles like bank loans and agency debts. They can secure bank credit on more flexible terms than CMBS loans. But CMBS loans, unlike bank loans, enable them to access larger loan amounts for longer durations and at fixed interest rates. Likewise, they can access agency debt at more competitive rates. The agency debt, however, is limited only to residential or multifamily assets. Borrowers cannot secure agency loans against commercial properties like hotels and office buildings.
Conclusion
Commercial mortgage-backed securities (CMBS) provide CRE borrowers with opportunities to access long-term, non-recourse credit at fixed interest rates. At the same time, CRE lenders and investors get attractive yields and diversify their portfolios by participating in the CMBS financing process.
Hence, CMBS issuance volume witnessed a significant rise between 2019 and 2024. However, the latest CMBS loan performance data suggest an increase in delinquency and distress rates. Many analysts believe that CRE borrowers will refinance their CMBS loans to leverage benefits, including favorable interest rates, extended maturity periods, and equity unlocking.
In this blog, we discussed what CMBS are by covering important aspects like characteristics, structure, benefits, and risks. Our next blog will cover the refinancing dynamics in CMBS financing and how AVANA Capital helps CRE borrowers address the challenges in CMBS loan refinancing.