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CMBS Loans – 8 Key Things You Should Know

This special category of loans creates opportunities at several levels of the commercial real estate sector: an opportunity for banks to increase lending; an additional opportunity for commercial real estate borrowers to access funds; an opportunity for investors may receive higher yields from fixed income securities than from government bonds. Below, we have summarized eight essential things to know about CMBS loans.

1. What are CMBS loans?

CMBS stands for Commercial Mortgage-Backed Securities. These are also called lead loans and represent what are known as first mortgages on commercial property. CMBS loans are made on all classes of commercial real estate assets. Once an individual loan is granted, they are pooled 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 is off the lender’s balance sheet, freeing up cash for the lender to make more loans to borrowers. CMBS loans are also a way to invest in commercial real estate at higher yields than typically offered by government bonds, as well as many other fixed income products.

2. How are CMBS loans structured?

CMBS loan packages are typically structured – or securitized – into three or four tranches, also known as tiers. The tranches of CMBS loans range from the highest quality, lowest risk assets to lower quality and higher risk assets. By titling commercial mortgage-backed securities and layering tranches, the Conducted Lender can balance any potential losses within a bundle, while providing a guaranteed return to the investor.

3. What are the underwriting requirements of lenders for CMBS loans?

The loans conducted will ultimately be consolidated and securitized, offering a fixed return to investors. As a result of this payment guarantee, Conduit Lenders take a more conservative and risk averse stance when taking out CMBS loans. Due diligence typically includes the following:

  • Cash flows are based on incomes in place, not on planned leases or future rent increases;
  • Leases are closely scrutinized to ensure current rents are at market value, reducing the risk of tenant default;
  • The loan-to-value ratio (LTV) is not greater than 75%;
  • Debt Service Coverage Ratios (DCSR) are at least 1.25;
  • Borrowers using CMBS loans are expected to have ‘skin in the game’, which typically refers to cash equity invested in the property against which the loan is issued.

4. Main features of CMBS loans

Borrowers and loan investors should be aware primarily of these six key characteristics of intermediary loans:

  • The term of CMBS loans is normally between 5 and 10 years, and amortizes over 25 to 30 years, with a lump sum payment due at the end of the term.
  • Loans made are non-recourse, which means that the secured property, along with the income stream it generates, is the only recourse available to the lender in the event the borrower defaults on the loan.
  • Prepayment penalties in CMBS loans are common, as the lender will seek compensation for the shorter loan term and the lower interest income that would be earned.
  • Maintaining the yield on CMBS loans is a borrower prepayment penalty structure that allows investors to receive the same return even if the loan is prepaid by the borrower.
  • Defeasance in CMBS loans replaces the original commercial property with alternative collateral such as bonds or other securities that generate the same cash flow as the original property.
  • The assumption of CMBS loans is common and allows the original borrower to sell their collateralized property and have the new buyer take over the remaining loan obligation.

5. Credit rating agencies and lending service for CMBS loans

As with other bonds and fixed income products, rating agencies assign ratings to CMBS loan products. Ratings range from AAA to Baa3 for investment grade classes, to BB + and B- for assets below investment grade.

A key aspect that investors should understand is that CMBS rating agencies do not look at the quality of the individual loans that make up the security, but only the overall quality characteristics of the security. The main CMBS credit rating agencies in the United States are Fitch, Moody’s and Morningstar.

The management of CMBS loans is carried out by a trustee 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 managing escrow accounts. The Special Servicer manages non-performing loans under the CMBS loan program. This includes coordinating restructuring and redevelopment activities, as well as managing the foreclosure of individual assets 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. Second, CMBS loans offer investors a guaranteed rate of return, while the returns of REITs fluctuate based on the performance of the underlying real estate.

Many professional real estate investors believe that when a real estate market peaks and then begins to decline, it is safer to hold debt rather than equity. This is because in a bear market, equity is the first thing to go. The conservative LTV ratios of CMBS loans help ensure that the higher percentage of the borrower’s equity is the first to disappear, thus providing a buffer to the underlying debt.

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 suffer losses if too many loans within a securitized package fail amid a weak real estate market. Even with a low LTV, lenders can still find it difficult to sell a foreclosed property for more than the loan value.

In the aftermath of the 2008 global financial crisis, CMBS loans practically disappeared, and then finally reappeared 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 generally limited to high net worth individuals, family offices and investment entities. Retail investors can opt for CMBS debt by purchasing shares of an exchange-traded fund (ETF) specializing in mortgage-backed securities. This allows the relatively smaller investor to benefit from the returns of the fixed income securities offered by CMBS loans, while diversifying the risk.

Whichever you choose, a good knowledge of market conditions and trends should be part of your due diligence as a potential investor or investment consultant. A CommercialEdge membership opens access to in-depth research on commercial real estate in US markets – detailed property data, as well as information on sales, ownership, debt, and leases.

Join CommercialEdge.com and unlock essential research on over 7 million investment properties nationwide.

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