Definition Of CMBS
CMBS stands for Commercial Mortgage-Backed Securities, and it refers to fixed-income investment products that are supported by loans on commercial properties. These mortgages or loans are specifically for commercial properties such as hotels, office and apartment buildings, shopping centers, and warehouses.
CMBS are created by merging a group of commercial real estate loans and selling them as bonds to investors.
CMBS Loans and Underwriting
CMBS loans are popular with many commercial real estate investors as they tend to be beneficial over traditional commercial loans. When applying for a CMBS loan, one has to go through its underwriting process, which is, by and large, the most time-consuming part of a CMBS loan application or origination (which is the process between the lender and the borrower where they decide the loan amount, rate and terms).
This underwriting process is used to determine whether a borrower presents a reasonable credit risk to the lender. Credit risk is basically the possibility of a loss resulting from the borrower’s failure to repay the loan or meet the decided contractual obligations.
Additionally, it is the risk whereby the lender does not receive his/her owed principal and interest, which results in disrupted cash flows and increased collection costs. So, it is very important to analyze the borrower’s financial status and the nature of the property he/she requires the loan for so that the lender knows if the borrower would be able to repay the loan or not.
Underwriting Guidelines
Now that we know how much of an integral part underwriting is for a CMBS loan, let’s take a look at the typical guidelines involved in it.
CMBS loans, or as others call them, Conduit loans, are guided by two important underwriting parameters, the Debt Service Coverage Ratio (DSCR) and the Loan To Value ratio (LTV). There are some other parameters as well, which pertain to the risk profile of the loan.
The DSCR is essentially a ratio of the net operating income to annual debt. This is widely used in the corporate, government, and personal finance areas. From the corporate finance perspective, the DSCR is a reflection of a firm’s or borrower’s financial ability to pay off debts. From a personal finance perspective, it is used by bank loan officers in the underwriting process of income property loans.
So, what makes DSCR so important? Well, lenders usually assess and inspect a borrower’s DSCR before approving a loan.
Let’s first look at what DSCR actually tells us. The DSCR is Net Operating Income divided by Total Debt Service, giving us an idea of how financially viable and strong the borrower is in paying back the loan.
A DSCR value below 1 indicates a budget deficit, which means that the borrower doesn’t have sufficient income to fulfill their pending debt obligations, which might induce further borrowing. For example, a DSCR of 0.80 means that there is only enough net operating income to meet 80% of the annual debt payment leaving the borrower with no more income to fund the loan.
This can force him/her to spend their personal savings. On the other hand, a DSCR of above 1 means the borrower is able to pay off his/her annual debt payments with some income left to spare. This is usually a good sign, but not when the ratio is very close to 1 like 1.05 or 1.1. So, the DSCR is a useful tool for lenders to assess the borrower’s financial situation and risk as they apply for a CMBS loan.
Typically, Conduit lenders require a minimum DSCR of 1.25 for most property types. As an example, Hotels are usually underwritten to a minimum DSCR of 1.40. Naturally, the higher the DSCR the lower the risk. For example, properties like offices seem to be less risky than land investments due to the relatively lower costs the borrower would have to pay off.
Secondly, there is LTV, which is the ratio of the amount of money borrowed to the value of the commercial property. In other words, LTV is a comparison between the loans and the property’s value, which gives you an estimate of how much of the property you truly own relative to the loan.
Additionally, it is used by the lender to assess the amount of risk they may face. The higher LTV translates to a loan with higher risk. The higher the money borrowed relative to the value of the property, the more the amount the borrower has to return, which can be risky given their DSCR. The CMBS loans usually give LTV maximums of 75% to investors.
These two parameters are essential in the loan analysis, as they help the lenders decide whether to give the loan or not and the maximum loan they can extend. Apart from DSCR and LTV, borrowers need to present equity of around 30% to 40%, post-closing liquidity of 5% of the total borrowed sum, and a total net worth equal to at least 25% of the loan.
Expense ratios and vacancies in the market are also some additional factors. Moreover, the commercial property type the borrower is seeking to invest in and its location are also factors lenders generally look at when underwriting CMBS loans.
Risky properties like Hotels and Shopping centers pose more risk as borrowers may have lower DSCRs. For example, an investor with a $200,000 annual income and $400,000 potential debt would have a 0.5 DSCR. So buying a Hotel with such statistics won’t convince any lender to help that person out. However, smaller properties like an office or apartments pose less risk, due to their lower cost.
Other Guidelines
Apart from borrower-centric data, the CMBS lender also requires third-party reports, such as a full appraisal and Phase I Environment Assessment to analyze the property being bought and if it meets normal environmental standards.
Last but not least is the borrower’s experience in commercial real estate ownership and management. Lastly, borrowers need to be aware that they have to pay a large amount in legal fees, significantly higher than other real estate loans.
Photo by Tirachard Kumtanom