What Is CMBS?
CMBS or Commercial Mortgage-Backed Securities are basically fixed-income investment products that are backed by loans on commercial properties. CMBS offers a form of security to investors as it provides them with interest-paying bonds, which are beneficial for them and a great repaying option for lenders.
CMBS is created by combining a group of commercial loans and selling them in a secure form as bonds. These bonds are ranked from the highest-rated and lowest-risk to the lowest-rated and highest-risk. The risk here refers to the borrower’s inability to pay off a loan.
Features Of CMBS Loans
CMBS loans are generally used to purchase commercial real estate buildings like office buildings, shopping centers, hotels, and warehouses. Usually, the minimum amount of a CMBS loan is $2 million and the maximum is determined in the underwriting segment of the process.
The lender assesses the borrower’s credit risk, their cash flow or income relative to debts due, and their experience in the commercial real estate market.
CMBS loans come with fixed interest rates, which over the years, have been hovering in the 4-5% range while going as low as 3% in some markets. These loans are non-recourse, which simply means the borrower is not liable for any loss since the real estate is usually responsible for taking care of this loan. Although the lender can use the commercial property and its generated profits as a means of repaying the loan, the borrower is usually not liable for any loss and is not held responsible for failing to meet the terms and obligations.
These loans are also fully assumable, which means if the borrower sells their property, the loan can be passed onto the new buyer.
How Do Commercial Mortgage-Backed Securities Work?
Now let’s take a look at how CMBS loans actually work. Let us look at a scenario where a real estate investor or business owner wants to purchase a commercial property. They find a bank that agrees to fund their purchase by issuing a mortgage or a loan.
The bank then takes this loan and merges it with other commercial loans into a trust called a Real Estate Mortgage Investment Conduit (REMIC), where they are converted into bonds. Bonds are an assurance issued by a financial institution that promises to repay borrowed money at a fixed interest rate. The generated bonds are sold to investors at a price depending on their rating in a process called securitization.
Here, the bonds are ranked from highest value to lowest value and sold to investors accordingly. The money earned from selling bonds is usually used to repay the original lender. From this moment onwards, the borrower no longer works with the lender but with a dedicated CMBS servicer known as the Master Servicer.
The Master Servicer is responsible for handling the repayment of the loan, which includes collecting payments and resolving any other issues. If in the event the borrower faces trouble paying back, the loan is passed onto another loan servicer called a Special Servicer who tries to adjust the terms of the loan that are easier for the borrower to manage and are still beneficial for the bond investors.
Advantages Of CMBS Loans
Now, when it comes to commercial real estate ownership and management, CMBS loans are usually preferred over traditional commercial loans. To understand the reason for this, let’s take a look at some of the advantages these loans have to offer. Unlike traditional lenders who might exclude borrowers with poor credit, a record of bankruptcy, and pending debts, CMBS loans are open to a wide array of borrowers regardless of the stringencies in traditional loans.
Moreover, Commercial Mortgage-Backed Securities loans are non-recourse, meaning if a borrower defaults (unable to meet the terms of the loan, e.g., principal amount and interest payments) on their loan, the lender cannot go after their property in order to repay the debt. Simply put, the borrower is not held personally responsible for paying the loan. That does not mean the borrower can harm the property or else the lender or the bond investors can hold them liable.
CMBS loans are assumable, meaning if the borrower decides to sell the property, they can pass on the loan and the CMBS financing to the buyer. However, lenders usually do charge a fee for this process.
CMBS loans show their superiority over traditional loans with their higher leverage rates and interest rates. With up to 75% leverage and attractive interest rates, they outshine what traditional commercial bank loans and government bonds have to offer. And as they are fixed-term, the borrower cannot repay the loan early without a penalty.
Another key advantage is that CMBS loans permit cash-out refinancing, which is fantastic for borrowers, especially businesses that want to extract equity out of their commercial properties in order to renovate them or use those funds to expand their business. The securitization process is essential as it enables banks to lend out more loans and bond investors to invest more with the extra money generated.
Last but not least, CMBS lenders offer flexible underwriting guidelines, allowing real estate investors to be financed according to their unique and specific needs instead of not fulfilling requirements for a traditional standard loan and thereby getting rejected.
Disadvantages Of CMBS Loans
On the other hand, there are some disadvantages associated with these loans. One of the biggest ones is getting out of the loan early. With no prepayment flexibility, it gets difficult for a borrower to get over with the loan early. Some of the CMBS loans feature a penalty known as Yield Maintenance which refers to paying a percentage-based fee to settle the loan.
However, most of these loans require Defeasance, which means the borrower will purchase bonds that will be repaid to the bondholders in keeping with the identical revenue stream as that of the duration of the loan term. This can get expensive for the borrower if the lender and investor require that the loan be replaced with U.S. Treasury bonds instead of less expensive ones.
Moreover, with so much flexibility given to the borrower, if they decide to default, the people who invested in the bonds in the CMBS would be at a loss. Similarly, supplemental and secondary financing is generally prohibited as increased leverage may pose a risk to bond investors.
CMBS loans, when compared to traditional bank loans, bring a lot of benefits and perks to the table and if a person has done his homework and has the right strategy, he/she can make full use of the CMBS loan without worrying about defaulting. And if we take a neutral stance, CMBS loans, apart from their complexities, are more borrower-welcoming with room for negotiation on the loan terms, unlike the stringent policies of traditional loans.
Photo by Binyamin Mellish