What Are Commercial Mortgage-Backed Securities (CMBS)?
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.
Because there are no uniform rules for structuring CMBS, their valuations can be complex. The underlying securities of CMBS may include a diverse array of commercial mortgages of varying terms, values, and property types—such as multi-family dwellings and commercial real estate. CMBS can offer reduced pre-payment risk compared to residential mortgage-backed securities (RMBS), as the term on commercial mortgages is generally fixed.
Key Takeaways
- CMBS are secured by mortgages on commercial properties rather than residential real estate.
- Commercial mortgage-backed securities are issued in the form of bonds, with underlying loans typically contained within trusts.
- The loans in a CMBS act as collateral, providing principal and interest payments to investors in the event of a default.
How Commercial Mortgage-Backed Securities (CMBS) Work
Much like collateralized debt obligations (CDO) and collateralized mortgage obligations (CMO), CMBS are structured as bonds. The mortgage loans forming a single commercial mortgage-backed security act as the collateral in the event of default, with principal and interest payments passed on to investors.
The loans are generally contained within a trust, encompassing varied terms, property types, and loan amounts. The underlying loans securitized into CMBS include loans for properties such as apartment buildings and complexes, factories, hotels, office buildings, office parks, and shopping malls, often within the same trust.
A commercial mortgage loan is generally considered a non-recourse debt—meaning it is secured only by collateral. In case of default, the lender cannot seize any assets of the borrower beyond the collateral.
Due to the intricacies of CMBS, they require a variety of market participants, including investors, primary servicers, master servicers, special servicers, directing certificate holders, trustees, and rating agencies. Each role is crucial in ensuring that CMBS perform effectively.
Types of CMBS
The mortgages backing CMBS are classified into tranches based on their levels of credit risk, typically ranked from senior—signifying the highest quality—to lower quality tranches.
- Senior tranche: The senior tiers are first in line for repayment, meaning they carry a lower risk profile and thus pay lower interest rates.
- Mezzanine tranche: These tranches carry more risk but offer higher yields. In the event of a default, these investors are repaid after those in the senior tranche.
- Equity tranche: This is the riskiest part of a mortgage-backed security but offers the highest potential gains.
Tranches lower in the structure contain riskier, potentially speculative loans. The securitization process in structuring a CMBS benefits both banks and investors by allowing more loan issuing and easier access to commercial real estate investments.
Investors should note that, in cases of loan defaults within a CMBS, senior tranches must be completely paid off before lower tranches receive any proceeds.
Components of a CMBS
Beyond the underlying mortgages, several terms in a CMBS contract can influence its profitability. Factors for consideration by investors include:
- Interest rates: CMBS loans typically come with fixed interest rates, often featuring favorable initial payment periods.
- Term length: Typically ranging from 5 to 10 years and often concluding with a balloon payment. Term length depends on various factors, such as the borrower’s credit risk and cash flow.
- Prepayment penalties: These penalties incentivize borrowers to continue regular mortgage payments rather than paying off the loan early.
Criticism of CMBS
Wealthy investors predominantly invest in CMBS due to limited availability for the average investor. Mutual funds or ETFs focusing solely on this asset class are rare, though some real estate mutual funds include CMBS.
Requirements for CMBS
In December 2016, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) instituted new regulations creating margin requirements for covered agency transactions, including collateralized mortgage obligations, to mitigate CMBS risks.
Advantages and Disadvantages of a CMBS
As with any debt securities, investing in CMBS entails certain risks and benefits.
Fixed Interest Rates
CMBS loans typically feature fixed interest rates, ensuring consistent repayment amounts throughout the loan term—beneficial for commercial borrowers who may not see revenues rise alongside loan terms.
Nonrecourse
CMBS loans are non-recourse, meaning borrowers aren’t personally liable if they fail to repay. However, scenarios such as fraud or misrepresentation allow investors recourse against borrowers.
Loan Assumption
When a commercial property is sold, the new owner can assume the previous owner’s loan for a fee, easing property transactions without requiring new loans.
Prepayment Penalties
Borrowers incur penalties for early loan repayment to compensate investors for expected future interest. These penalties often exceed those seen in residential mortgages.
Defeasance
Some CMBS include defeasance clauses, requiring borrowers who repay early to replace the lost collateral and interest with similar securities. For instance, a borrower might need to buy Treasury securities to offset the prepaid loan’s lost interest.
Pros and Cons of Commercial Mortgage-Backed Securities
Pros
- Fixed interest rates
- Non-personally liable for loan failures
- Loans can be passed on to new property buyers
Cons
- High prepayment penalties
- Requirement for alternative collateral for early repayment
Differences Between CMBS and RMBS
Residential Mortgage-Backed Securities (RMBS) differ from CMBS by being secured by residential real estate loans, such as for homes and apartments. CMBS, on the other hand, are backed by commercial real estate like office buildings, shopping malls, and other business spaces.
Risks Involved in CMBS
The primary risk for CMBS investors is the potential default of underlying loans, as these non-recourse loans do not hold borrowers personally liable.
Main Benefits of CMBS
The principal advantage for CMBS investors is the reliability of cash flows from a fixed interest rate. Prepayment penalties ensure continued interest payments, adding to investment stability.
Conclusion
Commercial mortgage-backed securities (CMBS) represent a complex and diverse investment class backed by bundles of commercial loans. Payments made by borrowers serve to repay CMBS investors, offering consistent cash flow and fixed rates.
Related Terms: Residential Mortgage-Backed Securities (RMBS), Collateralized Debt Obligations (CDOs), Collateralized Mortgage Obligations (CMOs).
