CMBS Loans

Non-Recourse, High-Leverage Apartment Financing for Multifamily Investors

While Fannie Mae, Freddie Mac and HUD apartment loans generally provide the lowest-cost financing available on the market today, they aren't ideal for everyone. For one, high net worth and liquidity requirements may prove a barrier for entry for many investors. In addition, HUD and agency loans are generally only available for strictly multifamily properties (typically with a small commercial component allowed), while mixed-use properties with a heavy commercial component usually do not qualify. For investors in either scenario, CMBS loans, also referred to as conduit loans, may be an ideal solution.

In addition to being a good choice for borrowers with a lower net worth or those looking to finance mixed-use properties, CMBS loans can also be an excellent choice for borrowers with credit or legal issues. As CMBS financing is generally asset-based, lenders are not as concerned with borrower qualifications and are typically more interested in the financial stability of the property itself.

How CMBS Loans Work

Unlike some other types of apartment financing, CMBS loans are securitized (pooled into a large group of CMBS loans) and are then sold to investors on the secondary market. This is good for lenders, who can, for the most part, wipe their hands clean of the risk associated with holding the loan. However, this can make things complicated for borrowers. Because conduit loans are packaged together and sold to investors, they're not serviced by the lender that initially issued them. Instead they're serviced by a third-party firm, usually referred to as a Master Servicer. These firms have a reputation for inflexibility and may not be willing to offer loan modifications (as a bank or agency lender occasionally might) in the case of financial hardship.

Traditionally, if a CMBS loan goes into default, the Master Servicer will actually send the loan to be serviced by a different company, a Special Servicer. The Special Servicer will determine whether the loan can be reasonably modified or whether they should initiate foreclosure proceedings on behalf of investors.

CMBS Prepayments, Property Types and Subordinate Debt

CMBS apartment financing is generally available in the form of 10-year fixed-rate loans, though other types of conduit loans exist, albeit more rarely. When it comes to paying off a CMBS loan early, borrowers can generally choose between yield maintenance and defeasance. Yield maintenance requires borrowers to pay the lender (or in this case the investors) the same yield as if the borrower was making all the loan's scheduled payments. In contrast defeasance requires the borrower to replace the loan's collateral with a sufficient amount of comparable, income-producing securities (often U.S. Treasuries).

CMBS Apartment Loan Terms

Loan Size: Generally $2 million+
Loan Term: Typically a 10-year fixed-rate loan (though other term lengths may be available)
Amortization: 20-30 years
Pricing: Starting at 200bps over the relative swap rate or Treasury
Amortization: 25-30 years
Leverage: 75% Maximum LTV
DSCR: Minimum 1.25x DSCR
Debt Yield: Minimum 6.5% DY
Recourse: Loans are generally non-recourse with standard “bad boy” carve-outs
Reserves: Insurance, taxes, leasing costs and replacement reserves are often required, though this varies on a deal-by-deal basis.
Prepayment: Yield maintenance or defeasance

Advantages:

Competitive interest rates.
Loans are non-recourse.
High leverage; typically up to 75% LTV.
Flexible loan sizes.
May be ideal for borrowers with mild credit or legal issues.
Qualified borrowers often have the option of adding mezzanine debt or preferred equity to their capital stack to increase leverage.
CMBS loans are generally fully assumable.
Cash-out refinancing available.

Disadvantages:

Loans can be pricey to exit.
Loans will not be serviced by the borrower's original lender.
Borrowers may face restrictions as to how they operate their property.
One to two-year lock-outs may prevent prepayment.

Secondary and conduit financing for apartments

A conduit loan is a commercial mortgage made in order to be sold. The lender originates it, holds it briefly, then pools it with other loans into a trust that issues commercial mortgage-backed securities (CMBS) to bond investors. "Secondary" refers to that sale: the loan is funded in the primary market between you and the lender, then sold into the secondary market where investors buy the bonds. The lender is a conduit between the borrower and those investors, which is where the name comes from.

Who conduit lenders are

Conduit loans are originated by investment banks, large commercial banks and specialty finance companies that run CMBS lending programs, often through mortgage brokers. Unlike a bank holding a loan on its balance sheet, a conduit lender is underwriting to what the bond market will buy, so its standards are written around predictable cash flow, a clean title and borrower entities that can be relied on for ten years.

How a conduit loan is pooled and sold

Origination. The lender underwrites and closes your loan using standardized documents, with a single-purpose borrowing entity.
Aggregation. The loan sits on the lender's books with dozens of others until there are enough to fill a securitization, usually alongside loans on offices, retail, hotels and other property types.
Review by the subordinate bond buyer. The investor buying the riskiest bonds reviews the loans before the deal prices and can ask for loans to be removed. This is one reason conduit lenders underwrite conservatively and avoid unusual structures.
Securitization. The pool goes into a trust that issues bonds in tranches, from senior to subordinate. Federal risk-retention rules require the sponsor to keep a portion of the credit risk, generally 5%, or have an eligible third party hold it.
Servicing. From then on you deal with the trust's servicers, not the lender that made the loan.

Most CMBS trusts are structured as REMICs, a tax classification that limits significant modifications to a performing loan. That, rather than servicer attitude alone, is why changes that a bank might approve with a phone call often cannot be made on a conduit loan.

Honest pros and cons for 5+ unit owners

For a typical stabilized apartment building of five or more units, Fannie Mae and Freddie Mac usually offer the more flexible package: apartment-only underwriting, programs designed for smaller loans, supplemental loan options and in many cases more prepayment choices. CMBS earns its place in specific situations:

Mixed-use buildings with more commercial space than the agencies accept, because conduits lend on every property type.
Sponsors who do not fit agency requirements on net worth, liquidity or credit history, since conduit underwriting leans on the property.
Non-recourse at full leverage when a bank would require a personal guarantee.
Assumability, which can help a later sale when the loan's rate is below market at the time.

Against that, weigh the costs that show up later rather than at closing:

Prepayment is usually defeasance or yield maintenance, with a lockout period after securitization. If you might sell or refinance within the term, price the exit before you sign. The defeasance calculator does this.
No changes after closing: adding a loan, releasing part of the collateral or restructuring through a hard patch all go through servicers working within the trust's rules.
Cash management and reserves can be triggered by DSCR or debt yield falling below set levels, sweeping excess cash into a lender-controlled account.
Cost of a small loan. Legal, servicing and third-party costs on a conduit loan are relatively fixed, so they weigh more heavily on a smaller loan.

For a side-by-side on proceeds, prepayment, recourse and servicing, see agency vs CMBS apartment loans. Background reading: conduit financing, securitization and single-asset single-borrower CMBS. Federal rules referenced above: the credit risk retention rule and the REMIC qualified mortgage regulation.