CMBS loans in Apartment Investing
CMBS loans are fixed-income investments that utilize commercial real estate loans as collateral.
Of all of the financing options that investors turn to for the acquisition of an apartment property, an increasingly popular option in recent years involves commercial mortgage-backed securities loans, also known as CMBS or conduit loans. In order to get a better understanding of why so many investors turn to CMBS financing, this article explores the attributes and nuances that make this financing vehicle so desirable.
What Are Commercial Mortgage Backed Securities?
Simply put, CMBS loans are fixed-income investments that utilize commercial real estate loans as collateral. The collateralized loans are those typically used to finance commercial properties such as residential apartment buildings, malls, office space, hotels, and even industrial assets.
CMBS loans are secured by a first-position mortgage — which is a mortgage that is the first debt in sequence to be repaid. In CMBS financing, these types of loans are bundled together in a group. These larger groups are then packaged to be sold on a secondary market as secured bonds. Each of these bonds is then categorized in what are known as tranches, organized by the level of risk involved.
CMBS loans are usually originated with fixed interest rates. In some cases, lenders may include an interest-only payment period. Interest rates for CMBS financing are generally based on the Treasury swap rate — with the inclusion of a spread, which serves as the lender’s profit. The typical amortization length for a CMBS loan is 25 to 30 years, and there is often a balloon payment that the investor must pay as the loan matures.
CMBS Tranches
Commercial mortgage-backed securities are classified by lenders into tranches, which are organized by level of credit risk — ranging from the higher tranches with the lowest risk to the lower tranches with the highest risk. The level of risk is based on potential returns, borrower risk profiles, and details of individual investments in the security.
Loans with the highest-quality credit rating — being the least risky for investors — are placed in the highest tranches and classified as “senior.” These tranches are prioritized as the first to be repaid with principal and interest payments. Similarly, the lowest-rated and riskiest loans are placed in the lowest tranches. Higher tranches typically offer lower interest rates and lower returns for investors, while the lower tranches generally offer higher interest rates but with higher potential returns for investors. That said, investors in CMBS bundles of the lower-risk tranches receive their principal and interest payments first. Similarly, in the event of a default on one or more loans bundled in a commercial mortgage-backed security tranche, the highest tranches (lowest risk, highest quality credit rating) must be fully paid off, with interest, before the lower tranches can receive any funds.
CMBS Loans and Prepayment Penalties
When it comes to conduit financing, borrowers can expect to face prepayment penalties — defeasance, yield maintenance, or a step-down prepayment schedule — for loans paid before their maturity date. These prepayment penalties are put in place as a means of dissuading borrowers from paying their loans off early, and, by extension, preventing the bondholders from receiving their scheduled returns. While other financing vehicles also utilize prepayment penalties, CMBS loans are unique in that they typically have prepayment penalties in place for almost the entire term of the loan.
Loan Assumption
Borrowers can escape paying prepayment penalties through a process called loan assumption. Loan assumption is when a property owner sells an asset, but in a manner that sees the buyer bound by the original loan documentation, allowing them to pick up where the seller left off. The assumability of a loan negates the need for a prepayment penalty, providing more exit flexibility for borrowers and less prepayment risk for bondholders — a prime reason why most CMBS loans are originated to be assumable.
Eligible Properties for CMBS Financing
Commercial mortgage-backed securities are primarily available for the financing of any income-producing commercial property. This includes:
- Multifamily assets (including mixed-use properties)
- Hospitality assets
- Office assets
- Retail assets
- Industrial assets
- Flexible underwriting guidelines
- Fixed-rate financing
- Fully assumable
- Lenders and bondholders can potentially achieve a higher yield on investments
- Investors can choose which tranche to purchase, allowing them to work within their own risk profiles
- Not serviced by initial CMBS lender
- Strict enforcement of prepayment penalties
- Higher closing costs
- Dishonest tranche ratings can have serious negative effects for borrowers and investors
What are the benefits of CMBS loans for apartment investors?
CMBS loans offer a number of benefits for apartment investors, including:
- Flexible underwriting guidelines
- Fixed-rate financing
- Fully assumable
- Lenders and bondholders can potentially achieve a higher yield on investments
- Investors can choose which tranche to purchase, allowing them to work within their own risk profiles
Additionally, CMBS loans offer the potential for cash-out for eligible borrowers, as well as allowing borrowers to procure financing for fully commercial or mixed-use properties.
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What are the risks associated with CMBS loans?
The major downside of CMBS loans is the difficulty of getting out the loan early. Most, if not all CMBS loans have prepayment penalties, and while some permit yield maintenance (paying a percentage based fee to exit the loan), other CMBS loans require defeasance, which involves a borrower purchasing bonds in order to both repay their loan and provide the lender/investors with a suitable source of income to replace it. Defeasance can get expensive, especially if the lender/investors require that the borrower replace their loan with U.S. Treasury bonds, instead of less expensive agency bonds, like those from Fannie Mae or Freddie Mac.
In addition, CMBS loans typically do not permit secondary/supplemental financing, as this is seen to increase the risk for CMBS investors. Finally, it should be noted that most CMBS loans require borrowers to have reserves, including replacement reserves, and money set aside for insurance, taxes, and other essential purposes. However, this is not necessarily a con, since many other commercial real estate loans require similar impounds/escrows.
What are the requirements for obtaining a CMBS loan?
In general, lenders look at two major metrics when deciding whether to approve a CMBS loan; DSCR and LTV. However, they also look at debt yield, a metric which is determined by taking the net operating income of a property and dividing it by the total loan amount. This helps determine how long it would take a lender to recoup their losses if they had to foreclose on the property. And, while it’s true that CMBS loans are mostly income based, lenders still typically require a borrower to have a net worth of at least 25% of the entire loan amount, and a liquidity of at least 5% of the loan amount.
Unlike borrowers for commercial bank loans, CMBS borrowers will not continue to deal with the same lender that originated their loan during the remainder of its life; instead, they will have to work with a loan servicer, referred to as a master servicer. If a borrower defaults on their loan, they will have to work with another type of servicer, known as a special servicer. This is not always ideal, as a special servicer will generally put the investor’s needs (and their interests) above the needs of the borrower.
By and large, the most time consuming part of CMBS origination is the underwriting process, which is intended to determine whether a borrower presents a reasonable credit risk to a lender. A lender will require third-party reports, such as a full appraisal and Phase I Environmental Assessment, and will check into a borrower’s credit history, net worth, and commercial real estate experience. While borrower credit, net worth, and experience requirements are significantly less strict for conduit loans than for bank or agency loans (i.e. Fannie Mae and Freddie Mac), having good credit and some commercial real estate ownership/management experience certainly helps.
To summarize, the requirements for obtaining a CMBS loan are:
- DSCR and LTV
- Debt yield
- Net worth of at least 25% of the entire loan amount
- Liquidity of at least 5% of the loan amount
- Third-party reports, such as a full appraisal and Phase I Environmental Assessment
- Check into a borrower’s credit history, net worth, and commercial real estate experience
What are the advantages of CMBS loans over traditional bank loans?
CMBS loans have several advantages over traditional bank loans. First, they are available to a wide swath of borrowers, including those that might be excluded from traditional lenders due to poor credit, previous bankruptcies, or strict collateral/net worth requirements. Plus, CMBS loans are non-recourse, which means that even if a borrower defaults on their loan, the lender can’t go after their personal property in order to repay the debt. In addition, CMBS loans offer relatively high leverage, at up to 75% for most property types (and even 80% in some scenarios).
Perhaps most importantly, CMBS loan rates are incredibly competitive, and can often beat out comparable bank loan rates for similar borrowers. CMBS loans are also assumable, making it somewhat easier for a borrower to exit the property before the end of their loan term. Finally, it should definitely be mentioned that CMBS loans permit cash-out refinancing, which is a fantastic benefit for businesses that want to extract equity out of their commercial properties in order to renovate them, or to get the funds to expand their core business.
Unlike borrowers for commercial bank loans, CMBS borrowers will not continue to deal with the same lender that originated their loan during the remainder of its life; instead, they will have to work with a loan servicer, referred to as a master servicer. If a borrower defaults on their loan, they will have to work with another type of servicer, known as a special servicer. This is not always ideal, as a special servicer will generally put the investor’s needs (and their interests) above the needs of the borrower.
How do CMBS loans compare to other types of apartment financing?
CMBS loans, or conduit loans, typically provide lower interest rates and have some of the most lenient borrower requirements of all multifamily loan options. The minimum loan amount for CMBS loans is a little higher, generally starting at $2 million, though exceptions are sometimes made. As is the deal with many types of commercial loans, CMBS loans are pooled together and securitized, then sold to investors on the secondary market. These loans are not serviced by the original lender, rather, they are assigned to a separate servicing company. This transfer can sometimes create headaches for CMBS apartment loan borrowers. CMBS loans, like HUD multifamily and agency loans, are generally non-recourse.
Keep in mind that banks, agencies, HUD, and conduit lenders aren’t the only types of apartment lenders available, but they’re generally the only types of lenders suitable for a first time apartment buyer. Some options for more experienced multifamily investors include life company loans, which offer long, fixed-rate terms at super low rates (but typically only want highly experienced investors), and hard money loans, which typically have extremely high interest rates, but are some of the only financing vehicles accessible to borrowers with credit or legal issues. For investors who want additional leverage on larger deals, borrowers are sometimes able to layer a CMBS or bank loan with an additional, second-position loan. This is known as a mezzanine loan, though this too is also not generally ideal for first time investors.
While this list is not exhaustive, many other property types fall into the larger categories listed above. There are also assets like parking garages and marinas that are a bit harder to classify. Regardless, as they are all examples of income-producing commercial properties, they are also eligible for CMBS financing.