CMBS Explained

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

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.

Advantages of CMBS Financing

  • 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

Disadvantages of CMBS Financing

  • 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