All About CMBS Loans And How They Work
A CMBS loan, or Commercial Mortgage-Backed Security, is a fixed-income security that is typically in the form of a bond, which uses commercial real estate loans as collateral. CMBS loans are for commercial properties and not single-family homes. These are created when a bank takes a bundle of loans- organized in tranches- and sells them in a series of securitized bonds. This process enables banks to provide higher-yielding alternatives to institutional investors.
CMBS loans, as opposed to residential mortgage-backed securities (RMBS) do not present a pre-payment risk to the holder considering commercial mortgage loans have a fixed term. When an investors buy a CMBS, they receive the interests and repayments of these mortgages as payments and they take on the borrower’s risks of default, or non-payment. Tranches tell the investor about the rating and risk associated with any given loan. Since these are higher-yielding than government bonds, it makes it easier for commercial borrowers to access funds. The terms of CMBS loans can last anywhere from 5-15 years (although 15 years is a rare exception) and have a 25-30 year amortization. Also, because the term doesn’t match the amortization period the loan balance will either need to be paid off or refinanced. Depending on market conditions, either a portion or all of the term is interest-based.
Yield Maintenance and Yield Defeasance are two prepayment penalty structures. Prepayment risk will potentially cause borrowers to refinance and pay back their mortgages earlier due to falling interest rates. As a result, investors will receive a lower-yield than anticipated. Since the finances behind CMBS loans can’t be repaid early by the borrower without penalty, CMBS generally does away with considerably lower prepayment risks than RMBS. Yield Maintenance is when a loan is actually paid off and the mortgage note is cancelled, whereas Yield Defeasance is when the source of collateral is substituted with a treasury bond that is transferred to a special purpose entity, also known as a “Successor Borrower.” Both penalty structures have the potential to cause the borrower to incur considerable monetary penalties when the loan is prepaid before the maturity date. Anticipation of future markets and expected hold time should be considered when contemplating the term for these types of loan structures.
While CMBS allow lenders to provide borrowers with additional loan product, it also maintains their liquidity position. With flexible underwriting guidelines, CRE investors that are unable to meet strict conventional liquidity and net worth procedures, can invest in commercial real estate due to commercial mortgage-backed loans.