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Our Assets America® Resource Center provides information on a broad range of topics that affect commercial real estate (CRE) borrowers (i.e., developers, investors and sponsors). In this article, we explain how CRE borrowers can choose conduit loans (also known as commercial mortgage-backed security, or CMBS loans) to finance CRE projects. Read on to learn about the special characteristics of this specialized financing vehicle, and how they become securitized. A securitized loan is also pooled, packaged, and sold to commercial mortgage-backed securities investors.
Moreover, we’ll see why commercial real estate borrowers might prefer CMBS loans for their higher leverage and lower fixed rates. This is compared to traditional bank commercial mortgage loans. Also, we’ll describe how rules that govern the securitization of CMBS loans affect the characteristics of these loans.
What is a CMBS Loan?
A commercial mortgage-backed security loan is long-term financing, secured by a first-position mortgage lien, for a CRE property. Conduit lenders are the providers of CMBS loans. Typically, they consist of pension companies, life insurers, large banks, bank syndicates, and financial services firms. The lenders transfer their CMBS loans to conduits (described below) for securitization, allowing the lenders to maintain their liquidity. Property types that work well with CMBS loans include retail, office, multifamily, hotel, self-storage, industrial and warehouse properties. In other words, these are properties that provide steady revenues from rental operations. Critically, you must understand the difference between commercial mortgage-backed security loans (or conduit loans) and CMBS. That is, CMBS loans create the pools that collateralize the CMBS sold to investors.
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The REMIC Connection
To understand the characteristics of CMBS loans, you must appreciate the rules that govern their securitization. Explicitly, the legal structure of securitized CMBS loan pools is a real estate mortgage investment conduit (REMIC). In other words, what makes a CRE loan a CMBS loan is that it adheres to the REMIC tax laws for pass-through entities. To clarify, REMIC pass-through entities are trusts that do not pay income taxes. Rather, they pass taxes, as well as income and expenses, through to investors who purchase CMBS. Investors price CMBS based upon the pass-through taxation of the pooled CMBS loans. For this reason, CMBS loans must comply with REMIC regulations.
To recap, REMICs are the entities holding fixed pools of CMBS loans (and other assets) that collateralize the commercial mortgage-backed securities that REMICs issue to investors. When the REMIC assume a CMBS loan, the borrower deals with a master servicer rather than the loan originator. Therefore, the master servicer collects all future payments from the borrower. However, a special servicer may enter the picture if the borrower misses payments. Accordingly, the special servicer will attempt to modify the loan’s fees and/or terms. Or, the special servicer may allow the borrower to pay collateral to make up the shortfall.
Video: What is a CMBS Loan?
Pooling and Service Agreement (PSA)
Pursuant to a pooling and service agreement (PSA), REMICs collect the interest and principal payments flowing into the CMBS loan pools. The REMICs then forward the payments to the different classes of interests, or tranches, of CMBS. Each CMBS tranche has a designation (A-class, B-class, etc.) that reflects its seniority and therefore its coupon rate and terms. Explicitly, the most senior tranche (A-class) receives its payments first. It is then followed in order by the other tranches, in the so-called “waterfall” payment structure. Thus, the most subordinate tranche runs the highest risk of loss should interest and principal payments fall short of expectations. Frequently, this can occur when CMBS loan borrowers default on their loans or prepay them.
Characteristics of CMBS Loans
Typically, CMBS lenders have looser underwriting standards than those of banks. With exceptions, CMBS loans generally have the following characteristics to comply with REMIC regulations:
- A fixed interest rate, possibly with an interest-only period
- Amortization period of 25 to 30 years
- Term lengths of 5 to 10 years, occasionally 15 years
- Balloon payment at end of term
- Minimum loan amount of $2 million
- Maximum loan-to-value (LTC) ratio of 75%
- Minimum debt service coverage ratio (DSCR) of 1.25x
- Anticipated debt yield starting at 7%
- Minimum borrower net worth requirement of 25% of the loan amount
- Borrower post-closing liquidity of 5% of the loan amount
- Non-recourse loans (i.e., no personal liability for borrower) with bad-boy carve-outs. Bad-boy acts are acts that harm the property’s value and can trigger recourse.
- Loans are assumable, for a fee. For example, the owner of a property financed by this type of loan might want to sell the property. And, the purchaser must be willing to assume the loan. Crucially, this arrangement avoids any prepayment penalty.
- Typically, they do not permit secondary or supplemental financing.
- Require the borrower to set aside reserves for taxes, insurance and other purposes.
- Prepayment penalty structures of defeasance or yield maintenance.
Prepayment of CMBS Loans
These financing structures usually have one of these prepayment penalty structures, often at significant cost to the borrower:
- Yield Maintenance (YM): YM occurs when this the loan pays off and the mortgage note cancels before the maturity date. This structure seeks to allow bond investors to receive the same yield they would have gotten before prepayment. The Note of the Loan Documents specifies the payment. It comprises the loan’s unpaid principal amount and a prepayment penalty. The penalty is the spread between the loan’s original interest rate and the replacement rate (based upon Treasury rates). Typically, the minimum prepayment penalty is 1%.
- Defeasance: The CMBS loan and note remain in place. The defeasing firm substitutes the property with Treasury bonds as collateral. The loan then transfers to a Successor Borrower, a special-purpose entity, allowing the sale or refinancing of the property. The Treasury bonds’ cash flows cover future loan payments. When the average yield on the Treasury bonds exceeds that of the CMBS loan, it’s cheaper to purchase the bonds to cover the remaining principal and interest payments. The typical defeasance fee is $50,000 to $100,000, however, depending upon the size of the loan, it can be much greater than that.
The severity of these prepayment structures is greatest when substantial time remains until the maturity date. This prepayment is also rather severe if the U.S. Treasury bond market falls substantially.
The Current CMBS Market (2019)
The first half of 2019 saw a 7.5% decline in the U.S. conduit CMBS market to just 21 deals. Additionally, there were 42 single-borrower deals, 2 small-balance deals and 1 large loan. There were no pooled floating-rate deals during the period. Most of the decline ties to the hotel and retail sectors. The big winner was industrial real estate, and the office and multifamily sectors registered small gains. Single borrowers accounted for 69.9 percent of CMBS market. Next came multiple borrower floating-rate deals at 19.1%. Lastly, 11.1% of deals stemmed from multiple-borrower, fixed-rate deals. CMBS market volatility was above average during the first half of 2019.
CMBS Spreads
A spread is the difference between the yields on two different securities. You can look at a CMBS spreads chart to see the CMBS spreads over swaps and CMBS spreads over Treasuries. You can see an example of a CMBS spreads chart at the Mortgage Bankers Association. Typically, the chart shows the spreads in basis points (bps) with CMBS yields above those for swaps and Treasuries. The CMBS spread over swaps has declined in recent years across the credit-quality curve. Naturally, the spread for the highest-rated bonds is the lowest, often below 100 bps (basis points). As ratings descend to BBB-, spreads increase to 500 or more bps. Currently, that spread is between 200 and 300 bps. Naturally, the CMBS spread over Treasuries is larger because Treasury debt has the highest rating and lowest yields.
Summary of CMBS Loans
CMBS loans are commercial mortgages that meet the necessary criterion for securitization. They offer easy underwriting, relatively high leverage and low-interest rates. They are fully assumable and non-recourse, and offer cash-out refinancing. Unsurprisingly, these characteristics make CMBS loans a popular option for commercial real estate deals. The biggest downside is the prepayment penalty, which can be substantial. Bottom line, if you plan to hold your commercial real estate for the duration of a CMBS loan period, it can be an excellent financing vehicle.